The Float

More on Residential Real Estate's Real Returns

A week ago, we posted an item on the perception that residential real estate is often a great investment (when the residential real estate market is falling off a cliff, of course). We've always thought that perception was flawed, not in the sense that it's always and everywhere wrong (because in some places and times it can be fabulously right), but in the sense that it reflects a very narrow sense of the costs and benefits of acquiring and possessing residential real estate.

In that post, we drew on a Wall Street Journal column by Brett Arends. Apparently Arends got so much feedback on that initial item that he had to write more on Friday. And once again, he got it right. After discussing tax benefits, transaction costs, the illiquidity of the collateral, and other considerations, he closed with this:

The real benefits of home ownership are any capital appreciation, plus the imputed rent, minus the effective cost of the mortgage and property taxes, other costs, and the return you could earn on your down payment elsewhere.

That's a complex figure, and it varies widely. But if your home's appreciation is lower than the annual cost of borrowing, as it has been for many over the last 20 years, leverage is not much of a friend.

Well put.

Sources

Brett Arends, "Is Your Home a Good Investment?" Wall Street Journal, May 27, 2009

Brett Arends, "Why Your Mortgage Won't Make You Rich," Wall Street Journal, May 29, 2009

Brett Arends' 12 Rules

Back on May 1^st, the WSJ's Brett Arends spun out "12 Rules for Investing in the Next Bull Market," most of which are insightful and helpful. We generally like Arends' work and this piece is no exception. Though we're quibblers by nature, this is pretty strong stuff and it deserves your consideration. Here are a few of Arends' rules followed by our comments:

2. Avoid big moves.
If you buy or sell heavily in one shot you're taking a needless risk. And waiting for the right moment to make your move is futile. You probably won't catch the bottom or the peak anyway. If a market trend has much further to run, then what's the rush? And if it doesn't...what's the rush?

No quibbles here. This is exactly right. 

6. Be truly diversified.
That means investing across a spread of different asset classes and strategies. As investors discovered last year, "large cap value" and "mid cap blend" funds don't offer diversification. They're just marketing gimmicks.

Though it's true that correlations rose sharply among risky asset classes during the last 20 months, we aren't willing to concede this point. There are ways to slice the market too narrowly, but historically there have been--and, we think, will be again--material differences in the risk/return profiles of various classes of equities. Tilting strategic portfolios in one direction or another by weighting assets classes isn't just a marketing gimmick. Or, to be more precise, it isn't necessarily, or always a marketing gimmick.

10. Be patient.
Investment opportunities are like buses. If you missed one, you don't have to chase it. Relax. If history is any guide, others will be along shortly.

Yes.

11. Don't sit on the sidelines completely until it's too late.
You'll probably end up splurging at the last moment. If you are afraid to invest, do it early, little, and often.

Yes.

12. And above all: Price matters.
After all, an investment is just a claim check on future cash flows, whether it be a company's profits, a bond's coupons or an annuity's income stream. By definition, shares in a solvent company are twice as good at half the price...and vice versa. It's amazing how many people get suckered into thinking it's the other way around.

And yes.

But then there's this morning's Arends column, in which he taps some recent research suggesting that near-term economic prospects have almost nothing to do with stocks' long-term returns, which in turn makes the notion of "price" a little less concrete that most investors--and certainly less concrete than most fundamental analysts--would like to believe. Here's an excerpt:

The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

(The second reason is that short-term deviations from long-term trends in economic growth are typically resolved back toward those long-term trends within a few years.)

"This sort of analysis is a useful antidote to stock market moods," writes Arends. Maybe. But the other way of looking at Inker's research is that all we really have in the short run is "stock market moods." Which means you either trade on the technicals (with some attention to short-term expectations of the fundamentals, as in a Keynesian beauty contest) or, like Joshua in War Games, refuse to play the short-term trading game in the first place.*

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* It's one of the great lines in movie history: The rogue computer program "Joshua," having realized that "global thermonuclear war" produces no winners, declares that "the only winning move is not to play."

Sources

Brett Arends, "12 Rules for Investing in the Next Bull Market," Wall Street Journal, May 1, 2009

Brett Arends, "How to Value Stocks? Ignore Economic News," Wall Street Journal, May 11, 2009

Ben Inker, "Valuing Equities in an Economic Crisis," Grantham Mayo Van Otterloo & Co., April 6, 2009 (registration required)

The Fiduciary Question

Today's Wall Street Journal includes a special "Wealth Manager" section, the primary feature of which is "Seven Questions to Ask When Picking a Financial Adviser." The questions are generally sensible, though #2 ("What do the adviser's clients say?") can be problematic due to the prohibition on the use of client testimonials.

But here's our primary objection: Only in the last paragraph of #6 ("Can the adviser put it in writing?") does Shelly Banjo raise the fundamental question in the financial services industry: "Whether the advisers are going to take on fiduciary responsibility, in which they are legally bound to act in your best interest."

By our lights, that should be the first question, and a negative answer should pretty much make all the rest of the questions (and answers) moot.* 

For more on the fiduciary difference, see this excellent discussion from the National Association of Personal Financial Advisers. And, also from NAPFA, here's an even better, more-to-the-point list of questions investors should ask of people selling financial services.

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* Off-topic but fun: Jesse Jackson in his classic 1984 SNL sketch "The Question is Moot." Arguably better yet: Jackson reading Green Eggs and Ham on SNL.

Source

Shelly Banjo, "Seven Questions to Ask When Picking a Financial Adviser," Wall Street Journal, April 13, 2009

"What Do I Do Now?"

With the financial world lying in rubble, nest eggs cracked wide open, and easy, long-held assumptions open to new scrutiny, individual investors are left wondering which way is up. We were pleased to see the WSJ publish 10 solid ideas on what people should (and shouldn't) do now. These recommendations are clearly relevant these days, but they're also timeless, applicable to pretty much any economic or market environment. 

Here are the 10 commandments:

1. Reduce Your Expensive Debt
2. Get On a Budget
3. Guard Against Inflation
4. Have a Stock-Market Strategy
5. Preserve What You Have
6. Don't Bury Your Money in the Backyard
7. Don't Chase Returns
8. Don't Abandon Diversification
9. Don't Stop Saving for Retirement
10. Don't Ignore Common Sense

Read the whole thing. It's good.

Source

Dave Kansas, "What Do I Do Now?" Wall Street Journal, April 7, 2009

BrightScope in the News

Our friends at BrightScope have enjoyed some good--and well-earned--press lately. Here's the most recent example: A new "slideshow" (i.e., click-maximization program) at BusinessWeek.com, for which BrightScope provided much of the data. As quick tours of the 401(k) landscape go, this one's serviceable.

Check out slide 11 in particular. Nearly two percent in annual expenses for very large plans? Yikes. This market needs some serious fixing.

School Is In

Two interesting items on page D2 of today's Wall Street Journal.

First, Karen Blumenthal spends a few hundred words noting that the mutual fund industry makes it very difficult for young, first-time investors to get started, even in IRAs. Though none of our clients fall in this category, we've noticed this problem in doing some "pro bono" work for young people. It really is ridiculous.

Here's a telling passage:

Decades ago, when I was a teenager, I deposited my work savings into a money-market account with Fidelity Investments, and guess what? I'm still a customer. But Fidelity requires minimums of at least $2,500 and its index funds usually require at least $10,000, to help keep expenses down, a spokesman says.

Lovely. Fidelity imposes low minimums for those who commit to contributing $200 per month or $600 per quarter, but as Blumenthal notes, that's not necessarily easy for young people who work uneven/seasonal jobs. Sometimes we wonder where investor loyalty comes from in this business. Why is Blumenthal still a Fidelity customer? The more we learn about physics and financial services, the more we understand the all-encompassing power of inertia.

Blumenthal settled on a total-market ETF from Vanguard. We think that's a good call, and the logic of her choice undercuts the mutual fund apologists who argue that ETFs' brokerage costs make them an unwise choice for small-dollar investors. No, you wouldn't want to do monthly dollar-cost averaging using ETFs. But $1,500 in one trade? We see Blumenthal's point.

Then there's this, late in the column:

The last and most resonant lesson in all this, of course, was last fall's stock-market debacle. "How did that IRA investment work out, mom?" my daughter teased over the holidays. Like the market, her IRA is down about 40%.

We know Blumenthal will make the obvious point to her daughter (we know this because she does it in the very next paragraph), but this notion, that what happens in the first year of a thirty- to fifty-year investment program is indicative of anything at all...well, it frustrates us to see stuff like this. Blumenthal's daughter should be absolutely beside herself with glee that the future of the global economy has been put on sale. And she should work hard this Summer to increase her 2009 Roth contribution when the buying's good.

Immediately adjacent to the Blumenthal riff is a Jane Kim story on 529 college savings plans offering more "safe" choices in their menus of investment options. That's fine, but as with the insurance industry rolling out "guaranteed" products to 401(k) plans after the market meltdown, this is a little like handing flood victims umbrellas...after the rain has stopped and the water is up to their knees.

As with near-retirees who are on the verge of annuitizing their savings, this is very simple: college savers with short time horizons should not be invested in volatile assets.* In fact, college savers wth short time horizons probably shouldn't even bother with the hassle of the 529 plan in the first place. The plans' tax benefits can be great for those with more than a few years to contribute (and, of course, ride out market swings). But for short-timers, what's the point? A good, solid, FDIC-insured online savings account would almost certainly be a better bet.

What we hate to see is so many people get thrown off track by market volatility. This is just another reason why good, truly independent, fiduciary advice is so indispensable to so many people. The alternatives--the do-it-yourself route on the one hand and being subjected to Wall Street's product-driven selling on the other--aren't good at all.

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* As we've written over and over in this space, the situation of the near-retiree is different. He has to protect and invest for what is likely to be a much longer period than a four- or five-year stint in college. The key for the about-to-retire, then, is to ensure that they have enough liquidity to avoid tapping into depressed assets at or near market bottoms.

Sources

Karen Blumenthal, "Obstacles for Young Investors," Wall Street Journal, February 11, 2009

Jane J. Kim, "States Offer Safe Choices in 529 Plans," Wall Street Journal, February 11, 2009

Mortifying Insight of the Day

From yesterday's Investment News salvo (emphasis added in bold):

Compounding the problems of increased unemployment and slowing economic growth, investors yanked more than $225 billion from equity mutual funds last year--a record level of outflows.

"Many people have been forced to sell off some of the assets just to cover their day-to-day expenses," he said. "So this isn't money that will be reinvested in the markets--it's being tapped by many just to pay bills."

Cash on the sidelines? In a manner of speaking, yes.

Truism of the Day

From a January 9th piece in the Wall Street Journal...

"You have to look at the big financial picture. Americans in general are under-invested for retirement and over-invested in their homes."

And yes...that's a problem.

Diversification and Varieties of Risk Management

Kathleen Pender published an interesting piece in the New Year's Day edition of the San Francisco Chronicle. Pender's basic question is this: What good is diversification when pretty much everything lost value (and with relatively high correlations) in 2008?

Asking that question suggests a subtle-but-important misunderstanding of portfolio design and expectations thereof. Throwing volatile asset classes together (say, U.S. stocks, EAFE stocks, and BRIC stocks) can help smooth a portfolio's trajectory (as it did in the first years of this decade, when non-U.S. equities outperformed), but that smoothing is hardly a sure thing.

The fact is, sensibly risk-averse investors (as opposed to those who have become risk-averse* only in the aftermath of the last 18 months) can/should/must reduce expected short-term risk by adding high-quality fixed-income (i.e., treasuries notes and bonds) and cash-equivalents (i.e., treasury bills) to their portfolios. As it happens, those asset classes did hold up last year, which makes this passage from Pender's piece a little mystifying:

"Diversification is supposed to work, so that not everything goes down by the same amount. It didn't work (in 2008). If you were diversified or not, it didn't matter," says Jennifer Ellison, a principal with San Francisco money management firm Bingham, Osborn & Scarborough.

If asset managers and investors allowed themselves to believe that small-cap and non-U.S. equities provided some sort of safe haven...well, let's just say they earned last year's nasty bear market.

Some say diversification is the only free lunch in investing.** There's some truth to that. But when it comes to diversifying across asset classes with an eye to reducing volatility, the only way to make a meaningful dent in expected short-term risk is to reduce one's exposure to equities and equity-like assets. And the time to do that, for the vast majority of investors, passed by several months ago.

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* In a perfect world, we'd never see "adverse" used where averse belongs. Alas, that's a world we're unlikely to experience.

** In a former life, we copped a few actual free lunches courtesy of the Wall Street selling machine, but that's another matter entirely.

Source

Kathleen Pender, "Investors ask: Where did all that money go?" San Francisco Chronicle, January 1, 2009

Target-Date Funds

Given the severe retrenchment in asset values over the last several months, it's not surprising that near-term target-date funds ("2010" funds especially) are getting so much scrutiny these days. Our office has fielded several media inquiries on the topic, with the most common (and important) question concerning whether funds with 2010 targets have held up well enough.

So we were pleased to see Craig Israelsen's informative piece on this subject in the November issue of Financial Planning. Israelsen's central argument is that most 2010 funds--and especially the biggest 2010 funds, those provided by Fidelity, T. Rowe Price, Vanguard, and Principal, which together amount to roughly 90% of the assets invested in 2010 vehicles--feature excessive equity allocations. In fact, these four monster funds had an average equity allocation of 52.2%. (As far as we can tell, these data are through September 30, 2008. Given October's epic ugliness, Israelsen's arguments take on more significance still.)

Here's the heart of the dilemma:

What would happen if investors intended to withdraw their money at the target date and purchase annuities? Isn't it true that the glidepath (the dynamic asset allocation model that governs the portfolio from inception to the target date and beyond) is supposed to guard against exactly this sort of meltdown?

This is the question on which all thinking about target-date funds has to turn: What's the annuitization date?* As we've noted in this space on many occasions, one's retirement date is not one's financial finish line. And given current/future life expectancies, the true finish line is stretching further out across the horizon. All of which means that people at or approaching retirement might need to bear some (or even substantial) equity risk to give their assets a better chance of outliving them.

But Israelsen's argument, that target-date funds should protect soon-to-be retirees against the risk of losses of the sort we've seen in recent months, is spot-on for those who plan to transfer their longevity risk to an insurer through the purchase of an immediate annuity.

So all of this boils down to what a new retiree plans to do with his or her accumulated assets. If annuitization per se will take place soon, significant equity exposure make much less sense. If the annuitization date is more flexible or more distant, then non-trivial equity exposure makes a little more sense.

Assuming near-term annuitization, it's hard to argue with Israelsen's conclusion:

A target-date fund that fails to attenuate risk near its target date has failed in its primary purpose. Given that premise, nearly all 2010 target-date funds are failing right now. Even worse, virtually all of the target-date funds coming down the pike (2015 funds, 2020 funds, etc.) are cut from the same cloth and will likewise experience big losses near their target dates if the equity markets decline.

As ever, these questions imply no easy answers (which reminds us of Charles Lindblom's description of the human condition: "Small brain, big problems"). Whatever the number attached to a target-date fund might say, investors and their advisors simply must dig beneath the marketing language to understand the vehicle's asset allocation, its constituent funds, its expenses, and its investment policy.

Target-date funds have made things easier in many ways, but there's still no substitute for heeding that timeless warning: caveat emptor.

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* A related question would concern the method of annuitization, i.e., the purchase of a immediate annuity per se or some other means of planned, systematic withdrawals from a corpus of assets.

Source

Craig L. Israelsen, "2010, A Fund Odyssey," Financial Planning, November, 2008