Monday, September 30, 2013

Retirement - Your Second First Job (2)

The old rule of thumb regarding asset allocation calls for a portfolio to consist of a percentage of debt securities equal to your age and the balance invested in equities.  At the age of 65, you would have 35% of your retirement funds in equities under the rule.  As with all rules of thumb, they should not be followed blindly.  Setting your allocation percentages is not a "one and done" decision.  You should expect to change your allocation over time as circumstances dictate.There are a couple of other factors to keep in mind.  

A retiree must take the present state of the market into account in establishing his or her allocation between debt and equity securities.  Is the Market rising, declining or moving sideways?  Some consideration of the market is necessary when deciding how to allocate your portfolio.  As the Market changes, it is possible that your asset allocation must follow in some fashion.  How that occurs must be based in part on your investment mentality.

More important than the state of the market is your mental state.  You must honestly determine your risk tolerance.  Warren Buffett said that if you could not tolerate a decline of 50% in your portfolio's value without selling out your position, you should probably not invest in individual stocks.  Over your remaining years, the Market will rise and fall several times, carrying a portfolio of common stocks with it.  If a drop of 50% in value will likely lead you to panic selling, your equity allocation should be smaller than that of an investor who is psychologically able to ride out the decline.  It is said that someone once told J.P. Morgan that frequent changes in the value of the individual's  portfolio were causing him to lose sleep and asked what he should do about it.  Morgan's famous reply was "sell down until you can sleep."  Although anecdotal, the advice may be a good way to decide how much you keep in equities.  Retirement is supposed to be relaxing, not nerve wracking.

The most frequent question asked by the soon to be retired individual focuses on how large a portfolio he or she needs.  Remember the TV ads with the tag line, "What's your number?"  Fred Schwed, in his book Where Are the Customers' Yachts? or A Good Hard Look At Wall Street pointed out an interesting difference between American and British investors as follows:

The British, as a race, have been engaged with the problems of capital investment for a longer period than we have, and accordingly have reached a greater maturity regarding it.  Have you noticed that when you ask a Britisher about a man's wealth you get an answer quite different from that an American gives you?  The American says, "I wouldn't be surprised if he's worth close to a million dollars."  The Englishman says, "I fancy he has five thousand pounds a year."  The Englishman's habitual way of speaking and thinking about wealth is of course much closer to the nub of the matter.  A man's true wealth is his income, not his bank balance.

The retiree's goal is to manage his or her portfolio in such a fashion that there is enough income to sustain a desired life style.  It is up to the individual to do this; the Second First Job.  We will continue to look at this issue in the next post.

Excerpt from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright 1940, republished by John Wiley & Sons, Inc, page 190.

Comments are always welcome.


Monday, September 23, 2013

Retirement - Your Second First Job (1)


Congratulations!!  You made it to retirement.  As the title of this post implies, you now have a new job.  During your working career, the majority of your retirement savings have, in all likelihood, been managed by a pension administrator or a 401K plan provider.  You may have picked the investment options or opted for the portfolio suggested by the plan provider.  In other words, while you were busy with your career, someone else was making most of the investment decisions for your retirement portfolio.  Like many others, you will probably choose to receive a lump sum transfer of those retirement proceeds into an Individual Retirement Account (IRA) after you have wrapped up your last days of work.  

You are now sitting at the kitchen table on that first morning of your "golden years" wondering where all the time went.  At some point you will begin to wonder about how much money you have and will you outlive your savings.  Your new job, what I call your Second First Job, is to make sure your money is there for you through the remaining time you have, hopefully a few decades.

When Social Security was created in 1935, the retirement age (when benefits could be received) was set at 65.  There were approximately 7.8 million people that age when it was established. Today, a 65 year old enjoying reasonably good health can expect to live at least an additional twenty plus years.  Most women have even more time left.  Remember, these are averages, and when trying to calculate your remaining life expectancy, you need to factor in family history and your life style. For our purposes, let's assume that, as a 65 year old man or woman, you have another twenty years of life ahead of you.  Your money has to last that long if you are single.  A couple must make the expectancy calculation based on the prospects for the survivor.  Here is a link to the Social Security website with a life expectancy calculator.  Another issue to consider is whether you want to leave a legacy for your children, but that is beyond the scope of this post.

The truly organized individual has probably lived within a budget for many years.  Many of us have not, thinking that there is always going to be another paycheck.  The game has now changed.  There will be no more paychecks, unless you intend to keep working in some capacity.  If you are not going to continue full time employment, the size of the paycheck will shrink.  It is now time for a budget to figure out what you can spend and where that money will come from for the duration of your life.  Once a budget is established, your Second First Job begins: how to fund that budget.

A typical retiree will have three sources of income:  Social Security, proceeds from an employer's retirement benefit program (pension or 401K plan) and personal retirement savings, usually an Individual Retirement Account (IRA).

As mentioned in an earlier post, there are three certainties in this life: death, taxes and inflation.  Of the three, inflation is a retiree's worst financial enemy. The annual inflation rate is low these days, but anyone 65 or older will remember the late 70s and early 80s when annual inflation rates were double digits.  There is no reason to believe that this could not happen again in the next twenty or so years.  Even low inflation rates, over time, will significantly erode the purchasing power of a retiree's income.

We will continue exploring this topic in the next post.

Comments are always welcome.

Monday, September 16, 2013

Einstein's Eighth Wonder


One of Albert Einstein's famous quotes dealt with finance, not physics.  He said, "Compound Interest is the eighth wonder of the world.  He who understands it, earns it...he who doesn't...pays it."

Compound interest is interest on a debt which includes any previously unpaid interest as principal.  In other words, interest on interest.  The classic example is the credit card.  Assume you have a balance of $1,000 on your card which accrues interest at 12% per annum.  Therefore, the simple interest on the debt is $120 per year or $10 per month.  If you make a payment of $5 one month, the unpaid $5 of accrued interest becomes part of the principal the next month.  Next month, your new balance is $1,005 on which the interest rate is again calculated.  On a larger scale, think of America's national debt.  One of its bonds comes due.  To raise the cash to pay off the bond, the federal government issues a new bond which includes the principal of the old bond plus the accrued interest.  

Compounding also works in calculating returns on investments using the mathematical Rule of 72.  It states that you can determine your annual rate of return on an investment if you know how many years it takes for the investment to double.  If you divide the number 72 by the number of years, the result is the rate of return.  Conversely, if you know your rate of return on the investment, you can determine how long it will take for your investment to double.  Using the same formula, you divide 72 by your rate of return and the result is the approximate number of years it will take for the investment to increase 100%.

All Wall Street professionals advise people to start investing as early as possible, length of time being one of the factors in growing a portfolio.  The sooner an individual starts investing, the longer for the portfolio to grow.  One simple example (and a suggestion to parents and grandparents).  Assume you open an Individual Retirement Account for your child with $2,000 per year starting when he or she is 14 years old.  You invest an additional $2,000 each year for four years for a total of $8,000.  Neither you nor your child make any further deposits into the account.  Assume that amount is invested in an S&P 500 Index fund, which has, despite yearly ups and downs, grown at an average of 8% per annum over the last several decades.  If the return is 8% per annum, then the Rule of 72 states that the amount will double every nine years.  At that rate of return, the $8,000 will have doubled by the time he or she reaches 27.  The $16,000 will become $32,000 by his or her 36th birthday.  When your adult child celebrates his or her 45th birthday, the IRA will be worth $64,000.  That amount will have grown to $128,000 by age 54.  By 65, with one more double, the IRA will be worth $256,000.  And this is without putting one more penny into the account!  With continued $2,000 investments over and above the initial $8,000 (that's his or her job), the IRA should grow to well over $1 million dollars by the time that former 14 year old reaches retirement.

Compounding is an investor's best friend and a debtor's worst enemy.

Comments are always welcome.

Monday, September 9, 2013

Does My Money Need A Passport? (2)


It has been reported that 54% of investment opportunities in the world, based on capitalization, are located in countries other than the US.  Of the ten largest car manufacturers in the world, only three of them are American.  Similarly, seven of the ten largest companies engaged in telecommunications are in other countries.  Half of the ten largest household products manufacturers are located outside the US, but their products are available here.  The vast majority of mining operations are found overseas.

If an individual investor has decided that a portion of his or her portfolio should be invested in foreign stocks, there are several alternatives available.  International investing can be accomplished with mutual funds, exchange traded funds (ETFs), direct investing in a foreign market and American Depository Receipts (ADRs).  The costs, expenses and difficulties of directly buying a stock in a foreign market put this strategy out of the reach of most individuals.

Mutual funds and ETFs come in two varieties.  A "Global Fund" invests in companies throughout the world.  This means that a portion of the fund will hold stocks in the investor's own country.  If the fund is labeled "International" or "Foreign", there will be no stocks from the investor's country in the portfolio.   

Some mutual funds and ETFs invest only in developed countries, such as England, France, Japan and Germany.  Others focus on emerging markets, less developed countries with prospects for increased rates of growth.  In 2003, the investment firm Goldman Sachs identified Brazil, Russia, India and China as the four emerging markets with the greatest potential to become dominant in the global economy.  The countries are collectively referred to by the acronym BRICGoldman projected that China and India would together lead the world in manufacturing.  Russia and Brazil would become leading suppliers of raw materials. These countries are, obviously, not a political bloc.  However, if they worked together financially, they could become a very powerful economic force in the global economy by 2050BRIC could surpass today's economic powers, including the US.

The investment firm JP Morgan introduced ADRs to American investors in 1927.  This was one of the first ways to invest internationally in this country.  An investment firm purchases and holds large amounts of foreign stocks in safekeeping.  It then sells shares or receipts in that portfolio (just like a mutual fund) to US investors.  Those receipts are traded on Wall Street in US dollars, just like US stocks.  These days, some foreign companies cut out the middle man, the investment firm sponsoring the ADRs, and issue their shares directly into the US markets.

International investing brings added risks.  Since foreign companies are not necessarily subject to the disclosure requirements imposed on US companies by the Securities & Exchange Commission, financial information can be difficult to get and may not be entirely reliable.  Political instability in emerging countries could detrimentally affect companies in those countries.  There are many examples of companies being nationalized by foreign governments.  Currency exchange rates fluctuate daily, which can impact the US dollar value of an investment.  Inflation rates vary from country to country and could drive down the value of a foreign stock held by an American investor even though the actual business of the company has not changed.

One last thing to keep in mind.  US companies are increasingly becoming global in their own right.  Approximately half of the companies on the S&P 500 Index break out global sales in their financial reports.  Global revenues of the reporting companies represented 46% of their total revenues.  Therefore, almost 25% of all S&P 500 revenues came from foreign countries.  If you assume that the same percentages hold true for the companies which do not break out their foreign business, it could be that almost 50% of the revenue of the S&P 500 companies is international.  If this is the case, an individual investor might safely invest "internationally" by simply buying an S&P 500 Index mutual fund or ETF.

Comments are always welcome.

Monday, September 2, 2013

Does My Money Need A Passport? (1)


Once upon a time Corporate America was top dog and paid little attention to the industries of other countries and their products.  Then change started to happen in the US.  People began driving Volkswagens and Toyotas instead of Chevys and Oldsmobiles.  Some bikers bought Honda motorcycles instead of HarleysSony televisions became market leaders, pushing aside Zenith and Magnavox.  Pasta actually came from Italy.  You could find excellent wines from South America at your local liquor store at a reasonable price.  Chocolate lovers traded their Baby Ruth bars for Nestle Crunch.  Interestingly, Baby Ruth bars are now made by Nestle.  Globalization hit with a vengeance and continues to this day.

One of the earliest pioneers in international investing was Sir John Templeton.  Born in Tennessee, Templeton ultimately moved to Nassau where he became a naturalized British citizen.  He was knighted for his work in several fields, including philanthropy.  He formed the Templeton World Fund in 1978, one of the first mutual funds to invest on a global basis.  Templeton had a value/contrarian investment strategy.  Unlike most of his contemporaries, however, he would look for low priced companies beyond America's shores.  He is considered one of the top international investors in the history of Wall Street.

Peter Lynch managed the Fidelity Magellan Fund  for thirteen years with an astounding average return of 29% per annum.  A little known fact is that a portion of that return was attributable to his foreign investments.  In his book, Beating the Street, he revealed what he called his "adventures abroad" as follows:

With the exception of John Templeton, I was the first domestic fund manager to invest heavily in foreign stocks.  Templeton's fund was a global version of Magellan.  Whereas I might have 10 - 20 percent of the money invested in foreign stocks, Templeton invested most of his money abroad.

With the pile of cash I now had to invest, I was almost forced to turn to foreign stocks, particularly in Europe.  With a big fund, I needed to find big companies that would make big moves, and Europe has a higher percentage of big companies than we do. 

So, what does this mean for the individual investor?  Investment possibilities are now global.  Many Wall Street professionals advise their clients to diversify a portion of their portfolios with the stocks of foreign companies. 

We will explore the world of global investing further in the next post. 

Excerpts from Beating the Market by Peter Lynch with John Rothchild, copyright 1993, published by Simon & Schuster, pages 122-123

Comments are always welcome.