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In This Issue: Portfolio Contamination A Learning Experience
Until last year, it was marvelous fun to open our quarterly 401(k) or brokerage statements. Every three months they made us feel like we had just won the Publishers Clearing House Sweepstakes. The last quarter to provide this thrill ended on March 31st, 2000. It has been mostly downhill ever since, and a growing number of 401(k) participants have resorted to leaving their statements unopened. It was as if the outside of the envelope has replaced the familiar “You Can Be a Winner!” with “You Can Be a Wiener!” Fortunately, the market has shown recent signs of strengthening. In late May, the Dow Jones Industrial Average returned to its 11,000 levels of last year, while the S&P 500 index rallied to within 4% of where it started the year. Even the much-maligned Nasdaq is up 39% from its low of a few months ago. So what’s next? Is the springtime rally for real or merely a false signal — what Wall Street cynics call “a dead-cat bounce”? From my window as a pension consultant, I view a broad cross section of businesses whom we service. With the exception of a few dot-com bombs, I have yet to see evidence of the deep, pervasive malaise we experienced in the early 1970’s and early 1990’s. Some businesses are clearly slowing down. Overall, though, the economy from where I sit seems to be more normal, rather than being in the state of hyperventilation it exhibited last year. Anecdotal evidence sometimes offers a better glimpse of the future than reams of economic reports. Some businesses are better “forward indicators” than others. Brisk sales in the machine tool industry, for example, are an indication that big business is gearing up to meet growing demand. The box industry is another example, because companies expecting to ship a lot of product order boxes in advance. The stock market is itself a forward indicator of future economic strength. The recent rally is a result of five downward ratchets of interest rates — and interest rates have the single most important impact on company profits. In addition, today’s stock prices anticipate future events. A consensus is telling us that the future looks bright. The fact that we have highly-publicized layoffs doesn’t necessarily mean that companies will stop being profitable. The layoffs are an effort to maintain or regain an acceptable level of profitability. Of course, the big question for many retirement investors is: What do we do with these mutual funds that have plummeted in value — the ones lurking inside that quarterly statement that sits unopened on the desk? Most investors over the past five to ten years put their money into growth funds, which had great returns throughout the Roaring 90’s. Now, we are reluctant to sell those funds, even though our newly discovered “supreme grasp of the obvious” tells us that we should be investing in value-oriented funds. That raises the key issue of rebalancing. The last five years should have convinced you that it makes sense to strike a balance among different types of investment styles. However, learning the lesson is only half the battle. The other half is to get there constructively. Turning a portfolio can be like maneuvering an aircraft carrier. It might take as long as a year to change the complexion from total growth to a blend of growth and value. Remember, scale is not important here, because a small portfolio of $25,000 is just as important to a person with limited resources as a $5 million portfolio is to a wealthy investor. To rebalance a portfolio during a down market you must confront a formidable obstacle: yourself. We humans are genetically programmed to hate losses. Mathematical games demonstrate that avoiding a $100 loss is twice as important to us as winning $100. Therefore, to bite the bullet and sell half of our growth funds is probably not going to happen. Nor would it be wise. If we had done that a few days after viewing our March quarterly-end statement in disgust, we would have missed a substantial gain in most of these growth funds during April and May. Instead, we may want to use the magic of dollar-cost averaging. This means that we systematically move funds from one type to another on a regular basis until the balance we seek has been realized. In addition, our new inbound money can go exclusively toward the new fund type to accelerate the process. An opposing school of thought maintains that every day you own a stock is a day that you have effectively purchased it. In other words, because stocks or funds are completely liquid, every day that you own a stock is no different from having made the decision to buy it that day. This ignores the cost of commissions and taxes, but trading no-load mutual funds in a tax-deferred retirement plan, such as a 401(k) or IRA, is like trading in the zero gravity of a space capsule. In theory, there’s nothing to hold us back. In reality, however, it’s “Houston, we have a problem.” We are naturally inclined to give our mistakes time to work themselves out because we are so loss-adverse. We hold losers and sell winners too soon. Recently I had the experience of enduring what is a common discussion in many investment committee meetings these days. Members of the group had decided to add value-oriented funds to a 401(k) plan. One member said that he was hesitant to add a fund that had just done so well in the immediate past. He asked, “Shouldn’t we be considering a few funds that have just done really poorly with the thought that they will be the better performers going forward?” My response was to say, “Mark, I’m embarrassed to have to point out that you already have plenty of those funds in your plan.” The lesson
is that it is impossible to consistently forecast the future.
Instead of trying to do the impossible, you should rebalance
your retirement portfolio so that it can withstand the shocks
and swings that inevitably occur. To accomplish this, utilize
a system or process, such as dollar-cost averaging, which will
do the heavy lifting for you over time.
Many current and future retirees are considering more economical lifestyles outside of the United States — especially after the market jolts of the past year. The trend may have started with Butch Cassidy and the Sundance Kid when they retired to Bolivia. In the same spirit, Mexico may offer one of today’s best opportunities for a convenient, pleasant and cost-effective retirement locale. I just completed a 3,000-mile round-trip motorcycle ride from San Diego to Puerto Vallarta by way of the Baja peninsula. My three friends and I went by ferry from La Paz, near the southern tip of the peninsula, to Mazatlán on the West Coast, and then on to PV through jungles, villages and banana plantations. Along the way, we chatted with numerous American retirees who have made their homes in Mexico. These conversations convinced me that there are major advantages in Mexico for those who can come to terms with “the fear of the unknown.” The Economics First the economics. Anna, a former supervisor at a Borg Warner transmission factory in Muncie, Ind., showed us her attractive ranch-style home built about 10 years ago for $12,000. It took a dozen workers three months to build, and it is located 50 yards from the beach in a small fishing village about thirty miles north of Puerto Vallarta. Anna also built an eight-room hotel that caters to long-term visitors from the United States. If she needs to go home for extended periods, the guests run the hotel. Speaking of her three children and grandchildren, Anna says, “Hey, they don’t want ‘Gramma’ back up there in Muncie. They would much rather come visit me here in Mexico ... especially around Thanksgiving, Christmas and spring vacations.” At a party, we met just about the entire American community living in this village, which is called Punta de Mita. One person had just developed the town’s Web site, and another was teaching English in a Mexican school. Dinner for eleven persons at a local restaurant serving great Mexican food came to a total of $16. The consensus is that an income of about $2,000 per month can provide a very adequate lifestyle anywhere in Mexico, outside the hardcore resort communities. Many retirees living on their sailboats manage comfortably on $500 per person per month. In the Lake Chapala area, as well as around Mazatlán, there are large communities of Americans and Canadians. Many of the Canadians have renounced their citizenship to avoid Canadian taxes. Taking this initiative is a major cost-reducing step. With regard to health care, Mexico offers some good resources. On a previous motorcycle trip, one of my travel friends (a surgeon himself) had a little accident and broke seven ribs and a collar bone. The attending physician in Mexico was a McGill-trained specialist working in a hospital with first-class surgical facilities. A knee or hip replacement costs half to one-third as much as the same operation in the United States For obvious reasons, Blue Cross loves it when its U.S. members receive medical care in Mexico. Apart from good medical care, the cost of around-the-clock assistance for, say, a spouse who has had a stroke or who suffers from Alzheimers can be a fraction of the prohibitive cost in the United States. This is another compelling reason for retirees to consider this adventurous alternative. ‘Funky’ Lifestyle Some aspects of Mexico take getting used to. Outside the resort communities, little English is spoken. You have to learn at least the basics of Spanish, but when you’re there, the basics come pretty easily. Spanish is an appealing language to learn, and a reasonable amount of study and diligence can make you conversational. There’s also the issue of climate — it tends to be dry and dusty for much of the year and humid in the summer. Overall, things are just “funky” compared to life in a typical United States or European suburb. The resources are just not there to create the same degree of neatness that people enjoy in, say, Holland. But everyone certainly tries. The warmth and friendliness of the people more than compensate. The legal system is different as well. To oversimplify, it is easier to ask forgiveness in Mexico than it is to ask permission. The law is just a starting point for discussion. It reminds me of what they say in Hollywood: “After the contracts are signed, the negotiations begin.” Thankfully, there is not the same sense of personal liability that we have in the United States. Best example: A popular beach activity is to be pulled by a speedboat while sitting in a para-sail that rises 200 yards above the ocean. Riders motion that they want to be pulled closer to the beach so their friends can videotape them. A strong puff of wind sends them into shore and beyond the beach, where they often splatter like mosquitoes against the sides of their high-rise hotels. To the dismay of the American legal profession, there is no liability issue here. The law serves a different function in Mexican society than it does in this country. Many, including the dean of the Harvard Law School, maintain that aspects of the Mexican legal system are an improvement over ours. Mexican culture is as different from ours as, say, an Asian culture. One example: time is infinite, rather than something considered from minute to minute. Retirees suffering from heart conditions or high blood pressure may live a lot longer in this slower-paced Mexican culture. Spending money is not as important to Mexicans as it is to Americans. The country has one of the highest per capita savings rates of all industrialized nations. Other cultural differences trace their roots back to Spain and the influences of the Moors and the Middle East. A single Spanish word, for example, means “It is Allah’s will.” Differences that exist today between California and Mexico are evaporating. One-third of all Californians are now identified as Hispanic, and people of Mexican origin constitute the largest group within the Hispanic communities. Meanwhile, the Free Trade Area of the Americas moves one step closer to reality this week. It extends NAFTA by creating a free trade zone of all of the Americas — a market that includes 700 million people. Further cross-pollination of cultures and economies is inevitable. Want to
know more? An excellent book on the practical aspects of Mexico
is “People’s Guide to Mexico” by Carl Franz.
The web site www.puntamita.com shows what a typical coastal
town has to offer. Of course, an exploratory vacation trip to
see things for yourself is the best strategy — even if
you choose to leave your motorcycle at home.
Portfolio Contamination A Learning Experience Back in the 1300s, when Italian city states were at war with each other, battle tactics included the use of catapults to hurl plague-infested dead donkeys over the walls of a city under siege. Imagine the horror of looking up from the streets of, say, San Gimignano, to see furry bundles of toxic waste whistling through the air like incoming mortars. About the same time, not surprisingly, the securities industry as we know it today was born to meet the needs of those city states. They floated bond issues to finance their growth and their defense budgets. The past year’s financial markets have offered something similar in the form of tech stocks that we catapulted to ridiculously high price earnings ratios only to have them plummet and lose 90 percent or more of their value. “Toxic waste” is, in fact, the term used on Wall Street for these stocks. Meanwhile, analysts promoting them (all the way down) found a need to whistle in the dark. It is clear that the primary role of many stock analysts today is to support their firm’s investment banking business. We investors are really alone with our money as never before. To some extent, anyone with any money invested in the market was caught up in the euphoria of the past several years. Even someone with just an S&P 500 Index fund was benefiting from the fact that roughly 30 percent of the largest 500 companies are technology-based. “Yahoo!,” remember, was inducted into the fold as company number 500. For many of us, the boom and bust of the past five years offers a valuable laboratory for introspection. Now is a time to think about how we behaved as investors from the mid ’90s through 2000 and to ask ourselves if we have been gambling, speculating or investing. If we conclude that we would have done some things differently, that may set the stage for a more satisfactory result during the next stock market cycle. Gambling and speculating are fun. Let’s face it. Both are attempts to increase wealth dramatically. Gambling actually creates a risk while speculating usually involves taking over an existing risk. Not that it makes much difference. Compulsive gambling is a sickness in parts of our society and speculating may be just a more sophisticated expression of the disease. Investing, on the other hand, involves the attempt to generate ongoing income and to protect against the downside. It is less concerned with trading assets than with owning and nurturing them. In the end, it is safe to say that we are better off attempting to be investors rather than speculators when it comes to investing our retirement assets. However, it is difficult to resist being part of the mass movement into those investments where everyone else seems to be making a fortune. So, how much of our financial decision-making is an effort to assure a long-term positive result, and how much is entertainment and stimulation? Looking back over the past six years, we should all ask ourselves that question. It may help to know that we are genetically programmed to enjoy the hunt for the “ten bagger.” This was the term used by Peter Lynch of the Fidelity Magellan Fund’s glory years when he bought a stock that increased ten-fold in value in a year. Imagine investing your entire retirement account in a single stock that increases to ten times its value within a year. In 1841, Charles Mackay wrote a book “Extraordinary Popular Delusions and the Madness of Crowds” in which he talked about the tendency of societies to succumb to delusions and mass madness. He was writing about the Tulip mania in Holland, and other speculative frenzies of the time. He concluded that “Men think in herds ... go mad in herds ... (and) recover their senses slowly, and one by one.” Women, not to be spared, have had a history of even more rabid inclinations to speculate, but their patience and fortitude make them better equipped for success. In an era where they were discouraged from working and where they had no right to own land, speculating offered an opportunity to create financial freedom. The Duchess of Marlboro, Winston Churchill’s ancestor who had created a family fortune through successful speculation, had what he once termed, “almost repellent common sense.” Looking back on my own investment experience of the past several years, I am reminded of the man in Los Angeles who filled some balloons with helium, tied them to his aluminum chaise lounge, armed himself with a pellet gun, and cut himself loose to rise swiftly up into the commercial airspace above Los Angeles. His plan was to shoot the balloons on an “as needed” basis until his vehicle settled slowly back to the ground. For whatever reason, he couldn’t bear to shoot any of the balloons and just kept going higher until he was reported by pilots in the landing pattern for the LA airport. He was rescued eventually in a daring maneuver conducted by a helicopter with a very long rope ladder. I owned a few stocks and mutual funds that I couldn’t bear to shoot down. In one example, I had a five-fold gain on a stock that is now worth one third what I paid for it. I simply liked the stock too much to sell it, and I still do. Unfortunately, as they say, the stock doesn’t know I own it, so my love is, for the moment, unrequited. Nevertheless, my experience of the past several years has taught me that not all of my investment decisions have been coldly rational. They should be. Entertainment and wishful thinking have no place in a cohesive retirement investment strategy. A great
book is titled “Devil Take the Hindmost — A History
of Financial Speculation” by Edward Chancellor. It is an
excellent historical account of the waves of speculation through
history and helps to put our own recent “bubble” into
perspective.
Spending and investing are really two sides of the same coin. Here are some key examples of why this is true: Buying a home, owning a car, and college expenses are probably the three largest expenses you will ever have. Figuring out just how much of each, if any, you can afford, is a major effort if you want to get it right. These days, there is a wealth of information and guidance available on the Internet that will help you work through figuring out how much you can afford to pay, how much you will need to save before you invest, and in the case of education, sensible ways to prepare for the ever-increasing costs of higher education. Buying
A Home College
Expenses Buying
A Car Five-Year
Cost of Owning A Camry
That’s
a lot of money, and it doesn’t even include the cost of
borrowing or the time value of the money you invested. For
more detail, visit www.calcbuilder.com, or www.financenter.com.
The concept of dollar-cost-averaging comes in a close second to compounding as a magical tool for the long-term investor. It smooths out the very bumpy day-to-day performance of the marketplace in such a way as to: optimize results; and minimize risk over time. Here’s how it works: One of the central notions about investing is that by investing the same amount each month, variations in the stock market are minimized and long-term gains maximized. This notion is known as dollar-cost-averaging, or hedging. When you do this you are sometimes buying more shares and sometimes fewer because the price varies daily according to what buyers are willing to pay and sellers are willing to accept. An example of the effect of dollar-cost averaging is shown in the following table which tracks the results of a hypothetical $2,000 investment made in four equal monthly installments at prevailing market prices as well as a single sum invested at the beginning of the period.
As is readily apparent, the fact that you invest regularly reduces your average share cost by $1 and increases the number of shares purchased by 25 over a single investment made at the beginning of the investment period. What’s more, the value of the 225 shares at the end of August is $4,500 and represents a capital gain of 125% (admittedly a little exaggerated, to illustrate the point). The single payment investment has grown as well, but is worth $500 less. It’s a powerful concept. Now, dollar-cost-averaging doesn’t guarantee gains in value. The market will determine the value of an equity at any given time, whether one uses this approach or not. Dollar-cost-averaging operates in a different way: as a hedge against risk. If you are interested, change the prices in the above table so that every purchase costs less than the last, as it would in a declining market. Then compare the results with the value of a single purchase made at the beginning of the period. While the investment will show a loss, the result from dollar-cost-averaging is far less severe than the result of a single purchase. It pays
to dollar-cost-average. A friend once said that when he began
his career, his employer took him aside and advised him to invest
10% of his income every year, in equal monthly installments,
and without fail. He was told that it would be one of the hardest
things he would ever do; and that it would also be one of the
most rewarding. Thirty years later, he was able to report that
his employer had been spectacularly right on both counts.
Indexes Fixed
Mortgage Home
Equity Loan New Car,
48 Month Loan Internet
Sites www.homepath.com www.calcbuilder.com Dow Jones
Averages
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