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In This Issue: Irrational Exuberance and Beyond Retirement Investors Love Plunge 401(k) Loan Can Provide Shelter, Too
Irrational Exuberance And Beyond Has the stock market gone nuts? A provocative answer to that question comes in a new book, “Irrational Exuberance,” by Yale economist Robert J. Shiller. The title refers to a comment by Alan Greenspan, the powerful chairman of the Federal Reserve Board, who suggested that stock prices might have been elevated by an emotion he termed “irrational exuberance.” Since Greenspan made the comment in 1996, the Dow Jones industrial average has risen even further, from below 6,000 to almost 11,000 — meaning the chairman was either all wet or just premature. Shiller clearly believes the latter. Shiller works in a new academic field, behavioral finance, that seeks a linkage between mass psychology and economics. “The market is high,” he asserts, “because of the combined effect of millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom.” OK, but most stocks aren’t traded directly by the public but by giant mutual funds and professional money managers — the infinitely wise and eminent gurus who are constantly yakking away on CNBC. These rational right-brain types are making investment decisions based solely on dispassionate analysis, right? Wrong, says Shiller. He points out that money managers are only too human. They want to remain employed. In an effort to retain their jobs, they purchase stocks that everyone else in their peer group is buying. For example, if you run a biotech fund and you believe that everyone is buying Amgen, you buy Amgen, too, regardless of its price or what you think of its prospects. Monkey see, monkey do. By purchasing stocks this way, a fund manager is sure not to fall too far behind his or her peers. When biotech stocks drop in value, everyone in the group will suffer much the same drop. These investment professionals have prepared an acceptable excuse for disappointing performance. It’s like the teenage kids at the shopping mall who all wear baggy pants hanging off their butts so they can look like they belong to the in-crowd. The “baggy pants” equivalent for the money management in-crowd is an r-squared rating of 90 — that is, a performance that tracks within 90 percent of the broader market, as measured by the S&P 500. Professional money managers are subscribing to “the greater fool theory.” This theory says that it doesn’t matter what you pay for something today, because there is always someone else who will pay more tomorrow. We saw this in commercial real estate in the 1980s, when seemingly-expert lenders and developers managed, between 1976 and 1986, to double the entire amount of office space built during the first 200 years of American history. Experienced real estate people did what was stupid because they made lots of money in loan fees and developers’ fees. Barron’s recently conducted a poll which reported that 72 percent of professional money managers believe that the stock market is in a speculative bubble. Yet these are the people who keep purchasing stocks and driving the market up. I always contend that the nicest people in the world can rationalize what is in their self-interest. So where does that leave you, the prudent retirement investor? In some respects, a severe market decline is favorable for long term investors who are buying on dips or are dollar cost averaging (i.e., investing the same amount of money on a fixed pattern, month in and month out). For people with shorter term goals, or for people who need Rolaids by the barrel when their account balances drop precipitously, here’s another idea: allocate some resources out of individual stocks and stock funds, and into bond funds. A blend of short-term, intermediate-term, and high-yield corporate bonds can cushion the pain of a sharp stock decline. Most 401(k) plans offer a selection of good bond funds. If yours doesn’t, rattle the cage of your 401(k) decision-maker and demand them. Another option for 401(k) participants: borrow from your plan and begin paying yourself back at an interest rate that would be around 9 percent today. It can make sense to borrow from your 401(k) to wipe out steep credit card debt, or to pay off a non-deductible car loan, while you hedge bets within a retirement portfolio. Your employer will simply deduct the loan payments directly from your paycheck — and you’ll be buying stocks at depressed prices as you pay the loan back. Think of it this way: paying back a loan from your 401(k) is equivalent to a fixed income investment with a guaranteed rate of return. If you use the money to replace a conventional loan with high after-tax interest rates, you are accomplishing two things. Your portfolio will be hedged against what Shiller and others feel will be an inevitable major correction. You will also reduce credit card debt. There have been many reviews of Shiller’s book, but the most comprehensive one appears in the March 27 New Yorker Magazine by John Cassidy.
Retirement Investors Love Plunge For those who can bear to look, the past 12 months have presented one of the purest expressions in recent times of the stock market’s risks and rewards. Pick a stock — any stock. Softbank, a Japanese company with big Internet holdings was trading at $150 a share about this time in 1999. It rose to a high of $1,600 earlier this year. Today it’s at $250. The trajectory of Softbank and its peers looks like a manic snowboarder’s jump. As a former stock broker I know put it, “The market always goes down a lot faster than it goes up.” What does this volatility — or even a prolonged decline in stock prices — mean for you as a retirement investor? To answer that question, recall the utterance of Ivan Boesky, a notorious insider-trading felon of the go-go 1980s. In a speech at UC Berkeley, of all places, Boesky told students that “greed is good.” The phrase was later used memorably by Michael Douglas’s character in the film “Wall Street.” Today, I would paraphrase Boesky’s speech and say, “A plunge is good.” That’s right. As a smart retirement investor, you must learn to love the plunge. A sharp fall-off in equity prices represents a great buying opportunity that didn’t exist a few months ago. Ignore
the Timers As luck would have it, there will always be someone, someplace who was in the right place at the right time — like a stopped clock that is correct twice a day. You will receive fervent solicitations from these market timers, making claims about their remarkable prescience. Of course, most market timers have “helped” their clients miss huge portions of the greatest bull market in history. What the market-timers ignore are the impact of dividends and new inbound investments. When the stock market craters, it often has little to do with whether or not companies are making money and paying regular dividends. Dividends today pay only about a 1.3 percent annual return. During a severe market downturn, they rise to around 3 percent. For example, PG&E during the past 20 years has paid dividends as high as 8 percent a year. If you are in a retirement program, these dividends are buying shares at new, bargain prices. Retirement plans using mutual funds are automatically reinvesting these dividends for you. Then there are additional contributions flowing into the program. In IRAs or 401(k)s, we are depositing money every week or every year. My stock broker friend, who remarked on the market going down faster than it goes up, unwittingly highlighted a powerful advantage for retirement plans: The shock of a sudden plunge, and the slow, upward grinding that follows, allows dollar-cost averaging to take advantage of lower prices longer. How Terrible? If you simply can’t resist the allure of market timing, I propose a rule of thumb. Market timing, if it ever makes sense, applies to a finite amount of money, where dividends and interest are either paid out in cash or where no dividends exist. In other words, there are no new inbound contributions. Most retirement
investors, however, have many more years to contribute. In many
cases, the greatest volume of inbound money occurs in the years
just prior to retirement, when people are at peak earning capacity.
My rule of thumb proposes that if the projected new contributions
between today and retirement are roughly equal to the amount
of money in the plan currently, forget about market timing entirely.
Stay invested, because a plunge will serve your best interests. Need more help? A free booklet, “Roadmap to Riches” is available at my Web site (www.pensiondynamics.com). The booklet features a useful tool for estimating the right mix of bond and stock mutual funds in your retirement account. You can also e-mail us to receive a hard copy, or call us at 925-299-8080.
401(k) Loan Can Provide Shelter, Too A creative new financial tool enables anyone with a 401(k) account balance to obtain a no-down payment first mortgage for a home. This innovation, known as MAP 100, can be especially valuable here in the Bay Area, where high home prices require buyers to marshal all the financial resources they possibly can. If you are planning to purchase a home and also have money in an employer’s 401(k), you should know about MAP 100 (the name is an abbreviation for Mortgage Acceptance Program). First, though, let’s review the basics of 401(k) loans. When you borrow from your 401(k) account, you pay the loan back over five years at an interest rate that is competitive with neighboring financial institutions (about 9 percent currently.) Every dime of this interest is credited right back to your own account, so you have effectively created an investment with a return of 9 percent per year. You are basically serving as your own banker, borrowing money from yourself and paying yourself back. For the past three years, this 9 percent return would have been a tepid performer compared with zooming stocks and stock mutual funds. However, in the light of the past few weeks, a 9 percent guaranteed return may turn out to be the star performer for the year 2000. In general, 401(k) loans are a good idea for both individuals and plan sponsors. The flexibility they offer encourages greater use of the plan, especially among younger employees. People are taking advantage of the opportunity to save pretax dollars that build up on a tax-deferred basis. The fact that one of the investments is a loan to the participant is almost incidental. Having said that, there are risks involved with 401(k) loans. For example, it can be expensive to leave a company without first paying back any outstanding balance, because a loan cannot be moved into a rollover IRA like other plan assets. Any unpaid balance not returned to the plan before the rollover will be taxed at your highest possible combined state and Federal tax bracket. For most Californians, this will be at least 33 percent. If you are under age 591/2, there will be an additional state and Federal penalty totaling 12 percent. In short, you get slaughtered. Technically speaking, you can sometimes elect to continue making loan payments back to your old plan after leaving, but with most of today’s plans valued daily with an 800 number, this is not a practical alternative. The automation requirement of these plans only allows contributions from people on the company’s payroll. Also, some plans will allow you to roll your old 401(k) balance, including your loan, directly into your new plan at your new job, but don’t count on it. This option is rare. In another scenario, if you leave your present job and have over $5,000 in your 401(k), you have the legal right to leave the money there indefinitely. However, if the account includes a loan with no mechanism for continuing the payments as a former employee, the loan will automatically go into default after 90 days. This triggers taxable income for the amount of the outstanding balance — an unpleasant surprise for people who weren’t aware of this hand grenade with the pin pulled out. So what’s the solution? For home buyers, MAP 100 offers a no-down-payment loan as long as the borrower can produce a quarterly statement showing that he or she has at least some amount of money in a 401(k) that allows loans. There is no minimum amount requirement. It’s
easy to see why a 401(k) investment, even a modest amount, makes
someone a good credit risk. The individual has demonstrated
foresight and the discipline to save money. Most people who
are in financial difficulty, or between jobs, would choose to
tap their 401(k) money through a loan (if employed) or through
a distribution (if between jobs) before they would let their
house go into foreclosure. The lenders have exercised intelligence
and creativity in creating this new instrument. MAP 100 offers two other advantages. The first is that you may be taking money out of a mutual fund that would have earned 15 percent or more to replace it with a loan that only offers your plan a 9% return. The difference, known as an “opportunity cost,” over time could be huge. Over time, the stock market has averaged a 10 percent annual return, and interest rates on consumer loans averaged between 7 percent and 8 percent. Based on these long-term averages, we could argue that it would always be better to borrow from outside the plan for a 100 percent home mortgage rather than take money out of your 401(k)’s equity mutual funds. The clincher,
however, is that the interest on the entire home mortgage is
tax deductible. If you borrowed from the 401(k) for, say, a
10 or 20 percent down payment, your 401(k) loan interest is
not tax deductible. With a 100 percent mortgage, all of your
interest is tax deductible. When is a MAP 100 a better option than a 401(k) loan for a home down payment? It depends. If you change jobs often, or expect to earn better than 9 percent in your stock-oriented 401(k) investments, then you are a serious candidate for the program. To find out more about it, go to MAP100.com or call them at 310-777-2095.
According to Warren Buffet, chairman of Berkshire Hathaway, “Rising Markets are for sellers, not for buyers. It’s during a down market that the best investments are made.” In these days and times, it’s a comforting thought. For the 401(k) investor, a market like the current one is an opportunity to dollar-cost average more shares into the portfolio for the same money. Rather than moving entirely to the sidelines, this is a very good time to strengthen one’s position for the long term at increasingly attractive share prices. The stock market is currently trending down, having lost around 8% of its value since January. Many analysts expect the market to end up the year about where it started, for little or no gain. Others believe that, following this correction, the year will finish up strongly. It is likely that, as the technology sector adjusts to the realities of economic life, we may be in for a prolonged period of relatively indifferent stock market performance. In such times, the 401(k) investor should examine the option of allocating some dollars to money market funds as a means of moderating risk. While such funds typically yield much lower gains than those promised by securities, the return is fairly predictable and the risk of capital loss is negligible. For the 401(k) investor, allocating dollars to such funds amounts to increasing the level of savings while sheltering the income from tax. While such funds are not as liquid as bank savings accounts, they can be accessed through loans (see the article elsewhere in this newsletter).
If you need a really good reason to invest in your 401(k) plan and haven’t yet found one in your reading and discussions, consider this: your 401(k) investment dollars are tax deferred; and a tax that is deferred is the functional equivalent of an interest-free loan from our buddy Uncle Sam. Here’s how it works for an investment held for 25 years and then redeemed and taxed:
By comparing the amount deferred with the present value of the 25 year deferral, we find that we are getting a 91% bonus, which is about as close to interest-free as one can get. Now, during the 25-year investment period, the initial $1,000 investment presumably increases in value as well. Using a 10% average annual yield and assuming that all distributions are re-invested as is the case in 401(k) accounts, the initial investment compounds to over $10,000. When the investment is redeemed, the $9,000 gain is also taxed. Assuming that the tax rate is 34%, the tax will be $3,060. The present value of that future tax is $280. This means that Uncle Sam is effectively paying 91% of the tax on your behalf. When all is said and done, our tax deferred $1,000 invested at 10% for 25 years returns an after-tax gain of $5,600, or 560%. Had that investment been taxable from inception, our gain would have amounted to only $2,260 or 40% of the tax-deferred return. As we can see from this illustration, the 401(k) plan is a powerful deterrent to the impact of taxes on total return.
Indexes Prime Rate - 9.5% Fixed Mortgage 30 Year - 8.02%, 15 Year - 7.74% Home Equity Loan 9.6% Automobile Loan 9.03% Internet Sites
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