Trust Funds For Kids

Like the famous Seinfeld episode where Kramer struggles to figure out how to profit from the fact that Michigan offers a 10 cent return on recycled bottles, I have been starting at this ad from Interactive Brokers for some time now. This had has been run in myriad financial papers and I have seen it all over the place. It is notable for the fact that it looks like it was drawn “on the back of a napkin” like the fabled dot-com business plans.

The specific elements of the investing plan are as follows:
- Interactive brokers can make margin loans at 1.25% annual interest. This LOW rate of interest is made possible by the country’s current super-low rate policy
- Some stocks are offering dividends as high as 5%. In the current low interest rate environment (you are likely to get 2% on CD’s & government paper, and almost nothing on your money market and bank deposits), that 5% rate seems very enticing, especially since dividends are taxed more favorably on individuals than interest income (dividends are as low as a 15% rate, while interest income is as high as 35%+)
- Interactive brokers will offer you LEVERAGE. By leverage, this means that they will LOAN you more money than you have in your brokerage account so that you can invest and magnify your returns, either UP or DOWN

Using this method, the specific “napkin” offer is as follows:

- You put up $100,000 of money in a brokerage account
- Using that money as collateral, you borrow $400,000, or 4X leverage
- Now you have $500,000 in your account to invest with
- Pick 5 stocks yielding 5% or more, and invest $100,000 in each stock
- Your stocks should then bring in ($500,000 * 5%) = $25,000 / year in income
- The interest on your $400,000 that you borrowed from Interactive Brokers costs you ($400,000 * 1.25%) = $5000 / year in expenses
- Your net income is $25,000 – $5000 = $20,000 / year
- $20,000 / year in income on an investment of $100,000 is a 20% annual yield, at a time when you can only earn maybe 2% risk free. This is a substantial return

The first thing people would ask is WHY Interactive Brokers would lend out $400,000 on a $100,000 investment at such a low rate? From a margin account perspective, Interactive Brokers doesn’t take much risk. Let’s say the value of all the stocks fall 10%. In this model, your portfolio value has dropped from $500,000 to $450,000. While your equity (investment) has shrunk from $100,000 to only $50,000, they haven’t taken a loss yet, because they can step in and liquidate your portfolio in the open market, take back their $400,000 (including the accrued interest to date plus any fees they want to charge), and hand you back your remaining cash. As long as they “pull the trigger” to liquidate the positions before it reaches the $400,000 mark (or nearby, so that they get their interest and fees), they will be made whole.

This example indicates the “down side” of leverage. When the markets go against you, and your equity component is but a sliver of your total portfolio, even small market moves can kill you. At some level this is what caused the banking crisis in late 2008; the large institutions had little equity capital and super high levels of debt (more than 30X their equity available, depending on what you count as equity capital), meaning that even a small crisis of confidence or repayment risk started to topple the entire structure. You might ask WHY these banks, whose depositors are guaranteed by the US government (FDIC) and who are so central to our financial system that they cannot be allowed to fail could leverage up so much, but that is grist for another post (failed regulation).

One question that I started asking as I stared at the napkin – how many quality companies are there out in the market that pay greater than 5% dividend yields? I am looking for companies with a reasonably strong share price and a history of paying high dividends, not companies that paid a modest dividend but whose stock price has fallen so far that it SEEMS like they offer a high dividend (these are unstable dividend payers who likely will lower their dividend at some point in the future).

Using the cool Google Finance stock screener, I put in a criteria of stocks with a greater than 5% yield, more than $1B in market cap, and that they couldn’t have had a 52 week return of worse than -20% (to screen out ones that have a big dividend yield because their price has been plummeting). I was surprised that there were a number of major companies offering such high yields, including:

- AT&T (T) at 6.62%
- Altria (MO) at 6.9%
- Southern Company (SO) at 5.38%
- Bristol Myers Squibb (BMY) at 5.2%

So at least there were a number of reasonable candidates for this sort of analysis. You can see how the value of a company paying out dividends this high would rise in our current minuscule interest rate environment. On a personal note, when an ETF specializing in dividend paying stocks, DVY, came out about 5 years ago – I jumped in right away, figuring that it would be a good play with the reduction in taxes on dividend payments to 15%. However, this fund essentially loaded up on financial firms, which were viewed as reliable dividend payers, and was socked during the financial meltdown when many of the components either vanished or were severely punished.

So far the “back of the napkin” has checked out – the real issue, however, is that we are mixing “apples and oranges” by seeking yield with a volatile assets. The 5 stocks (in this example) could easily drop by 10% in a narrow range of time, essentially making Interactive Brokers enact a margin call (they aren’t going to wait until you have zero equity in your account, at that point you’d be levered up 9 to 1). What you are betting on is that you can hold these assets and that they’ll trade in a narrow range (or up, a situation that we’ll get to next) for a reasonable amount of time, in fact at least a year or so in order to obtain that yield.

The flip side is that if stock prices go UP, you will have a bonanza on your hands. In addition to the 20% yield that you’d earn if you were able to hold for a year, you’d get gains on both your money and the money you borrowed. If stocks went up 10%, your gain would be ($550,000 – $400,000 borrowed money – $100,000 original investment) = $50,000 on a $100,000 investment, or a return of 50% (on top of the 20% yield you’d receive). This is the “magic” of leverage – I saw an analysis one time that compared the S&P 500 return against hedge funds and if you levered up the S&P 500 with this sort of margin you’d receive returns that would give the hedge funds a run for their money (they almost all use leverage, too).

The odds that this basket of stocks will decline by 10% or more, causing IB to liquidate your holdings to pay off the margin call, is pretty high. The yield play is really secondary to how long that you can avoid that sort of a down turn. On the other side, gains are very beneficial in this model. It probably doesn’t make sense to mix yield with leverage to this degree, unless you are a professional investor and this is only a small part of your broader portfolio.

The low interest rates that we have today encourage risk taking because the government has set the rates so low. With low rates, virtually any business model with any sort of return looks at least feasible on a napkin.

Personally, I was pretty impressed by the number of solid-looking companies paying such high dividends. Even with zero leverage, a 5% return is great, especially since the effective tax rate is 15% on these dividends (for now, at least, until the tax cuts are rescinded which is likely in 2011). The issue is that even a small market downturn will make that 5% return moot, if these stocks fall harder than a general corporate issue.

This ad certainly did make me think about a lot of things; the power of leverage; the ability of a low interest rate environment to make almost any business idea sound good; and what is driving these companies to such a high dividend payout ratio.

Cross posted at LITGM and Trust Funds for Kids

In this article titled “Why Many Investors Keep Fooling Themselves” by Jason Zweig from the Wall Street Journal, Mr. Zweig does an excellent job of explaining why individuals assume that they will receive a rate of return that is too high, which means that either they are not saving enough to meet their goals or that they are taking too much risk of running out of money.

This post describes what the rate of return means in practical terms, and why it is important.

One of the core elements of investing is the assumed “rate of return”. Along with your base investment (or amount that you are periodically adding, say annually), your time frame (number of years out you want to go), the “rate of return” is the percentage variable used to determine whether you will have enough to retire and / or meet your needs for a specific goal (such as will you have enough funded to send your child to college).

What is Rate of Return?

The rate of return is what you EXPECT to earn, in gains, each year. Typically this rate of return is highest for stocks, in the middle for bonds, and lowest for cash or cash-equivalents (short term money market, CD’s, etc…). A sample plan might have stocks at 10%, bonds for 6%, and cash-equivalents at 2%.

A rate of return utilizes compound growth; thus $1000 for 10 years at a 10% rate of return does not give you $1000 + ($1000 * 10% * 10 years) or $2000 at the end of the period (ignoring taxes and transaction costs, which I will get to next), it gives you
about $2850, because you earn a return on your gains each year, so the gains compound. If you go out even further, to 20 years, you don’t go from $1000 to $3000 ($1000 * 10% * 20 years), you get $7400. Thus the part of earnings due to “compounding” (not just the base payment times the rate, for the time period) is $850 over 10 years ($1850 – $1000 = 850 / 1000) or 85% higher. The part due to compounding over 20 years ($6400 – $2000 = 4400 / 2000) or 220% higher.

Basically, ignoring the math, in general, the higher your “assumed” rate of return, the greater your assumptions on your ending value. It isn’t “linear” – it is “geometric” – so a 2-5% difference in assumptions makes a GIANT impact if you are looking out 20-30 or so years.

When I started out investing about 20 years ago in my first 401(k) plan, people thought 10% / year was a reasonable assumption for equity returns. I don’t know what the assumption on bonds / cash investments were, but let’s say that it was 6% or so. Under these plans, if you set aside a decent amount towards your 401(k) and your company made a decent “match”, you could easily see your amount available for retirement grow to a seemingly large and acceptable number, assuming that you put most of your money in stocks (since you were just starting out in investing).

Problem One – Losses

The first giant, gaping hole in the rate of return model is how to handle losses. Losses have a very significant impact on your portfolio, because your rate of return has to be MUCH higher to “dig” out of the hole. For example, if your portfolio loses 40% in one year (which happened to most of us in 2008), and goes from $100,000 to $60,000 ($100,000 * -40%), you just took a big hit. But then, your future growth has to be much higher in order to reclaim the ground you just lost. If you lose 40% one year, and then have 10.75% growth for 4 years, you just break even. However, you lost FIVE YEARS of future compounding (the year when you went down 40%, and the 4 years you earned 10.75%) just to get back to ZERO (where you started). Thus if you wanted to earn 10% a year for 5 years when you started (which takes you from $100,000 to $175,000), and you still want to get to $175,000 at the end of 5 years, then after your first “big hit” of 40% losses, you have to earn at a 23% for the next 4 years to 1) make up the loss in year one 2) to earn enough in all other years for them to get their “base” return, too.

So let’s go back to this (semi-real world) example again, in just dollars. You have $100,000 on 1/1/00. You are using what seems reasonable to you or me when I started investing (a 10% return assumption), which would have my balance at about $175,000 on 12/31/05, over 5 years.

In year one, ending 12/31/00, the market goes down 40%, leaving you with $60,000. Gulp. If the market goes up a bit more than 10% / year over the next 4 years (your original rate of return assumption), then you basically end up back near your ORIGINAL $100,000 balance, after 5 years are done. This isn’t good, you could have left your money in a guaranteed account and done about that well. You just made NO progress towards retirement or towards a college education account.

Thus in order for your portfolio to be able to afford some occasional large losses (such as we received in 2002 with the dot-com crash and in 2008 as the credit markets seized up), you will need to make FAR more than 10% the OTHER years in order to reach a target as high as 10%. In fact, you will probably need to earn something like 20% every OTHER year in order to make up the lost ground of years that have big losses.

Basically if you aren’t seeing a return of something like 20% / year in MOST years on equities, you aren’t going to make anywhere close to 10% when you factor in our frequent years when the markets take big hits. Not only do you lose DOLLARS (your balance declines 20% – 40% those years), you also lose TIME for future compounding and your rate of return is much smaller than it appears.

If you go back to 1990 and ran the S&P 500 for 20 years, you’d get an appreciation of around 6% / year. If you just run the last 10 years, you get negative appreciation (no growth). I realize that stocks have a longer term horizon than this but these are the relevant milestones within my life. The “net” of these two, in very simplistic terms – around 3%, given that you are putting money in “in increments” and didn’t just have a lump of money at the start of 1990 and watch it compound all those years.

Problem Two – Transaction Costs

I had a friend who used to live in Las Vegas. He always said that the fact that they had lavish facilities and gave out subsidized meals and drinks meant that the house had a big edge, and that they always won in the end. While this is common knowledge, actually seeing the scale of their vast casinos put this “edge” in perspective.

The same thing applies to the big bonuses and huge financial services industry that exists in the United States; to a large degree, these institutions exist and can pay bonuses because of transaction costs that they put on customers such as yourself that invest in the markets.

Since the time I started investing in the 1990’s transaction costs have fallen a lot. It was common to pay a 5% “load” up front when joining a mutual fund, on top of annual expenses in the 1% – 2% range. Nowadays mutual funds with a load have become much scarcer and transaction costs have fallen into the 0.5% range if you shop around a bit. ETF’s, which also have big tax advantages, have risen in power and they also offer low transaction costs since the cost to trade a share of stock has fallen over the years (for mutual funds you typically don’t pay a transaction fee to invest, but you do for ETF’s). It depends where you shop and what other fees to take into account but nowadays an electronic brokerage like TD Ameritrade allows stock trading for $9.99, a significant drop from the $30+ dollars it cost “net” back when you had to call a broker by phone in the early 90’s. This reduction is even bigger in “real” terms when you factor inflation into account.

While transaction costs have fallen, they still add up, and they eat into your return. Your return now has to “make up” for the “loss” years (and time), as I noted above, but also at least 1% / year in transaction costs for equities (all in). You probably could do it for less depending on how you structure your portfolio, or it could be higher if you trade a lot.

Problem Three – Taxes:

Taxes also impact your earned rate of return. There are many kinds of taxes that hurt investors’ returns.

1) capital gains – when you sell something that has appreciated in value, you pay capital gain taxes, which vary depending on how long you held the asset. Currently, the US has favorable tax rates for assets held > 1 year, it is 15% – this would rise potentially to 20% when these rates expire in 2010 assuming this is not renewed. Assets held less than 1 year are treated as ordinary income, which is as high as 35%
2) taxes on dividends – each year dividends are paid out from many corporations; since dividends are subject to “double taxation” (the corporation pays dividends after tax has been applied), the US has a favorable rate for investors who receive taxes of only 15% on US corporations. This is scheduled to expire and may or may not be renewed; if not they will be treated as ordinary income, assume 35% or so
3) taxes on interest – if you receive interest income, it is taxed as ordinary income, assume 35% or so. There are exceptions to this, but they also cut into your return – municipal bonds are (generally) exempt from Federal taxes, but they make up for this by offering a lower rate (a municipal bond might offer 3% when a corporation would offer 4.5% for the same credit quality bond)

While you can defer taxes by using various plans 401(k) and defer gains on other plans (IRA), and also completely avoid taxes by using funds for designated purposes (529 college plans), in general as the saying goes, you can’t escape taxes. You can structure your portfolio in a manner to minimize tax impacts (i.e. put interest income in IRA funds, and low dividend ETF’s in your after-tax brokerage), but you need to factor in taxes into your implied return. They generally take off at least 1-2% of your return, but like all else, it depends. But it isn’t zero and needs to be taken into account.

Problem Four – Investor Behavior

In order to “earn” the returns listed above, investors need to act rationally. Investors, historically, have NOT acted rationally. Investors tend to buy after a stock has risen (chasing returns) and they don’t re-balance their portfolio after gains. They need to HOLD on to stocks after big losses have occurred, rather than selling at the trough, so that they can be there when the stocks “roar back” and go past the losses incurred.

Investors also tend to minimize their re-investments in stocks when they go down; this is human nature – when something has bitten you (stocks for losses), it takes an iron stomach to invest MORE money in stocks again. But in order to earn the rate of return that stocks (theoretically) can offer, you need to buy low and sell high (through re-balancing, effectively).

While research on the impact of investor behavior is all over the map, in general the “average” investor does much worse than his “rational” or “theoretical” counterpart. This probably drops 1-2% (or more) off the return.

Conclusion:

In the article by Jason Zweig, he uses the term rate of return “net-net-net”. This means the REAL rate of return after transaction costs and taxes. Typically irrational investor behavior needs to be taken into account, too.

With all of this, that 10% rate of return is likely to be far lower; perhaps 5%, perhaps less. If you put those numbers into your model you won’t be retiring for a long, long time.

Cross posted at LITGM and Chicago Boyz

Recently I covered iBonds, which are a government bond that you can purchase online that provides assurance against increases in inflation and other tax benefits. The amount you can purchase is limited, however, to $5000 / year, and you can’t redeem them for 12 months, which makes them unsuitable as a short-term cash vehicle.

Certificates of Deposit (CD’s) Through a Brokerage:

If you are looking for a practical way to earn interest income with the minimum risk possible than certificates of deposit are a good alternative. When I was growing up you had to physically go to a bank and set up a CD, and then you had to retain paperwork for each instrument. In addition, you wanted to disburse your funds among a number of banks to get around FDIC limits, as well. Finally, the CD’s were not easily redeemed, although you could redeem them in some circumstances depending on the issue with a penalty on interest.

Today – all of above disadvantages and inconveniences with certificates of deposits have been eliminated. You can buy CD’s online (I used to go through a voice broker, but last time the guy showed me how to do it myself, online, so now I will just purchase them that way), they are integrated with your brokerage statement so there is no additional paperwork (on issuance, or at year end for taxes) beyond what you already receive, and also there is a “secondary” market when you can re-sell your CD if you need the proceeds sooner. There is no “guarantee” that you will be able to sell your CD at the price you want, but since a CD is a simple commodity with a rate, timing payment frequency, and a duration, I’d expect that you’d be able to sell it for something very close to the market price and receive not only your cash back but essentially be made whole on your interest. However, the overall interest rate market may have changed which would mean that your CD would be worth “more” or “less” if you had to sell it – longer dated CD’s that I purchased a couple of years ago are now selling for more than 100 cents on the dollar (say 102) but that would only come into play if I decided to sell them prior to their redemption date, which I don’t plan to do.

Creating a “Ladder”:

The typical way to invest in bonds or CD’s to earn interest is to create a “ladder”. You purchase equal lots spaced out over equal intervals (in this case it is 5 “lots” with 1 year intervals), and as the current CD matures, you re-invest that money as the longest purchase in your range (the 5th year). Let’s look at my current ladder:

The older CD’s I have are as follows:

3.9% through Jan 2011
3.9% through Jan 2012
4.1% through Jan 2013

I had to fill in some gaps in my “ladder” recently. One of my CD’s (yielding over 5%) hit its redemption date and the proceeds showed up in my brokerage account. Then another CD was from a bank that failed and the Federal government seized the bank and liquidated my CD and then the proceeds also showed up in my brokerage account (plus accrued interest). Without meaning to do so I “tested” the FDIC guarantee process and it worked very smoothly, in my case, at least.

The new CD’s I purchased were as follows:

2.75% through January 2014
2% through January 2012

So in looking at this my ladder is a bit bent. I essentially am doubled up on the same maturity, January 2012, which is the 2 year point (from today). The “standard” item would have been to purchase a January 2015 CD, which would be essentially a 5 year maturity. Those CD’s were offering around 3%, and I did not want to lock myself into a 5 year CD at such a low rate. Here is my current ladder:

3.95% Jan 2011
2.00% Jan 2012 (new purchase)
3.90% Jan 2012
4.10% Jan 2013
2.80% Jan 2014 (new purchase)

You can see how interest rates have declined over the last year or so. CD’s that offered almost 4% are now down to about 2% for the same duration. This is a big drop for savers. Remember, too, that these are pre-tax rates – the after tax rates for these amounts are probably around 25% – 30% lower (maybe around 1.4% or so). The average interest rate across this portfolio is 3.35%, with my older purchases bringing up the total.

The interest rates paid by banks are impacted by our overall interest rate policy. The current interest rate policy is near zero. I am not smart enough to predict when US interest rates will begin rising but it doesn’t seem feasible that our current almost zero interest rate policy can continue indefinitely. This is why I am “doubling” my ladder at about the 2 year mark; I’ll re-assess the situation then and if rates are higher I will be in a position to take advantage of them. They can’t get much worse (from an interest-seeking investor perspective, that is).

In summary, purchasing CD’s through a brokerage is a way to put your cash to work in an extremely low risk, easy, and liquid manner, especially if you just hold them through to maturity. This would not be the sole item in your portfolio, obviously, but everyone needs a secure component of their portfolio and CD’s, along with iBonds and savings, can make up this “leg” of your financial plan.

We will continue to cover other savings and investing outlets in future posts.

Cross posted at Chicago Boyz and LITGM

I have written about iBonds on this site in the past and wanted to re-visit them.

IBonds are US government bonds and thus they are the “benchmark” for low risk debt instruments. IBonds have the following characteristics (which are well-summarized at the US Government web site here):

- a “fixed” interest payment that is set when you buy the bond. This component is set at the time that you make the original purchase and is constant throughout the 30 year life of the bond (or until you redeem it). This component has ranged from a high of 3.6% back in 2000 (before the government basically went with a zero-rate policy to prop up the markets) down to ZERO in the middle of 2008. It currently has a rate of 0.3%
- every 6 months you get a return equal to the inflation rate. This rate (for comparison purposes I am multiplying it by two to get an annual rate, although it is a tiny bit more if you are into statistical details due to compounding) has ranged from 5.7% (2.85% * 2) back in 2005 to NEGATIVE 5.56% in mid 2009 (which meant that EVERYONE who owned an existing iBond was getting NO interest for 6 months, because even if you bought one of those “golden” 3.6% ibonds back in 2000 that annual rate was less than this negative inflation component
- If you buy an iBond now, you get an annual rate for the next 6 months of 3.36%, which is basically the 0.3% “fixed” rate plus a bit more than 2 times the current inflation rate of 1.53%
- Your existing iBonds take the “fixed” rate from the year that you bought them plus 2 times 1.53% to determine the current yield; so if your rate was 1.55% (mid 2006 vintage) then you are currently earning about 4.6% / year
- There are also some tax advantages. You don’t need to pay state or local taxes on the iBond interest that you earn until you redeem the bond (you have the OPTION of reporting interest annually, which could be a good idea if you are buying them for a child and they are in a low interest rate bracket, but this is beyond the pale for the current discussion)
- One disadvantage is that you can’t get access to your funds for 12 months after you buy a bond issue. If you redeem them within 5 years, you lose the last 3 months of interest. After 5 years, there are no penalties

I wrote about iBonds most recently when their interest rate paid on ALL iBonds regardless of fixed rate component went to ZERO. I was interested in following up with them to see the current fixed rate being offered as well as the interest component.

Basically, iBonds are a GREAT deal right now. They provide inflation protection for when interest rates increase (which will drive inflation), they are the lowest risk class bond available (when the Federal government can’t float debt any longer we are all in big trouble), and they provide deferral opportunities for taxes.

In reviewing other debt alternatives (something I will come back to in additional posts), right now a 2-3 year CD is yielding 1.5% to 2% / year. This is less than the iBond is yielding now (although it is guaranteed, while the iBond can fluctuate and go down if there is deflation, although not below zero). Other government securities are in the 2% range (or less) and then you need to go up the risk ladder a bit to get even 3% or 4%.

The Federal government knows this and they want to keep the iBond program relatively small, I guess, because they are limiting the purchase of iBonds to $5000 / year. You can go online to treasurydirect.gov to purchase them (it is very easy to do) and they will sweep the $ out of your bank account. If you really put your thinking cap on you can buy some for you and some for your spouse but in general for most the $5000 cap will apply unless you have a comprehensive estate plan in place. For a while you used to be able to buy $30,000 / year of iBonds which in hindsight was a great purchase plan but they cut it back accordingly.

All in, iBonds should be considered by anyone looking for an effectively zero risk component of their savings. Right now banks and CD’s are offering almost nothing so this is a very viable alternative. You can’t get at your money for 12 months but since your purchases are only limited to $5000 / year this likely isn’t a significant deterrent.

Cross posted at Chicago Boyz and LITGM

“Net Worth” is a key concept in personal finance. From the wikipedia definition:

In personal finance, net worth (or wealth) refers to an individual’s net economic position; similarly, it uses the value of all assets (long term assets) minus the value of all liabilities.

For the layman, “assets” are what you own – your cash on hand, the stock in your account, and any accumulated value in your pension and 401(k). People tend to over-value their personal belongings (collectibles, clothes, jewelry, etc…) – this is worth what someone ELSE would pay for them (think of the pawn shop) not what you paid for them, typically a few cents on the dollar. “Liabilities” are what you owe to someone else – so for your car, if you are paying on payments, typically you are underwater – as soon as you drive it off the lot the value drops by 20%, plus you are paying interest, so you likely have very little value in your car, unless you paid it off already. For your house, it is more complicated, but many people are “under water” where their mortgage is worth more than the current value of the house, or very close.

According to this “Net Worth Calculator” at CNN Money, you can put in your age and income and see how your personal net worth compares against others. For example, a 30 year old making $40,000 / year, on average, would have a net worth of $8,250.

Why is the net worth so low? Because net worth is what is left after EVERYTHING is paid for, including taxes. When you see your paycheck there goes Federal taxes, state taxes, FICA (social security and medicare), plus sales taxes on everything you buy. If you own a home, there are property taxes, and when you rent there are utilities. Don’t forget your house payment, or rent, and your car payment. Plus – you have to eat, you need to pay for that cell phone and data plan, and cable, and then you might want to date, and everything else. After all this is done, whatever you save after taxes, goes into your net worth.

I remember working near the dot-com explosion in 2000-2002 and many of the companies I worked with and for were having hard times. They changed the timing of payments (from bi-weekly to monthly) and many people, even those making over $100,000, were complaining vocally because they were living check-to-check and this 2 week, one time lag, was killing them. Their savings that were accessible to them were almost nil. At least back then real estate was still appreciating – but now even the cash that isn’t immediately accessible (in your home equity) is gone, too.

Why is this significant? Portfolio one, which we have been running for ten years, has accumulated over $16,000. This is more than the net worth of the typical 30 year old making the average salary who has been working for almost a decade out of college. This means that by accumulating $16k-$20k you have the equivalent value in terms of net worth of working for a decade, which does mean something. Of course this analogy is imperfect because working 10 years means that you can earn more going forward, but it is a powerful analogy nonetheless.

We recently started portfolios four and five with the round of late summer investing. The process went per usual:

- each of the beneficiaries saved up $500
- we matched $1000 each
- we provided a list of 6 stocks to pick from
- each beneficiary picked 2 stocks from the list
- we purchased the stocks

Since it was a first time setup there were some additional steps in establishing the portfolio. I had to do some work to get the forms set up under my custodian umbrella with my brokerage firm. The firm waived some limits they had on the size of the account (usually they don’t set up brokerage accounts with only $1500) because it was part of my overall effort and because we will cross the $3000 barrier next year, anyways. The firm also was generous and waived some commissions for portfolios 4 and 5 since I had some free commissions left with my account (they originally charged for the commissions and then put the cash back in the money market account. I guess if I am super technical they are part of the basis but I will assume that they aren’t since it was returned).

Portfolio Four and Five Performance November 2009

I am not going to set up excel spreadsheets yet for them until we get another years’ worth of activity but am tracking them through that excellent google service that I mentioned in other posts.

The third portfolio has a life of three years. These three years coincided with many of the markets toughest years and thus the returns on this portfolio have been the lowest of the three so far.

Portfolio Three Performance November 2009

A total of $4500 has been invested in this portfolio over three years, and the current value is $3752, for a loss of $747. This represents a 17% loss, or an annual loss of approximately 9%. The beneficiary has invested $1500 and the custodian $3000, so at least the trustee is doing well with a value of $3752 vs. an investment of $1500.

This portfolio had one decent winner, China Mobile (we sold before the big drop), and two tough losses; one on ICICI bank (ticker IBN) from India which was sold at the peak of market turmoil (and since regained some of those losses) and also Nokia (NOK), which had losses and cut their dividend but we continue to hold.

With only 4 stocks in the portfolio (2 until recently) any portfolio in the early stages with this few stocks is subject to market gyrations. Portfolio Two now has 10 stocks and Portfolio Three has 15 stocks so they at least have more diversification across markets (generally 10 stocks means that you have decent diversification, as a “rule of thumb”).

Investing is a long term game and played with real money; so when you start investing in a bad market it can be stomach turning at times, especially for kids who see this as “real” money since they earned and saved their portion themselves. Given the time horizon of these trust funds in makes sense to stick with the volatility and continue to watch the markets and keep going rather than pulling out and putting the money into plain vanilla investments.

Portfolio One, as I noted above, has a ten year horizon and returned at an average rate of 4.6% over the ten year period.

Portfolio Two has a five year time horizon. Portfolio Two had a rougher ride because a longer portion of the time allotted fell during the “bust” period of the market. Portfolio Two barely ekes out a profit over this five year period, with a 5 year return effectively near zero.

Portfolio Two Performance November 2009

This portfolio has had some big winners, including China Mobile and BHP which were sold for a gain, and some that were sold for a major loss, including Cemex out of Mexico and ICICI Bank (IBN) from India. We are still holding on to Nokia, even though it has an unrealized loss, because they seem to be a decent stock looking forward, and Diageo, partially because they just raised their dividend (which is a bullish sign).

From the beneficiary’s perspective, they put in $3000 so far, and it is worth $9100, so that is a significant return on their investment (ignoring the double match). This is good, but we hope to do better in the future than an effectively zero return over 5 years.

From today’s WSJ on November 14th

For the 10-year period ended Sept 30, stocks, as measured by the S&P 500 stock index delivered an annual average return of minus 0.2%

Measuring performance is actually pretty hard. It is one thing to just have a “lump” of money and then re-visit it 10 years later, adding up all of the dividends and / or interest received and viewing its current value as opposed to the original purchase price. That is the simplest example.

More realistic examples have discrete lumps of money added in over the years. Then each of those investments accumulate into the final total, but they have been invested over varying years, so they will have different percentage returns.

For this on Portfolio 1, which actually is about 10 years as well ended September 30, I used IRR to determine an annual return of 4.6%
Portfolio One Results Ended November, 2009

If you go to the “cash flows” tab on the associated Excel 2007 worksheet, you can see how the IRR is calculated. You take the annual investments, which are broken out between the custodian (me) and the beneficiary. Then you put the current total portfolio value in the last column and through the miracle of excel you can calculate the internal rate of return, which is a reasonable proxy for an annual return, that we earned with this portfolio.

I am proud of the returns that we have achieved with this fund. Each of the 5 funds I run have different characteristics because each trustee chose different stocks each year from the list of 6 that I provided. And then due to varying circumstances based on those choices, I was able to make sales when the individual stocks had appreciated to a level the I found to be high, or a sale if I felt that the stock was going to be a poor performer.

What I do that your broker won’t do is explain what WOULD have happened had we not sold a particular stock. I keep tracking their performance going forward (there also is the avoided dividends if you are getting extremely detailed, but those won’t move the needle that much). Of all the stocks I’ve sold off, none have risen above the sale price, except for Amazon which we bought way back for $14 and then sold off in two different instances at $90. Amazon is currently above $120 nowadays but that is the only outlier. In addition, I am still happy with the sale because we diversified a bit and bought P&G way back which has been a strong performer with a good dividend.

One thing about performance, though, is it will all turn in a plunge. In the depths of the crash in 2008-9 this portfolio was flat or had an aggregate slightly negative return. Need to periodically watch the stocks and have a strategy for each one.

One of my brothers asked about tracking performance for the newly created portfolios 4 and 5 for the nephews that just reached the age that I set up a trust fund for them for the first time. I suggested the Google Finance gadget, rather than logging in to the web site that physically holds the stocks in their brokerage account.

The Google Finance gadget is shown in a screen shot above. Every time I click in to see the stocks it seems like Google is improving performance and features on this tool.

This screen shows (most) of the critical facts about your stock – your # of shares and the price you paid for them (which makes up your cost basis, excluding commissions, which I track on my page so that I can be perfectly accurate for tax time), your cumulative unrealized gain or loss (you don’t actually realize the gain or loss until you sell the stock, once again net of commissions) and that day’s gains or losses.

Entering data is easy – you just need to put in the stock’s price, and the number of shares. “Unclick” the cash box, because it makes it more complex with dividends, and then after you’ve added all of your stocks just estimate the cash value in your brokerage account as of that day and there you have it, an easy way to see your stocks at a glance. Every so often you need to change the cash holdings at the bottom to track dividends, but that is about it for complexity.

There is a second tab that you can click that shows the 52 week high and low for your stock, plus other market facts like capitalization. About the only fact that they don’t include that would be useful is the dividend yield, but I am sure that some time I will log in and it will be there, too.

Also they link all of your stock picks to news feeds so that just news feeds that are linked to your selections come up when you click on the detail page. You can just view the “summary” of this portfolio without drilling in to the details on a custom version of your google home page.

Once again I like this better than logging in to the site because for some reason they don’t show my basis and unrealized gains and losses on the main tab, although they are improving, as well.

It is the season where we purchase stocks each year. At a high level the process is:

- kids earn their $500 during the course of the summer (some have jobs, or find other ways to save)
- after I receive the $500, I add $500 and match $500 for a total of $1500
- this $1500 gets deposited into the money market account linked to their brokerage account
- I send them (or post on this site) the six stocks to pick from for the current year
- each of them select 2 stocks
- based on the market price, I place the orders overnight, leaving enough extra in the account in case of market fluctuations at the open, plus room for some commissions
- then the orders get executed
- later, I update the performance of the overall portfolio

So far:
- Fund 4 (new) – selected SNP (8 shares), SI (7 shares)
- Fund 5 (new) – selected WMT (13 shares), NUE (14 shares)
- Fund 1 – selected TEVA, SNP – also looking to increase the position in either AEP or MSFT (waiting on directive)

Still waiting on picks for Funds 2 & 3, some times it takes a while to get in touch and talk through it with homework and other after school activities.

In a recent post analyzing the performance of Portfolio One (the longest-lived portfolio) I included an excel spreadsheet with performance information. This excel spreadsheet was built over a number of years and I refined it to include more and more relevant information and responses to questions asked by the beneficiaries of the portfolio.

At first I thought that I could get answers merely by reading the statements that I received from my brokerage firm; but over the years I realized that there was a lot of information that wasn’t readily available, for one reason or another. This information includes:

1 ) inception to date, how much of the portfolio has been spent on fees including any annual fees for the account and commissions on buys & sells
2 ) how much of the return is due to dividends, and what is the accumulated dividends for each stock
3 ) inception to date, how much interest income has been earned on the portion of the portfolio that wasn’t invested in stocks but sat in the interest bearing money market account (usually while waiting to select a stock or immediately after a sale until it is re-invested)
4 ) what is the return on each individual stock, determined as dividend income for that particular stock and any unrealized gain / loss on the change in market price based on today’s price against original cost
5 ) for stocks that are sold, what was the gain or loss on that stock, and was it a short term or long term capital gain (was it held more or less than 1 year)
6 ) for stocks that were sold, how has the stock price done since then? The kids liked to ask this question, basically trying to determine whether or not I was right when I told them to sell a particular stock
7 ) what is the current dividend yield on each stock in the portfolio
8 ) what is the return since inception on the portfolio – there is the easy “is it worth more than put in” but the much harder “what is the rate of return in percentage since inception” which is difficult because you need to determine the timing of each investment
9 ) for the current year, what is tax information needed including dividends earned, interest income, and short term and long term gains and losses from sales of stock

In order to account for this you need to get your statements and do a bunch of work, and track it in a spreadsheet. There may be a simple, off the shelf program that does all of this, but I don’t know what it is. Anyways the real effort is in pulling all the transactions off the statement and entering it – once you set up the spreadsheet it mostly calculates everything for you – so even starting with a canned program wouldn’t save too much time (unless it was directly auto-fed from your brokerage account).

Here are the steps I follow each time and some of the “checks and balances” I do to make sure that I don’t miss anything.

Steps to updating portfolio performance:

1 ) update the prices of stocks in the portfolio (on the “balance” tab). Delete any stocks from the balance that have been sold and make a note to add any stocks that have been purchased to the list. If the stock has split (rare), make a note of this and adjust the share total. Make sure the total dollars in the spreadsheet ties out to the total on the site for those stocks (net of new purchases)

2 ) For sells… go to the sells tab, put in the shares and price, and then calculate the gain or loss by matching the cell against the appropriate one on the “buy” tab (you will have to update the formula). Note if there were commissions or not – we show the loss INCLUDING the commission (which is how it is calculated for tax purposes, too) but we want it separate so that we can calculate total costs to date

3 ) For buys.. go to the buys tab, put in the price and cost and commission

4 ) Go to the dividends tab, and add in manually all of the dividends paid out for each of the stocks specifically. For foreign dividends, put them “net” of the overseas with holding and any fees (so that the amount ties to what is added to the money market) – if this were material, we would collect them separately. This is needed for foreign stocks

5 ) Go to the dividends tab and update the pivot table and make sure the total ties out and that each stock is only represented once (i.e. if there are misspellings you will have 2 exxons, for example)

6 ) Go to the MM transaction tab, and add the monthly interest from the money market fund (only)

7 ) Go to the MM pivot tab, and update the pivot table and make sure all of the money market transactions are picked up

8 ) Go to the MM balances tab, and update the balances to match the statement

9 ) Go to the summary tab. You will need to add a line for each purchase. Copy the formulas across and update them. You will need to eliminate every stock sold from the top part with formulas, and put it in the bottom part with sales. For sales, use the net loss / gain from the sale tab and put a note of what the price was when you bought it, when you sold it, and the current price now. You can see sold stocks because they will have a #REF where their price used to be, as a check.

Also on summary tab, update the dividends by linking each stock to the line in the pivot table by stock to the main tab. The total by stock (done manually) for dividends should total to the same total as the pivot table.

Update the heading to show the month. Then update the date in cell A2 – this moves the month held column which is used to calculate the # of months which is used for the return calculation.

CROSS CHECKS on main tab; that the sum of the dollars for stock value matches the total of the balances; that the total of dividends matches the total of dividends pivot.

10 ) On summary tab – look up the “yield” for dividends of every stock on yahoo. While you are at it, update the notes section for each stock with analysis.

For sold stocks – update where they are today, given the original price and the sales price. This is for Monday morning quarterbacking only.

11 ) update the date on the cash flows tab for rate of return – if you have a new cash inflow, adjust the formula by adding a column and checking to see if it is calculating properly

12 ) if it is time for tax treatment, show the gain / loss for sales in the fiscal year, the amount of interest earned, and the amount of dividends received. These 3 items all go onto the return

Every year I provide six stocks for selection for each trust fund. Generally each trust fund selects 2 stocks, in amounts of $700 – $1000 depending on available cash (some cash accumulates from dividends and prior sales).

1) WMT – Wal-Mart. Retailer from US.
Wal-Mart benefited from the recession which drives a focus on price and value. WMT is tweaking their international strategy to produce better results and is a well run company. WMT also provides a dividend of 2.2% and is trading not too far off its 52 week low

2) TEVA – Teva Pharmaceutical Industries (ADR). Generic drug manufacturer from Israel (and ADR traded on US exchanges).
Teva is another well run company that could do well in most scenarios involving potential health care reform, as well. This stock also provides some international exposure. They have a 1.1% dividend yield.

3) SI – Siemens (ADR). A German industrial conglomerate, Siemens seems to have put much of the scandals behind them and is poised to grow as Europe comes out of a recession. Siemens is also very active in the green energy business. SI is often thought of as a European GE, for better or worse.

4) NUE – Nucor. A US steel manufacturer. Nucor is an extremely well run company that has thrived amongst a difficult environment for US steel manufacturers (pretty much everyone else state side went bankrupt over the years, killed by unions and a lack of investment). There is competition at home and abroad (Ross bought up most of the bankrupt company’s capacities and fashioned them into a new company). Nucor also has a 2.8% dividend yield.

5) SNP – China Petroleum and Chemical Corp (ADR) (also known as SINOPEC) – A massive Chinese oil and chemical company. China requires significant resource growth to power their growing economy. Chinese companies are also better able to work in some developing nations that have dodgy human rights records, where US and European countries would face legal difficulties. This stock is an ADR and has a 1.5% dividend yield

6) ADBE – Adobe Software - US software company. Adobe has a franchise with the PDF technology and graphical tools. Adobe has a strong software business with low debt and cash on hand. Adobe does not pay a dividend.

For the stock selections wanted to attempt to balance:

- US vs. non-US stocks – much of the future growth will take place outside of the USA, so limiting the portfolio to US stocks seems foolish. In order to ease difficulties on investing, only foreign ADR’s (which is when the stock trades on US markets like NASDAQ and the NYSE, mimicking the home market) are put on the list
- Limited / manageable debt load – many companies were burned when the thought that they could easily use the debt markets to refinance debt at reasonable rates, which turned out not to be the case in the latest recession. For the purposes of this trust fund I would like to stay away from companies with significant risk on debt; at various times I have sold stock because of looming debt maturities (CX)
- Small and large company sizes – while none of these are “small” or even “mid-sized” companies, I wanted to give some selections that weren’t absolute giants. Different sectors of the market behave differently in times of crisis and during a market advance

Background on Portfolio One

The first portfolio of my trust funds was set up right after the attack in September, 2001.  It seemed to be an inauspicious time to invest in stocks.  However, since these trust funds have a long time horizon (they start when the beneficiary is around 12 or so years in age) they should have a higher risk tolerance than a stock fund for someone later in life.

At the time I started the first fund, I was a confirmed “buy and hold” investor.  By this I meant that I intended to little or no “pruning” of the portfolio and intended to hold stocks until the fund’s control transferred over to the beneficiary.

While I still am generally of this temperament, over the years I did start selling some stocks when I believed they reached a “peak”  value and selling some stocks when I believed that they were at risk of dire consequences.

Investment into Portfolio One:

The first year (2001) began with an investment of $500 and then increased by $1500 for each year thereafter ($1000 from myself, the custodian, and $500 from the beneficiary).   There was also a special $1000 donation when the beneficiary graduated from high school.  Thus during the period 2001-9 (prior to this years’ investment round) the beneficiary has invested $3500 and the custodian has invested $8500, for a total of $12,000.

The investment typically involved purchasing 2 stocks / year, in amounts of approximately $700 / each (because brokerage commission fees and other investment fees also must be taken out of these funds).  In later years the investments got larger, because of re-investment of stock proceeds, dividends, and interest income.

The fund currently holds 13 stocks, whose market value varies between $436 on the low end to $1560 on the high end.  The average amount is approximately $900, for a total value of $12,265.  The fund also holds $1900 in cash; this cash position has increased due to volatility in the markets and the fact that the beneficiary is reaching an age where we might need access to some amount of cash and I’d rather have it “on hand” than have to liquidate a stock.

Overall Performance for Portfolio One:

Portfolio One overall has returned approximately 18% on the $12,000 invested over this 9 year period.  Until the recent market run up the return, overall, was slightly negative.  The fund is worth $2205 more than was invested.

This return is impressive given the overall poor returns in the equity markets from 2001-9.  Note that these investments were put in roughly equal installments during the period, so you can’t just compare it with a “lump” of money invested in 2001 against the return through 2009.  Also, this is a “real world” example so little items like commissions and fees need to be compared as well (this return wasn’t impacted by taxes because they were paid outside of this analysis if there were gains / losses in a given year).

Specific Analysis of Performance – Dividends:

During the analysis of this portfolio special effort was placed to track the performance of various components and their impacts on returns.  This analysis was done by creating a specific excel model which is included along with this post (at the bottom).

Dividends provided a total return of $1,135 during this period.  Dividend returns do matter during longer periods of analysis, and heavy dividend paying stocks provided much of this total.  AEP, a utility stock (which currently has a yield > 5%) provided $244 of dividends, Procter & Gamble, the consumer products company, provided $210 of dividends, and other dividend paying stocks made up the balance.  As of the time of this post, dividends made up approximately 50% of total returns, but this number varies significantly with the total portfolio gain – it was as low as 25% prior to last October’s market swoon.

Specific Analysis of Performance – Gains & Losses:

Gains and losses are the most complex component to analyze.  As you buy or sell a stock you incur fees, potential tax implications, and you change your portfolio performance depending on the characteristics of what you are buying and what you are selling.  For example, one of my earliest “sales” was Amazon, for a big gain (relative to the size of the portfolio, at least) and then I replaced it with Procter and Gamble.  Since Amazon paid no dividends and P&G does, this changed the character of my portfolio overall.

Here were the gains and losses by year:

- 2003 – Sold Amazon for gain of $1191

- 2005 – Sold Southwest Airlines for a loss of $3 and Tribune for a loss of $218

- 2007 – Sold Dell for a net loss of $132, Chuck E Cheese for a loss of $58, Sold Amazon for a gain of $1345, Sold China Mobile for a gain of $1276, sold ICICI bank for a gain of $541, and sold Netscout for a gain of $556.  None of those stocks with gains has approached the price where I sold it (their current prices are noted on the spreadsheet by stock).  Unfortunately, some of the reinvested stocks did poorly, as you can see in the 2007-8 purchases.  Generally I was trying to take advantage of a run-up if I thought stocks had hit a speculative peak

- 2008 – Sold GE for a loss of $589

- 2009 – Sold Cemex for a loss of $1235 (both GE and Cemex were stocks that I viewed as dangerous during the heat of the financial melt down since GE is mostly a finance company and Cemex is heavily indebted)

Specific Elements of Return – Fees:

This portfolio began in 2001.  At the time, fees for purchasing or selling a stock were a bit more than $20 / share.  These fees have declined over the years as pretty much everything has gone electronic and competition has increased.  Depending on your “total” package, some of the trades are less than $10 and some are free.  Over the life of the portfolio fees (plus a fee they used to levy on all accounts annually) total $667.

We track fees and commissions specifically even though they are often buried in the total cost (gain or loss) of a sale.  Brokerage firms don’t make a special effort to break out fees, usually, and you can probably guess why.

Given that the portfolio has had a decent amount of trades (26 purchases, 12 sales) this is a pretty low net amount of commissions, and reflects the declining cost / trade as mentioned above.  I believe that this rate is reasonable; if you put it in a typical mutual fund with around 1% / year expenses and had an average balance of $7000 (the midpoint of the current balance) with a life of 8 years you’d pay ($7000 * 1% or $70 / yr * 8 years = $560).  My point in this wasn’t to have the absolute lowest fees, but to work to minimize fees as a cost of the portfolio while not letting it impede trading where necessary.

Specific Elements of Performance – Interest Income:

Over the life of this fund (2001-9) interest rates generally have been very low.  In the beginning just enough cash was left to pay an occasional fee and commissions and to leave some “slack” in case the executed stock price was significantly different than the time when I put the order in.  Towards the end I started leaving more cash in the fund as the market gyrations became more and more significant – it seemed prudent.

Thus given that the balances don’t even average $1000 across the life of the fund in cash it makes sense that interest income was a relatively paltry $123 over 2001-9.  Current interest rates on money market accounts are minuscule… it is hard to imagine how important this portion of total return was during inflationary periods.  The return on your money market portion of your brokerage account is something to keep your eye on, but with such low rates the total return is very low regardless.

Summary:

I think that portfolio one did well, all things considered.  The fees and expenses were kept reasonably in line, we earned a decent amount of dividends, and sales at peak provided more money to reinvest into other stocks.

On the downside, many of the reinvested stocks performed poorly; not necessarily worse than the market as a whole, but certainly worse than just leaving the money in the money market account (which almost everyone would have done in perfect hindsight).

The current portfolio is relatively balanced across sectors, size of companies, by country, and has 13 stocks which means a swoon in a single stock may hurt a lot but it won’t kill the account.  The current portfolio is also leaving some more money in cash which is new, but seems reasonable in the current environment and considering all factors of the fund.

Excel File:

Excel File of Portfolio One Performance 2001-9

Attached is an excel file if you’d like to see more detail about the specific details of the portfolio performance.

I have 2 nephews that are now of age where I am going to being investing on their behalf as part of a trust fund. The plan is:

- I put in $500 / year
- If they put in $500 / year
- Then I will match another $500 / year

Thus on a typical year we invest $1500 and this process starts when they are 11 or 12 and will go on until they are at least 18. For an account that means that the child will put in $500 * 7 or $3500, I will have put in $1000 * 7 = $7000, and then hopefully the market goes up by maybe $5000 over that time span, depending on performance.

The process of setting up a trust fund or UGMA / UTMA account (depending on which state that you reside) used to be kind of complex – but now it is very simple. You need to set up a brokerage account with yourself as a custodian and the child as the beneficiary. It is most practical to do this for a vendor where you already have brokerage accounts – someone like Schwab, Fidelity, or Vanguard.

The only information that you need is the child’s SSN, date of birth, and name (I assume you already know 2 of 3 of these, or they are having lonely birthday parties). In the past you had to fill out a lot of paper forms but now you can do it online and do an “electronic signature” which means that you don’t even have to sign the completed form and send it in (which can be a pain because there are a lot of pages and then they have to type in all the information and you have to re-check it to make sure it was set up properly). I was able to set up each of the 2 trust funds in about a half hour or so.

Every trust fund has 2 components – a money market account (where the cash initially goes in for investing, and where dividends are deposited and fees such as buys / sells are taken out of by the company), and a brokerage account where the stocks reside.

The trust fund can be connected to your own accounts with that same company (i.e. Fidelity or your own) so that you can electronically transfer funds into that account from your own money market account, for example. You can also set up the account so that you can transfer in funds from your bank, but this is more complex (you need bank routing information).

More information coming soon as we start to select stocks for the new 2009 investing round. I typically do this in mid-August before the kids go back to school – this gives them the summer to save up their share of the money through chores or working a summer job.

A recent Wall Street Journal titled “Rebound of the Losers” from July 6, 2009 described how some specific actively managed mutual funds with large losses recently booked better performance. From the article

Ninety-four diversified U.S.- stock funds that finished 2008 in the bottom 10% of their peers are now performing in the upper 25% of their categories

The article then described their reasons why these specific managers were able to “rebound”. They included:

- purchased shares of better-performing foreign companies (the markets in China and Russia, for example, fell further and later rebounded better as a % than US markets)
- commodity markets improved, so stocks with a commodity footprint like energy benefited
- some managers described their own “guts”

“It’s funny how quickly things can change,” Mr. Soviero says, “but I’m glad I had the level of conviction and stuck with a concentrated strategy.”

- others used terms like “discipline” and said they were looking for companies with a “sustainable advantage”

But the journalist on the article missed the simplest, and most obvious answer –

REGRESSION TO THE MEAN

What this means, in practical terms, is that stocks or sectors that have the largest rise now are likely to fall later, and vice versa. One financial magazine I read had “Chicos”, the clothing store, as the “worst” performer over the last year, and the “best” performer over the prior decade, in back to back pages.

Something to watch for, especially when people describe their recovery in personal terms, rather than ascribing it to typical market “bounce”.

From time to time I have posted about iBonds as an investments. iBonds are interest securities backed by the US Government that you can purchase online or at a bank (I guess, although I have never tried that). The general attraction to iBonds is that their interest rate goes up as inflation goes up – which provides protection in times of rising prices (hence the “i” in the name – I originally thought it was tied to the “dot com” era). Here is an in-depth analysis that I wrote about iBonds in December, 2008, noting that the government had reduced the total amount that you could buy each year from $30,000 / person to $5000 / person. Note that you can’t LOSE money on iBonds unless the US government defaults, in which case we all have some big problems.

In short – there are 2 components to your iBond return. The FIRST part is the “fixed” interest rate that the US Government offers you. I bonds have been issued for about 10 years, and the “fixed” rate used to be as high as 3.4% / year which dropped as low as 0.0% (yes, that’s zero) but recently were bumped up to a negligible 0.1% rate. What this means is that if you bought an iBond years ago and kept it, that is a better iBond than one that you are buying today since the rate today is near zero. I think that the iBonds that I purchased over a couple year period have a rate near 1%, give or take.

The SECOND part of your iBond return is the variable component. This component takes into account inflation. Thus if prices are going up (you have inflation), then the interest rate that you receive will go up, as well. For the decade or so the iBonds have been in existence, this rate has been positive (meaning rising prices), providing an interest rate of between 1% and 6% or so.

Thus since iBonds have been created, the return that you could have gotten (depending on when you purchased the underlying bond) your return would vary from a fixed component of between 0% and 3% and a variable component of between 1% and 6% meaning that the “real” range of interest is between 1% and 9% overall.

TODAY, however, the new iBond rate has been unveiled… and since we are in a deflationary period (prices are going DOWN), for the first time, the rate of return on iBonds is ZERO (the interest rate can never go negative). The decline in real prices is -2.78% for six months per the government calculations, which means that it annualizes to -5.56%, so no matter when you purchased your iBond your return is ZERO, because even the highest iBond rates were about 3% or so they are all dwarfed by the -5.56% annual rate.

OUCH. It is never good to have an investment with a return of zero, especially when you purchased it explicitly for interest income (and to ensure you didn’t LOSE any money). However, the inflation rate will be adjusted in six months, and if prices are going up then, the interest rate will reset upwards.

I wouldn’t invest in iBonds now if you haven’t already bought some, especially because you are just getting this anemic 0.1% return as a base level. Check again when they announce interest rates for the next six months, which will be on November 1, 2009. I wouldn’t sell what you have, however, because you’d just have to re-invest the money in something else, and savings and checking accounts are generally yielding almost nothing now, as well, along with money markets.

Note – for those of you that don’t get the reference (probably those younger than 21 or so… of course it is from Caddyshack).

As part of running a trust fund or being a beneficiary of a trust fund you need to have some understanding of taxes. As always, if taxes are not your specialty get professional help I am only writing from my own experience.

Every year I need to review the taxes for each of the trust funds that I run. Here are the elements of determining taxable items:

1. interest income – every brokerage account is attached to a money market account, which bears interest. When you put funds into the trust, it starts out in the money market account and earns interest until you make an investment, and as you earn dividends, the dividends also go into your money market account. You also may opt to NOT invest a portion of the cash that is in your money market fund, because you are waiting or are afraid of the market, so it will also earn interest until you invest it in stock. Generally, your interest income nowadays will be puny because rates are extremely low right now (less than 2%) on short term money market funds and unless you have large balances the amounts are trivial. For tax purposes, unless your money market account invests in tax-exempt (municipal) securities, you will pay taxes on this interest income, generally at the highest taxable rate

2. dividend income – many, but not all, stocks pay dividends. Dividends may be paid out quarterly, semi-annually, annually, or on special occasions. The “dividend yield” takes the current payout plan of the company divided by the stock price, to see what the stock would pay if it is the equivalent of an interest bearing bond or CD. Right now, for example, Procter and Gamble pays out a dividend with a 3% yield. When a stock price plunges, the yield can get very high, but that is a sign that the stock may reduce payouts – for example right now Nokia has a yield of 10%. Dividends are taxable when received, and they generally are eligible for a reduced taxable rate of 15% if they are “qualified” and US based.

3. capital gains and losses – when you buy or sell a stock, you earn capital gains or losses on the difference between the price you paid for the stock and the price you sold it for (including commissions). Thus if you bought a stock at $10 / share and bought 20 shares, and then you sold that stock for $15 / share, you’d have a capital gain of ($15 – $10) * 20 or $100. If your “holding period” of the stock was less than 12 months, it would be a short gain, and if your holding period was greater than 12 months, it would be a long term gain. Generally long term capital gains are eligible for favorable tax treatment. Note that all capital gains and losses are “netted” against each other, and you can roll-forward your losses. For practical purposes this means that the VAST majority of Americans won’t be paying capital gains taxes for years to come, since most of their existing stocks are trading for less than what they paid for it. Even if you want to sell a stock for a gain, it is easy to find something to sell for an equivalent loss to avoid paying taxes.

Portfolio one – $352 in dividends, $32 in interest, and a long-term loss of $590 on a sale of GE stock

Portfolio two – $188 in dividends, $22 in interest, and a short-term loss of $761 on a sale of ICICI (IBN) stock

Portfolio three – $21 in dividends, $11 in interest, and a short-term loss of $550 on a sale of ICICI (IBN) stock

FILING REQUIREMENTS

Filing requirements are complicated. For this purpose I am discussing whether or not you need to file a return on a given trust fund.

For 2008, if your “unearned” income (basically interest, dividends and gains / losses on sales) is less than $900, you don’t have to file. Based on the above items, they do not need to file. In prior years, we sold some stocks off for gains that pushed them beyond the filing thresholds and we did need to file.

There is an IRS publication 929 (they go by number) which attempts to explain all of this. I would recommend going to www.irs.gov and look for this publication (it is a PDF), download it, and read it. In another post I will explain some of the complexities the best I can.

Anyone who has a retirement fund or personal investments has an interest in the stock market.  I have an additional interest because I am the fiduciary in charge of trust funds and describe at this site.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”).  I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next.  I am starting out with what I’ve learned from this debacle.  As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1.  Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate.  Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay 14% for financing).  Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example.  Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high.  I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies.  For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way.  The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example.  The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail.  In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market.  Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together.  One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time.  Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

4. Liquidity can evaporate, and if you depend on liquid markets, you are in trouble – Not only did the risk premium (see #1 above) go up quickly, liquidity in the market evaporated, meaning that if you counted on liquid markets, you were in big trouble.  Illiquid markets mean that you can’t “roll over” debt and if you do have to sell, you will receive a distressed price for those assets (a big loss, in real terms).  One of the first items to fail were the “auctions” in the municipal area which were a sign of bad tidings to come

5. Real estate is no bulwark – For individuals, there was often an assumption that real estate is a “safe” investment, but real estate values have proven to be anything but.  Real estate losses for individuals were semi-spared because the government has set a very low rate for mortgages and nationalized Fannie and Freddie – without that floor mortgages would be illiquid and subject to #1 and #4 below.  Now, however, the mortgage market is basically subject to government fiat – see #2 above.  If the government decides that condominiums are too risky and pulls back on guaranteeing mortgages on half built condominiums, those investments will fail.  For real estate companies that specialize in building new homes, those stocks are basically dead, since demand won’t catch up with supply for years.  The government is definitely working to prop up the home market, with tax incentives for the new buyer (and likely no more talk about not making home interest deductible)

6. Complexity is dangerous – Another early warning sign was the fact that Citicorp and others had to bring in “off balance sheet” entities onto their balance sheet when liquidity failed (see #4 above).  Those companies were incredibly complex, and their financial statements were incomprehensible even to me, a financial professional.  These counter-parties, off balance sheet entities, and WAY too much leverage made a toxic stew.  In general, companies that have a very complex “story” will likely have a harder road to travel when trying to show their value to the equity community, since people have been burned by what they don’t understand

7. Dividends provide little shelter – over time a significant portion of the total “return” from stocks is driven by dividends paid to stockholders.  Many companies paid dividends at a steadily growing rate for decades, and constantly re-emphasized the importance of dividends to their strategy (giving investors confidence that these dividends would continue in the future).  However, virtually everyone gave up on their dividends, from the financial companies that are sliding to the edge of oblivion to GE (who really is a financial company anyways) to many other industrial companies.  There are exceptions to the rule (companies that are not facing dire straits) but the fact is that strong companies can pay dividends and weak companies cannot, so betting on a dividend independent of the underlying financial structure is a fools errand.  The dividend is nice to have (and starting from a solid one is better), but counting on it in the future has proved to be devastating

8. For the most part, no one (who talks) knows anything – yes you can point to the occasional seer who cried doom and certainly many, many smart and rich (and tight lipped people) made tons of money shorting the entire market all the way down, but for the most part the conventional wisdom was completely and utterly wrong.  There are people or firms that understand the market well and can profit in down times, but you aren’t getting their thoughts from Jim Cramer on CNBC or in the WSJ or Barron’s or anywhere else, much less the popular magazines like Time, Money or your local paper columnist.  Look at how their stock ratings performed, and generally it was terrible.  A lot of this is institutional bias because those magazines and paper can’t just tell you to short everything and get out of the market because those same companies buy advertising and those sorts of negative messages frankly sound un-American when explained out loud.

9. Timing IS important, as is re-investment risk – I resisted timing in favor of “buy and hold” for years but then I moved into selling stocks when I thought that they had peaked on the upside, or they had huge down side risk (financials).  Buy and hold really hasn’t done anything for anyone in the last decade or so except rack up huge losses.  That doesn’t mean that I have a better strategy, but it is a fact that the central issue is timing.  Tied to timing is re-investment risk – which basically hits you in that even though you sell at a gain, you have to re-invest in something else that has increased in price (due to strong correlation) and you don’t mitigate your risk that much by selling one overvalued stock for a gain and trading it for a new one.

10. If it seems too good to be true, it probably is – I am not a seer but I think that all these people piling into municipal bonds for the tax benefits and historically low default rates are in for a rude awakening when bad things start happening to the states.  I know that there are many ways to bail out a state including the Federal government but it just seems like the municipal financing is going to fall apart and I don’t want to be holding the bag.  This applies to “free lunches” everywhere…

Now with all these “lessons”, what is a forward looking investor to do?  The stock prices are down, and this could be an historic time to “buy in” to the market, rather than sitting on the sidelines licking your wounds.  I am trying to figure that one out now, but thought it made sense to take stock of what, if anything, I learned so far.

Cross posted at LITGM and Chicago Boyz

Virtually all of us have been touched to some extent by the decline in stock prices and asset devaluations (houses). I recently was talking to someone and they mentioned this thought experiment:

What if you had spent all the money that was lost in the recent market declines instead of watching it fall in value?

I was walking through River North last weekend when my personal answer sat on the curb right in front of me – a brand new Nissan GTR, valet parked by a high-end restaurant and club. Sure it has a sticker price above $70,000, but it is about the fastest thing on the road and has a great control layout and is a Nissan, to boot (so it likely won’t end up being a rolling pile of junk after a few years).

Of course, this is now fantasy-land, since reality binds me to the GTR’s all-too-practical sibling, a 1999 Nissan Altima, nearing a decade in service but still reliable and practical for the almost no driving I do in the city.

Not that I am encouraging this type of thinking (spend it now because it is falling in value), because it is critical for everyone to keep a long term perspective and to plan for the future. These market losses are discouraging but this is life and we need to keep marching ahead and learn from our failures. It is likely that high government spending and large deficits will mean that relying on social security, always a bad plan, will become even less viable, since all the other spending will crowd out this benefit.

But it is a fun thought experiment, especially when it is sitting on the curb, right in front of you…

Cross posted at LITGM