For Your Consideration

Should national health care be a reality soon, we will see the most important (R)evolution in a generation rapidly unfold before our very eyes: the EXTINCTION of the corporate employee and the EMERGENCE of the independent contractor. I’m sure this is not what the President and Congress have in mind of course, but while a free-market exists for human capital, it is this end that strikes me as most plausible.

Which ever version of health care scenarios wins out in the end is not at all relevant. In the end, they all rely upon workers to be classified as “employees” in order for this thing to “work”. Whether the new national health care “premium” comes in the form of new taxes, surcharges, fees or penalties, no business will stand blithely by and be gutted by legislation. Accordingly, an interesting question comes to light: what happens when the business employs a relatively few number of “employees” and contracts their work out to independent contractors?

Everyone (including the IRS) has a slightly different definition of what makes a person an independent contractor versus an employee. They all converge around the same issue, that one being the issue of control. Who controls the work product? Who controls where the work will be performed? Who control when the work will be performed? Who provides the tools in order to process the work?  Does the “independent contractor” have their own telephone number? Their own insurance? Do they invoice regularly or are they paid weekly? Is there an “arms-length” business transaction between the parties?

I think you get the point.

Ultimately, if the business assumes too much control over the worker, the worker shall be determined to be an employee…. Which is exactly why those companies that can structure their business processes to take advantage of true independent contractors in many aspects of their operation shall have a competitive advantage in the coming years. Now this may sound all horrible for the prior “employee”, now newly-minted “independent contractor” but it really isn’t: not when you stop and consider that EVERY business is in essence an independent contractor to its own customers. And surprisingly but naturally, it is this “Employee Extinction (R)evolution” © which may save our economy in the coming years, as people become their own “brands” and compete against each other in the economy for work.

Think of what this kind of (R)evolution could do to all levels of local, state and federal government! And what it could quite easily do to unions…

The progressive fascination with tinkering with 17% of our national economy will have its consequences. Some can be foreseen and some cannot. Here’s one possible consequence which future generations may hail as our President’s greatest unintended accomplishment.

The current credit crisis, how it affects the global marketplace and why it’s important to our entire economic system. Made so simple that a fourth grader can understand it.

Given our recent proclivity to nationalize financial “pain”, it seems that it’s only a matter of time before those very well-heeled hedge funds (and their very well-heeled investors) taken in the $50B Bernard Madoff ponzi scheme will formally request a bailout of their own. I suspect it will happen very shortly after January 20, 2009 and just might be one of the first national policy “tests” of our new President, Treasury Secretary and SEC Chairperson.

From this recent Newsday article, “There’s no doubt that hearings will be held on this, and some government aid is a very logical request,” said Robert Schachter, an attorney with New York-based Zwerling, Schachter & Zwerling, which is representing several Madoff victims. “If we’re bailing out Wall Street and the auto industry, maybe these individuals should be bailed out too.”

When the time comes, will you blame them for making this, using Mr. Schacter’s own words, “very logical request”? Especially in light of the SEC’s own press release on the issue which reads in part…

“The Commission has learned that credible and specific allegations regarding Mr. Madoff’s financial wrongdoing, going back to at least 1999, were repeatedly brought to the attention of SEC staff, but were never recommended to the Commission for action. I am gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them.”

Well if that isn’t a prima facie admission of negligence, I don’t know what would qualify….

In fact, read for yourself the SEC “Case Closing Recommendation” which plainly states that the SEC staff “found no evidence of fraud” as of November 21, 2007.

….This has not gone unnoticed by the legal community as Phyllis Molchatsky has filed an “administrative claim” against the SEC for damages due to its alleged failure to protect investors.

Luckily for the SEC, like most government agencies, it operates under the doctrine of sovereign immunity, which means that for all intents and purposes, “the king and queen can do no wrong” and cannot be sued under most circumstances.

But such claims against the SEC will provide “cover” for the politicos who’ll support the notion of a Madoff claimant bailout. And thankfully for them, they don’t have to look very far for the potential sponsor of such a bill: Senator Frank Lautenberg of New Jersey, who entrusted his family’s charitable foundation to Madoff. According to the Senator’s attorney, Michael Griffinger, the extent of the foundation’s losses is not known as yet, but “that the bulk of its investments had been handled by Madoff.”

………

Still, I am struck by some of the most basic and glaring risk management deficiencies as the facts of this matter emerge…

In the risk analysis phase of the risk management process (once risks have been identified), assessments of potential impact on the firm are reviewed. If done comprehensively, both quantitative AND qualitative analyses are performed. Quantitative analysis deals with so-called “hard numbers” and includes a review of things like projections of loss, cost/benefit analyses and net present value calculations.

Well-trained financial “quants” on Wall Street get paid “the big bucks” to do these type of analyses, and their reports are usually quite impressive on paper.  The problem is that too many financial and business decisions are made on the basis of these “impressive” reports/projections alone.

Without a concurrent review of the qualitative risks undertaken, the risk analysis is INCOMPLETE and can lead to unforeseen and financially disastrous results as evidenced by the recent collapse of so many financial services firms.

Qualitative risks are by definition, difficult to define as they are not “hard number-oriented” and rely to a great extent on the experience, judgment and intuition of the members of the risk management team.

I think the primary reason I see almost no discussion of qualitative risk analysis undertaken is because IT IS HARD TO DO. It is also time-consuming. It requires a thorough understanding of the business, its processes, and its place in the physical, organizational and socioeconomic environments the business operates in. It requires people who are TRAINED IN RISK MANAGEMENT TECHNIQUES, not just financial wizards who can make a report read however management wants it to read. Finally, it requires corporate management support, which is notoriously difficult to get (and keep).

………

Despite the political grandstanding that is likely to happen when this matter is undertaken by Congress, we cannot legislate greed out of existence and scams like this will come to light in the future.

In Errol F. Moody Jr.’s discussion of “Investment Malfeasance and Breach of Fiduciary Duty” (which is an excellent read and is VERY highly recommended reading), he makes the case that for all intents and purposes, matters such as Madoff all come down to the same issue: “a failure to gauge risk”.

Clearly, the risks posed by Madoff were either not identified or analyzed properly by investors and a price for failing to properly manage risk shall be exacted.

The stack of stuff I want to share seems to be growing by the day… too much stuff and not enough time! So instead of writing fewer/longer pieces, here are a few succinct words of advice/counsel on each subject in one “omnibus” post. Hopefully, you’ll find a “nugget of joy” that’s of use to you and I can start to cut through my growing stack of stuff. So, let’s get to it…

1. Putting money in bank CD’s may seem like the safest choice today, but it might not be. You’ll be told that these things are “riskless”. They’re not. The one primary risk they don’t tell you about and that you retain (and it’s a biggie!) is inflation risk. Very simply. when the inflation rate is higher than the CD’s APR, you’re losing money. Historically, the one asset class which has a real return ABOVE inflation is equities. With stocks “on sale” at about 40% off, you might consider “buying low” today if you have the time to wait until the market recovers. I suspect that 10 years from now, you’ll wish you put every dollar you had in now.

2. Every personal insurance policy should be reviewed annually to make sure it still meets your needs. Take some time to do it. You might find that coverages can be eliminated, deductibles can be increased, insurers can be changed, etc. to reduce your insurance cost.

3. Every small-business owner should review their insurance program annually as well. If your business operates on a 10% operating margin and you save $10,000 in premium, the savings was not just $10,000- The real savings is $100,000 in gross sales you didn’t have to make just to pay the insurance premium.

4. The “annuity vultures” are out in full force. They usually take the form of “investment advisors” working for insurance agencies and especially prevalent in poor economic times, such as today. They prey on your fears that you’ll run out of money before you die which they cryptically call “longevity risk”. There’s 3 main reasons you should shun: 1. These are extremely complex insurance contracts. Most come with a 200-300 page prospectus. Unless you read and understand all those terms and conditions, be ready to get hurt. 2. Annuities are guaranteed by the issuing insurer- want to make any bets on which insurer(s) are going to survive? 3. COSTS. Depending on the insurer and the particular product being promoted du jour, the underlying costs of the annuity are outrageously high. Remember, the agent needs to be compensated for selling you this complex contract. You’re the one paying the freight.

5. If you have a private disability (DI) policy, look to increase your “elimination period” (which is a essentially a deductible measured in time, not dollars) to decrease your cost. I recently changed the elimination period on one of my DI policies from 30 days to 90 days. When the policy was originally written, I could barely afford to be without an income for 30 days. Blessedly today things are a little bit different. I saved over 25% in making this one change.

6. Our preconcieved notions and the media shape perceptions of risk. Do you really think that Congress knows how to “fix” the economy? Do you really have faith in their stewardship? Should we allow government to grow or would you prefer that industrious, entreprenurial Americans be tasked with our economic recovery?

7. Turn off CNBC. Stock market-timers have to be right not only once, but twice. Even Warren Buffett can’t do it. The stock market-timers “Hall of Fame” is an empty room.

8. Remember, it’s all relative. All assets are being repriced. Globally. There’s no place to hide. Forget U.S. Treasuries with their 0.01% interest rate. Invest in your own education. You want security? Look in the mirror. It’s the only place in this world that you’ll find it.

9. Worry only about the things you can DIRECTLY control. Everything else will take care of itself and you’ll save yourself a lot of heartache.

10. Continue to fund your 401k. If enough people opt-out, these tax deferred programs will go away and that’s not a good thing.

11. If you’re in business (or work for one), don’t forget to advertise and market the goods and services you provide. Your competitors aren’t and it’s a great time to steal market-share from them.

12. You may have noticed the increase in advertising by gold sellers, I know I have. Before buying, understand that gold has a ZERO expected rate of return, as it produces NOTHING. Gold has no intrinsic value, only the value we ascribe to it. You’re also going to need to buy A LOT of it to make it “worthwhile”. Where you gonna put it all?

13. Taking medications (legal ones, that is)? Want to try to save some dough? Live in NJ? Try www.njdrugprices.nj.gov for an online prescription drug registry. Prices for a one month supply can vary widely, even within the same zip code. It works surprisingly well.

14. According to John Montgomery, Founder and Portfolio Manager of Bridgeway Funds, there have been nine bear markets since 1940. The average time for the stock market to “recover” to its previous high is 13 months (excluding this current bear market). 13 Months- a little over 1 year. Of course, this time may be different but know that historically speaking, if you can keep your head when everyone has lost their’s, you’ll be well-rewarded.

15. THIS IS NOT THE GREAT DEPRESSION, PART TWO. We do not have 25% unemployment and the only thing we stand on lines for are HDTVs, not bread! Don’t “buy” the doom and gloom the media is “selling”. It’s all meant to manipulate.

Go live your life. Smile and be grateful.

Back in 2002, I was spending my time full-time educating myself as to the academic underpinnings of markets. I was uncomfortable investing with alleged financial experts without having a basic understanding of the language of and the basis for their investment ideas and techniques.

One of the very first things I learned was that according to academic research, over 95% of all investment returns was determined by your asset allocation. It should not surprise that a portfolio of 80% stocks and 20% bonds has a greater *EXPECTED* return over time than a portfolio constructed of 60% stocks and 40% bonds, yet this simple illustration eludes many.

Of course, because the 80/20 portfolio has higher EXPECTED returns, (by most commonly used risk measures) it is also more “risky” than the 60/40 portfolio.  One can slice and dice these portfolios (US vs. International Stock, Large vs. Small Stock, Growth vs. Value Oriented), but that is not the subject for today.

What I wanted to share was some insight and assistance in choosing an equity percentage from some of the finest academic-oriented financial authors, both of which I have listed in the Reading Room.

Authors William Bernstein (WB) and Larry Swedroe (LS) have published some guidelines relating to this issue. Both agree on two major points:

1. Determine your maximum tolerable percentage loss from the following tables,
2. Use the LESSER of the amounts shown to determine your maximum equity exposure.

Maximum      Maximum
Tolerable      Equity
Loss             Exposure
———- ……  ———-
5% …………….. 20%
10% …………… 30%
15% …………… 40%
20% …………… 50%
25% …………… 60%
30% …………… 70%
35% …………… 80%

This first table deals with a “stomach acid test“. If your heart starts palpitating at a 10% stock market loss, according to the first table, your maximum equity exposure should be no more than 30%. However, the “stomach acid test” is only the first gauge- we need to think in terms of time.

Accordingly, a person needs to consider the time horizon as to when funds placed in the stock market need to be “repatriated back” for use as originally intended. Both authors have a slightly different take on this issue as shown in the following table:

.                     Max Equity
Investment     Allocation
Horizon           WB … LS
———- ………. —– … ——
1 year ………. 10% .. 0%
2 years ……… 20% .. 0%
3 years ……… 30% .. 0%
4 years ……… 40% . 10%
5 years ……… 50% . 20%
6 years ……… 60% . 30%
7 years ……… 70% . 40%

So, if you need the money that you’ve invested in the stock market in four years, William Bernstein recommends no more 40% allocated to the stock market. Larry Swedroe is much more conservative, advising no more than a 10% stock allocation.

My personal belief is that Swedroe is right, as four years is simply not enough time for the stock market to recover ground in the event of a severe downturn. You may need to sell at a most inopportune time (like today), negating the market’s historical long-term benefits. Of course, you would lose the opportunity for gain if the market trends higher over that hypothetical four year period.

So when you hear/read about those people “soon to retire” who now have to postpone retirement due to the state of the U.S. stock market today, ask yourself: Were these people getting the “right” advice on asset allocation?

It appears they were not.

Regulatory risk is usually considered as a change in laws and/or regulations that will materially (negatively) impact a business or a business operation. In some cases, it can also refer to noncompliance with governmental regulations, such as in environmental liability exposures. But today let’s consider the soon to be announced $700B “Wall Street” bailout in terms of regulatory risk.

Many view the economic circumstances we are suffering through today as the natural culmination of events which started in 1977 with the passing of the federal law entitled “Community Reinvestment Act” and will end in the crescendo of debt our grandchildren will not have finished paying off.

The CRA was drafted as a high-minded and well-intentioned regulation intended to encourage banks to “help meet the credit needs” of the communities in which they operated and were to include low and moderate-income neighborhoods.

The CRA worked as intended for the most part until 1995, when the Clinton administration enacted certain updates to the Act which, in part, included a provision allowing the securitization of sub-prime mortgages (which were then “guaranteed” by Fannie Mae and Freddie Mac). These revisions further required the banks to offer “equal access” to lending and essentially forced the banks to make loans they, in all probability, would not have made absent these new requirements.

*As a minor historical footnote, it is ironic to note that in 1997 Bear Stearns became the first company to securitize the subprime mortgages and sell them to other financial institutions. As you probably recall, they were the first domino to fall.

So viewed through this historical lens, our economy is now bearing the cost of regulatory risk.

I found (an admittedly politically charged) video to help with following the “bouncing ball” if you have 10 minutes to spare. After about 4:00 minutes, the video digresses into more politics than explanation…

What began as a well-intentioned government mandate has unhinged our economy in ways we have just begun to experience. And as we stand on the precipice of another government mandated “solution”, I am justifiably concerned that while well-intentioned, this new legislation will contain some new regulatory risk that will rear its ugly head in the future.

Good day, boys and girls!

While the stock market is trying to figure out what it wants to be when it grows up and the media is hyping the panic game as shown in the graphic below, it might be helpful to close your eyes, take a step back, a deep breath and relax. (Double-click on it twice for a better view)

Many people have asked me how I have my personal investment portfolio constructed. I usually defer the answer, explaining that each portfolio must be put together on an individual basis and what is right for my circumstances and risk tolerance will most assuredly not be correct for theirs. As you can imagine, that answer, while true and correct, is not that helpful.

I recently came across a posting at Vanguard Diehards Investment Forum in which financial author and advisor Rick Ferri introduces a sample portfolio called the “Core Four”, which I think is probably the best starting point for new and seasoned investors alike. It is especially helpful for seasoned investors who might’ve lost their way and have a mish-mosh of inappropriate investments hodge-podged together that they have acquired though the years.

The “Core Four” outlines a 60% stock / 40% bond strategy and, as financial author Taylor Larimore has noted, has the following characteristics:

• It is globally diversified;
• It is very low cost;
• It is very tax friendly (tax efficient); and
• It is very easy to understand.

For those of you interested in percentages the “Core Four” strategy outlines the following:

• 35% of the total invested assets in the U.S. stock market (not individual stocks);
• 15% of the total invested assets in world stock markets (excluding the U.S.);
• 10% of the total invested assets in U.S. commercial real estate trusts (not sub-prime); and
• 40% of the total invested assets in the U.S. bond market (typically investment grade or “better”).

While my personal portfolio differs in some areas (for example, I take on more small equity and value risks than what’s present in the “Core Four” because I understand the risks I am taking), this is a superb launching point. You would be well-served to take the time and read the four pages of posts contained in the link above.

So, before you spend another night up worrying about your financial future, take some time to educate yourself. If you have any specific questions about the “Core Four” strategy, let me know and I’ll try my best to answer them.

Recalling a prior post (which recalled the “Death of Equities” from a prior era) is instructive if you can keep your wits about you. While pop psychologists and new agers repeat the oft seen “Danger + Opportunity = Crisis” it isn’t quite so. Risk is real. Market risk is real. And what we are seeing in the markets these last few days is the repricing of that risk.

“These are the times that try men’s souls” a phrase written over 200 years ago by a founding father, Thomas Paine, who knew a thing or two about risk. In his December 23, 1776 discussion of the our recent declaration of independence from Britain, he wrote about panics:

“Yet panics, in some cases, have their uses; they produce as much good as hurt. Their duration is always short; the mind soon grows through them, and acquires a firmer habit than before. But their peculiar advantage is, that they are the touchstones of sincerity and hypocrisy, and bring things and men to light, which might otherwise have lain forever undiscovered.”

Yes, our world is changing below our feet, but that doesn’t mean the end result is ruin. The market is gripped in panic, but it appears our final capitulation bewitching hour is nigh. I suspect this because the media has finally called the bottom with this gripping headline: ‘The World As We Know It Is Going Under‘.

Which to my eyes looks like this headline from AUGUST, 1979:

OK, as of today, the Fed has said to Lehman, “NO SOUP FOR YOU!“, and they are now at the mercy of a bankruptcy court. Merrill Lynch ceases to exist as an independent investment bank and will be swallowed up by Bank of America.

Now, we are witnessing the potential of the bankruptcy of AIG, American International Group. This potential collapse is so breathtakingly overwhelming it is difficult to find the words to express its impact.

As of the moment of this writing, the Fed is trying to help orchestrate a $100 BILLION DOLLAR “bridge” loan package to give AIG time to sell assets to stave off bankruptcy and it is EXACTLY this moment that we come to understand the magnitude and utter failure of AIG management who should not have allowed things to escalate to this point. I think in the future there will be entire business management classes and curricula devoted to the study of events surrounding this epic failure.

But the talking heads are missing the point. It doesn’t matter if/how financing for AIG gets arranged today or tomorrow, the damage is done. Credit analysts in the bond markets have marked AIG’s bonds to junk status and the rating agencies have put AIG on “credit watch negative”, which is a precursor to severe ratings downgrades. In essence, perception is reality and many smart people do not expect AIG to survive as it exists today.

But the biggest problem doesn’t rear its ugly head until January 1, 2009 when AIG’s reinsurance treaties expire. Reinsurance is essentially insurance for insurance companies. If the company cannot negotiate renewal of its reinsurance treaties, it  cannot survive as an insurer and will be forced to terminate all in-force policies, citing loss of reinsurance. This is the insurmountable issue as I see it today.  The question of the day is: What reinsurance companies will be willing to “belly up to the bar” for AIG?

Prudence dictates that individuals AND businesses review their exposure to AIG. This is not just an academic exercise. I would urge a review of insurance policies in force as soon as practicable. For individuals that may mean annuities provided by American General, life insurance policies and/or auto policies with 21st Century or AIGDirect. These matters and questions should be reviewed and discussed with your agent. For corporate risk managers or financial controllers: I would direct your insurance broker(s) to provide an assessment of exposure and immediately begin the remarketing of coverage in the event the unthinkable occurs.

That being said, there probably is only ONE person alive who has the gravitas with regulators, capital markets, and reinsurers to “right” the AIG ship: the deposed ex-Chairman of AIG, Maurice “Hank” Greenberg. I believe that only his direct stewardship will assuage these parties. Let’s see if the AIG board has the brass b@lls to bring him back.  Of course, that exposes another long term personnel risk management issue for AIG: life after Hank. But that is an issue for another day. Today is the day AIG needs its Chairman back.

These are truly momentous times. I, for one, will keep my eyes on January 1, 2009 and hope for best (but plan for the worst).

Quick Update as of 4:45PM EST: It appears that Mr. Greenberg has been rebuffed by AIG management (video in link). In this interview today, Mr. Greenberg (who was ousted from AIG over 3 years ago) was asked what “went wrong” and from his perspective, “what happened?”

Mr. Greenberg replied, “I think several things. I think risk management controls either disappeared or were weakened. There wasn’t attention being paid to the accumulation of risk. I felt there was a determination to grow without the right controls in the financial sector of the business. Many things went wrong.”

Now that the US taxpayer is now bailing out Fannie Mae, Freddie Mac and the home-debtor speculators (not to mention all the banks that are being liquidated by the FDIC) it might be a good time to ask this question: Who’s going to bail out the US taxpayer?

But wait, there’s more!  Why not bail out Lehman Brothers as well?

It just wouldn’t be “fair” if Lehman is denied the bailout status Bear Stearns, Fannie Mae, Freddie Mac, the banking industry and the home-debtor speculators have been afforded by our elected politicians from *BOTH* sides of the aisle.

It’s absolutely laughable that after 18 years at the Fed, ex-Chairman Alan Greenspan is warning not to use the Fed as a “magical piggy bank“. There apparently is no shame left in America.

In fact, why don’t we just nationalize the entire financial pornography services industry like our pols want to do with our health care industry? I’d wager there’s more fraud and wrong-doing in the financial services biz than in health care.

The US taxpayer might get a fairer shake then.

In a prior post, I mentioned that the US government debt is not $9 trillion as is most commonly reported by the main-stream press, but $53 trillion. Some of you asked for an outline of the difference:

It’s ugly. And it doesn’t include the most recent bailout numbers. Perhaps it would be better if Congress took off the next 4 years so we could catch up with the damage done.

OK, today let me drop a little insurance strategy on you to help you “evaluate your insurance premium savings quantitatively by increasing your risk retention”.

Got that? That’s a real “fancy-pants” way of saying, “save money by increasing your deductible”, but now you can sound important-like and impress your insurance-geek friends. Just one word of caution: don’t try that one at a party unless you’d rather be alone.

OK, bad insurance humor aside, it’s commonly known that by increasing your deductibles will generally lower your cost of insurance. But today, I’ll give you a strategy to analyze the premium savings to see if it makes sense to take on more risk.

It’s important to understand that insurance is provided by an insurance company on a “cost plus basis“. What that means is that very smart mathematics types (known as “actuaries”) figure out the dollar amount of the frequency and severity of losses that the insurer is likely to have to pay for the risks they assume. Think of this number as just the “pure” loss amounts, without any expenses associated with them. Let’s call that number “X”.

Once that’s done, the financial bean-counter guys and gals get together and add in the costs the company must bear to administer their customers’ losses, such as employing people and costs of adjusting and paying for the losses. Let’s call that number “Y”.

Then finally, once that’s done, the management types (you know, the one’s dressed in suits) add a cost which represents the percentage of profit they want to make. Let’s call it 10%. So the cost of insurance is figured like so: (X + Y) * 1.10.

Sounds too simplistic? It’s closer to reality than you think.

OK, so let’s go back to our generally misunderstood actuary friends (they need love, too). They know that if you take a $100 deductible instead of a $1000 deductible, their frequency of loss will increase, because you’ll be tempted to put in that $250 loss claim now. If you had chosen a $1000 deductible, they’d never see the claim. So, what do we learn from this?

By choosing low deductibles, you are trading today’s insurance premium dollars for future potential claim dollars.

The reason and logic should be clear from the example above: the company has to charge more to pay for its increased likelihood of loss, which also includes the very real and expensive loss adjustment expenses. And because you are paying premiums on a “cost-plus” basis, this is generally speaking a bad deal for the consumer because you are not only “prepaying” your small claim but you’re also paying for the insurance company’s costs and profit-margin targets.

If I haven’t lost you yet, here’s a very simple method of evaluating whether or not increasing your deductibles is a good “buy” for you. It assumes that you have the financial capacity to pay that deductible if/when the loss occurs- Remember: the fundamental rules of personal risk management dictate that we do not take on more risk than we can handle and we never risk a lot for a little.

So with those caveats aside, here it is: If today’s premium savings can “pay for” the difference in deductibles within 3 years, it’s probably a good idea to increase the deductible (assume more risk) and take the premium savings.

Say you have a policy with a $250 deductible that costs you $1000 per year. Your agent advises that the premium would decrease to $750 if you chose a $1000 deductible. So your out of pocket premium savings is $250/year (nice!), but your out of pocket risk has increased $750 (not so nice). Since the annual premium savings of $250 * 3 = the difference in our deductible ($750), it’s generally a good strategy to increase the deductible.

Of course, if you do have suffer a loss within 3 years, you’ve “lost the bet” so to speak, but it’s sting is tempered by your retaining the first year’s premium savings. On the other hand, any loss 3 or more years in the future has paid for itself. Actually, and then some, since premiums tend to rise more or less, every year. The percentage rate increase will be less with a $1000 deductible for example, than a $250 deductible, in keeping with our example.

Now that you got this down, call your agent, save some money (if appropriate) and then go treat yourself to something nice (some chocolate, an ice cream, maybe a new car…) because you’re now a much more savvier purchaser of insurance than you were mere moments ago.

Can’t get enough of this scintillating material, don’t forget to click here for more fun.

Just because something is simple, does not make it simplistic, which almost always is used to connote something negatively. And just because you like to keep things simple, does not make you a simpleton. I am amazed at how some people want to overdo the simplest of things, as if by employing the complex strategy the outcome will be better than if a relatively simple strategy was utilized.

It’s kind of like writers using “five-dollar” words, when using “one-dollar” words are sufficient to get the point across. Perhaps it’s an ego thing: the writer feels superior when their audience is forced to use a thesaurus (!) or google an unknown word.

Recently I was asked by one of my friends to help him deploy a financial strategy for a short term goal (which I’ll generally define as one that is less than 5 years away). In this case, the “goal” date for using the money was 4 years away. If you remember this previous post, I commented that it’s absolutely necessary to consider the time-frame for when the funds will be needed.

Failing to do this very basic concept can lead to poor (or disastrous) results.

Monies allocated to equities for short term goals are generally considered *unsuitable* as you may need to liquidate at the “wrong” time, say in a declining market. The inverse is also true, if money is allocated too conservatively for a longer term goal, you run the risk of not having “enough” money after the effects of inflation are considered. It’s these type of issues that the so-called “financial professional” world uses to prey on an financially uneducated populace.

The (unstated but essential) message: You *need* them to figure this stuff out for you because you can’t do it on your own.

It’s not true, of course: anyone with a high school senior math education can follow the basic concepts “along at home”. And despite the pleadings of the financial planning community to the contrary, financial planning is *not* an exact science. Heck, I’m not even sure it’s an “art”; more of a *discipline* than either an art or science.

…zzzzZZZZZzz…

… oh no, there I go again… Sorry about that. Let’s get back to the issue at hand: How did we decide to deploy capital for a 4 year time horizon? Bonds. Absolutely *not* sexy, but they get the job done and are appropriate and suitable for the task at hand.

First, we have to make sure that the investment is low-cost as every dollar confiscated in fees by the investment “professionals” reduces the investment’s total return. (Stunningly simple concept, isn’t it?)

Second, we have to make sure that the investment is internally diversified, meaning we want to hold many bonds to reduce the default risk of any one bond issuer defaulting on its obligation to repay.

Third, the bonds have to be of the highest quality, reflecting the bond issuer’s ability to repay. We need to preserve and protect capital, so “junk” (also known as “high-yield”) bonds were not suitable.

Fourth, we’d like to match the average duration (which is essentially, a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows) to the goal time-frame: in this case, 4 years.

So, following the 4 steps above leads us to the obvious answer: we were looking for a low-cost, mutual fund of high quality bonds with an average duration of 4 years.

Checking out Vanguard Group, my favorite mutual fund family for DIY investors, two bond mutual funds were reviewed: Vanguard’s Short Term Bond Index and their Intermediate Term Bond Index. As of today, the Short Term Bond Index holds 900 bonds and has an average duration of 2.5 years. Intermediate Bond Index holds 968 bonds and has an average duration of 6 years. Both funds have an overwhelming majority of their holdings in bonds that are rated “A” or better and both have an expense ratio of 0.18%, making them *very* low cost.

So, let’s recap:

1. Low-cost? Check.
2. Diversified? Check.
3. High quality holdings? Check.
4. Duration of 4 years? Uh-oh.

Darn. Everything was going so well until we got to #4.

Fret not, here’s the easy solution: We can “blend” the two funds together to get to our desired average duration of 4 years. The math worked out like this:

1. Short Term Bond Fund duration is 2.5 years * 60% (0.6) of the total invested = 1.5 years; and
2. Intermediate Term Bond Fund duration is 6 years * 40% (0.4) of the total invested = 2.4 years.

By investing 60% of the money in the Short Term Bond Fund and the remaining 40% in the Intermediate Term Bond Fund, we essentially have created a portfolio that has an average duration of 4 years. (Actually 3.9 years, if you want to get “technical” on me!).

One more thing: please be aware that bond fund durations are subject to change over time. You may need to adjust the “blend” as circumstances dictate.

But using this “simple” solution to invest for a short term goal, you’ll achieve better results than many of your friends. Of course, there is the possibility I could be wrong

Have you been to the grocery store lately? Erosion of the value of the dollar is not only present in the increase in the cost of energy, but also in the dramatic increase in the cost of our basic family food needs since late last year, as our economy started to unwind.

Like almost everyone I know, I’m trying to stretch the value of every dollar available. I’m still a net buyer of equities as my investment policy statement dictates- while most are unnerved (panicking?) by the gyrations of the stock market, I believe that our current economic slowdown is *temporary* and not representative of a systemic breakdown. But my family cannot eat future stock market performance today.

So I’ve been considering taking some short-term emergency fund savings (where we’re earning about 2.25% annual yield and losing money after the effects of inflation) and stocking up on non-perishable food and related supplies as a hedge against what is reasonable to expect: higher prices tomorrow.

It’s not a grand plan, but today every little bit counts; and it’s less about “math” and more about logic: The idea is based on the premise that I *expect* food prices to increase at a rate greater than 2.25% over the short-term. There’s limited downside if I’m wrong:

We’ll always use the toilet paper.

P.S.: Remember, there’s more literary goodness to read on the main page here.

Well, just a flurry of activity today, isn’t it? I’m going to be away on vacation until late April/early May so I wanted to commit a few ideas that I’ve been mulling over lately to the site before I either forget them or get caught up in other things. Some concepts I have “in development” as of today that’ll have to wait for my return:

1. A line item breakdown of variable annuity costs - OUCH!

2. Why stock market timing is a bad (but pervasive) idea;

3. A discussion of “senior” seminars and the art of the “sale” - beware the siren call of the “free” steak dinner!;

4. The allure of fixed index annuities and when they are suitable;

5. Long Term Care Insurance Objections (and rational responses);

6. Within every small business owner lies the soul of risk manager;

7. Moral and ethical obligations of a fiduciary;

8. Legal considerations of the sale of securities by “captive” financial advisors/insurance agents;

9. Exploration of the concept of “Personal” Enterprise Risk Management;

10. How to reduce health insurance premiums through exposure analysis;

11. Matching bond fund durations to meet a 1-5 year financial need;

12. “If investing *isn’t* boring, you’re doing it wrong”; and

13. An exploration of personal risk control techniques.

Just a little “light” reading, huh? Also, if you haven’t already done so, please consider registering your email address (or send me an email at md at marcd.com and I’ll register for you!) so that the site updates will be forwarded automatically to you by email. Consider referring a friend to the site - we need more friends! Thanks again for your support and I’ll see you in about a week.

Small business start-up capital financing is notoriously tricky. Even in the best of economies, banks won’t lend to start-ups without significant collateral. It shouldn’t be surprising then that in the vast majority of cases, a business’ initial capital financing comes from an owner’s personal savings. In fact, I cannot think of one of my businesses that *wasn’t* initially funded primarily by my personal bank account. It’s the ultimate in “putting your money where your mouth is”.

Self-financing of the initial capitalization of a company is a relatively easy (and subsequently dangerous) course. That being said, I find it prudent for a prospective owner to consider self-financing start-up expenses where all other sources are inadequate (either in amount available or in terms offered) or simply unavailable. It forces the owner to carefully consider whether or not to start the business and can save the owner from a financially ruinous affair.

Unfortunately, where I often see “trouble ahead” is when the owner starts using personal assets to cover the on-going monthly operational expenses of the company. Monthly expense items such as payroll, taxes, insurance, rent, etc. need to come from the company’s generated sales and revenues. If there is a consistent monthly shortfall that is being financed by the owner to keep the small business going, warning lights should be flashing!

I know all the rationalizations because I’ve been a victim of them at one time: “Things will get better”. “Next month will be a big month”. “If this business fails, I’m a failure”. Etc.

Here’s what I’ve learned from my own past mistakes: There is something fundamentally “broken” in either the operation or focus of the business if it experiences a consistent monthly income shortfall for 90+ days. The business is in obvious distress and most likely the owner is in denial.

Decisions will have to be made at this point. Line item expenses need to be reviewed objectively in order to reduce or eliminate unnecessary costs. Operations need to be objectively reviewed for redundancies and efficiencies. Income deficiencies need to be objectively addressed to determine the nature and extent of the product or service “saleability”. Indeed, some very difficult activities need to be undertaken to thwart dissolution and ensure survivability.

Keep an open-mind. There is a solution to almost every business problem. Unfortunately, as we all know, sometimes the rational decision is closure, but that should be a last resort only after exhausting all other options.

Sometimes I wonder if our founding fathers would recognize their country. Why is it that government officials, be it local, state or federal, always announce major new directives on Friday afternoons? No need to answer - the answer is self-evident.

Yesterday the Bush administration announced a proposal that would give sweeping new regulatory powers to the Federal Reserve, (which is not a government agency despite its name), according to this AP wire.

Is everyone asleep?

Most rational explanations of how the credit crisis evolved includes the Federal Reserve as a major factor. The concept is that when the Federal Reserve lowered interest rates and infused cash into the monetary system (increasing liquidity) in the days and months after September 11, 2001, it made money “cheap” and plentiful. These decisions at the very least, helped create the current monetary environment.

Banks were encouraged and expected to make loans available (to both businesses and individuals) who may have been affected by the 9/11 event. People were encouraged to “go shopping” to keep the economy afloat. And as it turned out, many people, in fact, did just that. A good question to ask at this point is how exactly did we finance this?

Many used their homes as an ATM, because it was “easy” money.

Banks were lent “easy” money by the Federal Reserve, and then in turn re-lent this “easy” money to others. Loan underwriting standards were lowered dramatically. People who couldn’t qualify for a Discover Card were given new mortgages, which in turn fueled the housing boom. People with current mortgages were encouraged by banks, lenders and mortgage brokers to take equity “cash-outs” because their home equity was just “sitting there”, not doing them any good.

Is there any other way this could have ended?

And now, we are asked to give the Federal Reserve more power. While I understand that the American people want a solution and a “quick-fix”, I think that this proposal is taking us in the wrong direction.

We all know the answer to that one: the stork (oops, right answer, wrong question). Really, have you ever considered where money comes from? Got visions of the US mint printing dollars or pressing coins? You’re not alone. I needed a legitimate resource for this question in preparation for my upcoming “Money and Investing” Girl Scout workshop.

Online research leads to many unsubstantiated conspiracy theories- not very helpful. And then I found a copy of “Modern Money Mechanics: A Workbook on Deposits, Currency and Bank Reserves”, originally written by Dorothy M. Nichols of the Federal Reserve Bank of Chicago in May, 1961. Now we were getting somewhere! I was able to obtain a pdf of the February 1994 revision and have made it available for download here. Sadly, this workbook is currently out of print. I would *love* to see the original 1961 edition for comparison purposes.

Without question, “Modern Money Mechanics” is a remarkable document. As a resource, it is “pure” and conspiracy-free. It quite adequately explains the basics of money creation and our modern fractional reserve banking system. It explains that money can be viewed “simply a tool used to facilitate transactions” and that in the US “paper currency nor paper deposits have value as commodities” and that, “Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries” (Emphasis mine).

In what makes money “valuable”, the text explains: “Money, like anything else, derives it’s value from its scarcity in relation to its usefulness” (Emphasis found in the original text). That makes sense: the more money that’s available, the less “scarce” it is and therefore the less “valuable” it is.

It further explains that “Control over the quantity of money is essential if it’s value is to be kept stable” (Again, the emphasis found in the original text). This is because “Money’s real value can be measured only in terms of what it will buy.” This time the emphasis was mine.

One can begin to understand why this document might no longer be available.

So where *does* money come from? According to “Modern Money Mechanics”, the “actual process of money creation takes place primarily in banks“.

Each time a loan is made, new “money” is created. Essentially, it is conjured into existence by the borrower’s promise to repay the loan and his/her pledged collateral. Taken to it’s logical extreme, if there was no debt, there would be no money.

It would be instructive to know what “counterparty risk” means since it’s the reason the Federal Reserve decided on the unprecedented act to lend $29 Billion dollars to JPMorgan Chase so that it could buy Bear Stearns. Counterparty Risk is the answer to the question, “Why did the Federal Reserve do this?”. I danced around this topic in a previous post.

OK, so what exactly is counterparty risk?

Let’s set the stage: Two large, competent and experienced organizations enter into an agreement (contract). Let’s say, as an example, Bear Stearns and a major national bank. The bank has no reason to believe that Bear Stearns won’t be able to fulfill its duties under the contract. And Bear Stearns has no reason to believe the bank won’t be able to fulfill its duties under the contract. In this example, so far, both parties are fairly confident in each other’s abilities to “perform” their contractual duties. Now let’s imagine for a moment that Bear Stearns had thousands of such agreements. All based, in part, that Bear Stearns was a financially able organization valued in the marketplace at about $19 Billion dollars. Until one day, it wasn’t.

Very simply, counterparty risk is the risk one party in a contract has that the “other” party in the contract will not be able to fulfill its obligations as outlined in the contract. I have mentioned previously that there is a crisis of confidence present in the markets today. At the core, the problem is that we can’t trust the numbers. A corollary to that is that we can’t trust the companies providing those numbers because it seems that *they* don’t even know the value (or lack of value) of the holdings on their books.

The Federal Reserve had to be concerned that a Bear Stearns failure might intensify the confidence crisis further. I am not alone in thinking this. Meredith Whitney, a bank analyst at Oppenheimer, as reported in the NY Times, had this to say: “The rescue was absolutely all about counterparty risk. If Bear went under, everyone’s solvency was going to be thrown into question. There could have been a systematic run on counterparties in general”. The emphasis is mine.

Remember the stories of the 1920’s depression “runs” on banks? Things are a lot more complex today. Back then we only had to worry about banks. How about a “run” on every financial institution: banks, credit unions, savings and loans, mutual fund firms? Only history will tell if the Federal Reserve made the “right call”, because right now, I’m not so sure.

——

UPDATE April 2, 2008: Well, we just heard from the Federal Reserve Chairman himself on the previously unprecedented Bear Stearns bailout plan: “With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions ….and could have severely shaken confidence.” Doesn’t that sound familiar?

So, I promised some info related to my CRM Principles of Risk Management course that I recently attended. The instructors were bright, articulate and engaging and as a result, the 20 hours of instruction went by fairly quickly. As you may deduce from a “Principles” class, the essential focus was the basics of risk. The class was a fairly large one, with about 90 people. It was also a very highly credentialed group, with about 120 designations granted to these folks. Definitely no slouches here.

The first risk concept explored is an identification of the three generally accepted types of risk, each with their own unique characteristics. They are:

• Pure Risk;
• Speculative Risk; and
• Gambling.

Pure Risks are those where there’s a chance of loss *only* with no possibility of gain. An example of this might be an airplane falling out of the sky wiping out a city block or the death of a loved one. With respect to individuals, insurance does a good job of protecting against many pure risks we face in our daily lives.

Speculative Risks are those where there is a chance of a loss OR a gain. These risks include a *variation* of outcomes where profit is possible. An easy example of this is investing. We invest money in stocks, bonds, commodities, etc. with the hope of a positive result (profit), but where exists the possibility of loss. To spin this concept to financial academia, having the majority of your investments in one company or one industry group, is called “speculating” (and not investing), and we all know how dangerous that can be!

Starting and operating your own business is another form of speculative risk. For my money, this is, for most individuals,  the most “risky” speculative financial risk. Since I have been a “serial entrepreneur” (stop me before I start another business again!) all my adult life, I guess this is why stock market investing seems nowhere near as risky as the commitment and deployment of capital in my own business.

The last risk group is gambling, where there is the chance of loss or gain, but the probabilities strongly favor a loss. I highly doubt this type of risk needs any explanation. Anyone who has ever been to Las Vegas or Atlantic City (or watched CSI: Las Vegas on television) understands this type of “risk”. In the real world, I’m not sure that gambling is really a form of risk. I don’t consider shooting craps or “putting it all on red” to be forms of risk, as I think it’s a virtual certainty that a loss will occur.

There is no formal definition of the term “financial pornography” (FP) but like the Supreme Court has written, “I know it when I see it”. The term commonly refers to the depiction of financial or investment material in such a way as to arouse or elicit an intense, emotional response. The cure for FP addiction, as you might expect, is an understanding of how capital markets work.

In some cases, FP is just annoying, like having to sit through incessant TV ads for “this” investment company or “that” investment company, each expressing how their method of investing is the way to go. These ads all play on one of two (and sometimes both) simple human failings/traits, fear or greed. True securities analysis may have at one time been able to give one investment company a *sustained* advantage, but the tragic irony is that there are so many of these very smart, very qualified people doing this type of work that they are unable to sustain an advantage, because they have to consistently beat all the other very smart, very qualified people doing the same work.

Passive investors paradoxically benefit from their toil. Because they are so good at what they do, the stock market is an “efficient” one, meaning that at any one given moment, the value of the market is likely to be the “correct” one. There are moments, like the one’s we are experiencing, that mis-pricings can occur. It does not mean the market is inefficient. We are emotional beings and accordingly, gross mis-pricings (if they exist) are due to behavioral reasons.

But FP addiction can be very hazardous to your wealth. Kindly note the video above. It is Jim Cramer on CNBC’s Mad Money show advising people not to sell Bear Stearns last week (when they could’ve gotten out at around $60/share). Now, I am not blaming Jim Cramer for this, he’s got an entertaining show to provide. That’s his job! Whether he was wrong because of a bad call or you think something’s “fishy”, is a question I’ll leave to you.

The blame for following this advice rests solely on the shoulders of people who equate investing to entertainment.

Financial advisors are not responsible for setting investment policy - you are! The corollary to this is that we don’t set investment policy from entertainers playing financial advisors on TV.

True financial advisors are those that are responsible for building appropriate portfolios that help meet your financial goals and match your willingness, need and tolerance for risk. They assist in fund selection, placement, and perhaps a little assistance in tax planning as it relates to tax loss harvesting. Can they *assist* in setting investment policy, OF COURSE, but the ultimate responsibility is yours.

Setting an appropriate investment policy in writing will save you from yourself.

I don’t usually care about what happens to an individual stock, but there is an important lesson to be gained from the short story of this one…

In case you missed it, over the weekend Bear Stearns was sold to JPMorgan Chase (using money loaned to it by the Federal Reserve). A very short stock price history:

• Within the last year, Bear Stearns shares were valued at just shy of $160 per share.
• Within the past week, it’s share price, which had fallen sharply, was still hovering at about $60 per share.
• Over the weekend, Bear Stearns was sold in an apparent “fire” sale to JPMorgan for $2 per share.

GULP.

About $19 BILLION in market value is gone. Vanished. The company was sold for the “bargain basement” price of $236 Million dollars. The answer to why this happened is the subject of another post. My immediate concern is for the company’s employees.

Today there are about reportedly about 14,000 Bear Stearns employees that have seen vast sums of their retirement and pension savings completely wiped out. Apparently, the lessons of Enron and Worldcom have not been learned because Bear Stearns employees figured it couldn’t happen to them. But very unfortunately for them, the risk has “shown up”.

When you hold a single security you are taking on what the financial academics call “specific risk” which includes within its very definition, the most extreme form of “business” risk, the risk of complete failure.

Author Charles Ellis, in his book “Winning the Loser’s Game” (the link to which can be found in the Reading Room) discusses this concept at great length. He explains that specific risk and “extra market risk”, which is the risk taken by holding related stock groups, cannot be diversified away, and therefore should be avoided. Investors are simply not rewarded or compensated for accepting specific and extra market risks. Because these kind of risks can be eliminated, they should be. Mr. Ellis calculates that about 75% of the risk associated with holding a single stock can be attributed to specific and extra market risks.

It’s important to understand that even if specific and extra market risks are eliminated from a portfolio by means of diversification, what remains is market risk, or in academic parlance, systematic risk, which can be managed. Market risk represents the overall risk of holding stocks and is the only type of risk that an investor has been rewarded for taking historically.

The best financial tool devised for the average investor to manage market risk is an index fund or ETF that tracks the Wilshire 5000 index, which is a composite of the entire US stock market. It shouldn’t be your only holding, but it is considered by most financial authors to be one of the most appropriate core investments for long term investing.

Here’s one silver lining: Today (March 17, 2008) Bear Stearns stock closed at $4.81, so JPMorgan has already seen a 240.5% return on its investment (using borrowed money, no less!). So, if anyone doubts the ability of Wall Street to make a buck, look no further.

———–

UPDATE: March 20, 2008 Stock Price: $5.96 - JPMorgan’s return on original $2 (borrowed $$$) investment: 298%; Don’tcha wish all your investment returns could be like this?

One of the best ways for people to conceptualize the benefits of passive investing is a game called “Outfox the Box”, created by author Bill Schultheis and found in his book entitled, “The Coffeehouse Investor”, a link to which can be found in the Reading Room.

The game is deceptively (and almost deviously) simple. There are 10 boxes from which to choose from. Which box do you want?

It’s not that difficult to figure out. Everyone wants the $10,000 box.

OK, let’s change the rules just a little. You are now asked to choose a box from here:

Now what do you want to do? Is it worth risking a lot to gain a little?

In other words, do you risk getting less than $8,000 for the prospect of $9,000 or $10,000? This is when most people opt to take $8,000. Passive management/indexing works as a strategy, as illustrated by the fact that 75% - 80% of all mutual funds do not beat their benchmark indexes.

Care for a little game?

“Outfox the Box” is a game I intend to share with the Girl Scouts to help make our workshops together a little fun.

A short note (that needs to be said): I have borrowed heavily (okay, stolen) from Mr. Schultheis’ website here and claim no ownership of his brilliant idea. My intent is to help make this game and his book more well known, *not* to steal his work. If asked, I will remove this blog entry.

John Montgomery is the manager of Bridgeway, a no-load mutual fund family (like Vanguard). One of their funds that is most interesting to investors (and that is still open currently for investment) is their Ultra-Small Company Market Fund (BRSIX), which is a passively-managed fund of the smallest of the small publicly traded companies. It’s benchmark index is one that you’ve probably not heard before, the CRSP Cap-Based Portfolio 10 Index, which is an unmanaged index of about 1670 smallest publicly traded stocks.

Small cap stock funds, like this one, is not for the faint of heart. Small companies are subjected to business and capital risks most large companies are not subjected to or at least to the same degree.

First there is the issue of access to capital. On whole, smaller companies have limited access to capital as compared to their larger cap cousins. Also, when it is made available, it is at a much higher cost. The reasons for this should be relatively clear. Smaller companies are subjected to much higher business risk, risks to the entire enterprise that may “take down” the whole ship. Again in relation to much larger companies, smaller companies tend to have immature product or services lines of business, less experienced management, greater costs (access to capital to grow) and a greater exposure to losses to net income from losses of primary supplier(s) and primary customer(s).

John Montgomery, in his February 25, 2008 investment management team letter stated that their examination of the data between 1926 and 2000 revealed that “ultra-small stocks fell an average of 35% more than large stocks during the average calendar year market decline” and that their “best generalized advice is not to have more in these funds than an investor means to have for the long haul, nor more than investor can afford to hold through a downturn.” He goes on to say that this generalized advice is good advice when considering one’s own stock market risk tolerance, i.e. what percentage of your total investments will be in stocks.

So why hold the stocks of small cap companies? Higher *expected* returns. Please note I did not write “higher *guaranteed* returns”. The evidence suggests that the longer the time period held, the more likely the higher expected returns of smaller cap stocks will show up. Investors in small companies demand (and historically have received) what the academics refer to as a “risk premium“, a premium for buying higher-risk investments.

Author Larry Swedroe gives an illustrative example of 2 companies: Wal-Mart and K-Mart. He asks readers to consider which is the “better” company. Most people would consider Wal-Mart the “better” company of the two. He then asks readers to consider which stock would make a better investment? Again, many would answer Wal-Mart, in large part because it is perceived as the “better” company. Mr. Swedroe’s argument is that K-Mart would likely be the better stock to own because of its risk premium. In a big picture sense, investors can allocate and deploy their capital as they see fit. They don’t *need* to invest in K-Mart. So, investors that actively choose to invest in K-Mart over Wal-Mart demand (expect) a higher rate of return over what they would get if they invested in Wal-Mart.

We can apply this example to smaller cap stocks. Investors (that can deploy their capital in any manner) that choose to invest in smaller companies demand (expect) that their investment returns in this risky asset class will be higher than large cap companies as the stock market has historically rewarded risk. If the expected returns were the same, there would be no reason for an investor to choose a riskier investment over a “safer” one!

Mr. Montgomery further noted in the investment letter cited above, “in ten of the last eleven recessions, stocks rose an average of 24% after the low”. He is referring to the average stock market gain (of all stocks). Because small cap stocks have a higher expected return, investors in small companies expect an even higher post-recession increase.

Again, not every expectation of gain materializes. If there were no risk, there would be no risk premium. But the longer the holding period time frame, the *more likely* the expected returns materialize.

In getting ready for the “Got Money?” Girl Scout workshop, I thought it might be neat for the girls to look at stock market volatility and returns in action. I chose (at random) six NJ publicly traded companies: Campbells, Bed Bath and Beyond, Commerce Bank, Johnson and Johnson, A&P and Prudential Financial.

I’ll ask the girls to “team up” for each company and tell me why they think the company is a good stock “pick”. Should be illuminating to hear the thought process. After we go through a little discussion, we’ll take a look back to 12/31/2005 where they’ve been “given” $1000 to “play” the stock market. We’ll chart the progress of each stock through March 12, 2008. This simple chart will illuminate the way:

GS - Value of $1000 Example

The main points I’d like to address:

• Volatility: What’s the likelihood of them holding Bed Bath and Beyond past 2006 (where the decline in value was of over 22%);

• Uncompensated Risk: Buying one stock or a few stocks is very risky as you do not get “compensated” by the stock market for holding a non-diversified portfolio; and

• Returns: Only 1 of our 6 stocks beat the Wilshire 5000 (Campbells) during this period. All others lost. How likely is Campbell’s out-performance likely to continue?

According to this Los Angeles Times news article, UCLA economists are standing firm on their prediction of no U.S. economic recession. Doesn’t mean that it doesn’t “feel” like one. One look at our investment statements or at the breathtaking drop in the financial markets and we all know how it “feels”. But essentially, this is a crisis of confidence. We’re seeing panic selling now, which I believe is a good and healthy thing.

Panic selling, which is a factor in depressing stock prices, means the future holds higher *expected* returns. That is the terrible mathematic truth. For those that have 10-20 years of market investing, this drop in prices is (as Martha would say), a “good thing”. It just doesn’t feel like it.

What’s also happening is our perception of market risk is changing. This is also a good and healthy thing. When perceptions of market risk are high, so are returns. Of course, the inverse is also true. Investing in stocks is risky and should not be undertaken lightly no matter what pretty color filled brochure you’ve been given. People who bought in to the market near market highs in 2001 and around August of last year had, generally speaking, a very low perception of market risk. Of course, market risk was there all the time, it’s just that our *perception* of it was not very high.

So, does this mean it’s all a bed roses from here? Absolutely not. Business cycles and societal trends don’t work like that. But as risk premiums rise, so do returns. So, if your investment policy statement is mandating that you sell some of that cash and fixed income you’re holding to buy equities and you’ve been resisting, reconsider your market risk tolerance.

Remember, it’s not very often that you get to buy equities while they’re on sale.

Liars figure and figures lie. Watch John Bogle, founder of the Vanguard Group discuss “financial engineering” and offers a reasoned argument on why many corporate pension plans are failing. He takes a very dim view of finance managers manipulating earnings and how it will effect us all. It’s only 2 minutes in length but a must-watch for anyone that has to work for a living.

Contrary to what some believe, I was not born with a particular math aptitude. Knowledge comes by study and commitment. For those who are interested in how to become better students of personal investment studies, I offer the Reading Room. The books contained provide a great foundation for learning more about personal investing. They are hype-free and easy to read. There is also a “nerd-gasm” section of the Reading Room for those who like more challenging math. Enjoy.

Well, this is a harbinger of things to come. As outlined here in the Wall Street Journal, the FDIC is looking to ramp up employment in preparation of an increase in the number of bank failures in the near future. That means we can look forward to more media “doom and gloom” about the economy and continued talk of “recession”.

In case you’re not familiar with the definition of “recession”, you can learn more here. In plain terms, a recession is 2 or more successive quarters of negative economic activity. Just so you know, the US economy hasn’t been in recession since November, 2001! Of course, you wouldn’t know that by the way the media talks about “how bad” the economy is.

Here’s how it ties together: our economy is completely reliant upon consumer spending, with about 70% of our economic activity tied to it. There’s a good reason why our economy is called a “service” economy! When people continue to hear “how bad things are” they stop spending because not spending is completely rational based upon what we hear on the news and read in the papers or online.

When people stop spending, economic activity slows (duh!) and it becomes a self-propagating, negative feedback loop. Why else would a government give us back our own money via a “stimulus package“? They’re hoping we spend the money because spending it lowers the risk of recession.

Ain’t macroeconomics grand?

This is great quote. Read it and just let it sink in for a moment….

“The entire real estate debacle is the fault of everybody that was involved. And it was all about greed and speed,” said Rachel Dollar, a Santa Rosa attorney who represents lenders in fraud and other cases. “The brokers wanted their commission. The lenders wanted their premiums. The borrowers wanted their homes.”

(Emphasis added by me). The direct source of the quote.

I love the way Ms. Dollar (sometimes this stuff just writes itself!) uses the word “everybody”…. Let me add some more people who need to be included in the “everybody” category…

• Real estate attorneys received payment for their closings;
• Newspapers received increased real estate advertising revenue;
• Home appraisers received payment for their (ahem) valuation reports;
• Home inspectors received payment for their services;
• Homeowners insurance companies received premiums (and still continue to get paid) based on inflated real estate values (which were required by the lender to fund the loan);
• We can add insurance agents/brokers to the line above as commissions in large part are based on the gross premium paid by the homeowner;
• Many local and state governments benefited (and continue to benefit) from inflated real estate values;

I could go on, but you get the point. In short, it’s turned out to be a big turd sandwich in which we will all now have to take a bite.

Double click on the chart above (it’ll open up a new window) and you’ll understand that home prices have a long way to fall before bottoming out. Ouch.

Almost every investor has a money market account (MMA) or a bond fund. Almost everyone knows these accounts are not ordinary bank accounts and thus are not insured by the FDIC. Of course, FDIC “insurance” is a bit of a canard, as there is nowhere near enough money in reserves to pay everyone who has an FDIC insured account in the event of a sufficiently large enough U.S. banking crisis.

What most people are blissfully unaware of is that a MMA is essentially a very short term bond fund. A bond is essentially a “promise to pay” a certain sum tomorrow (over time) for a certain sum today. There are many websites that explain bond funds in hyper detail (go here for a great primer) - this is the most stripped down explanation I could think of! Bonds can be offered by many entities (corporations/governments, etc.) and are used for many purposes (capital expenditures/cash flow/reserves, etc). “Short term” refers to what is essentially a bond’s duration (which is essentially it’s “repayment period”). The duration of a MMA is usually less than 1 year. Short term bond fund duration as of this writing is about 2 years. Intermediate term bond fund duration is about 5-7 years and long term bond fund duration is 7+ to 3o years.

Let’s consider ABC Company, which needs money to manufacture a new plant. It decides to sell bonds (backed by its ability to repay) to meet its needs. It becomes the bond’s “issuer”. It will pay the bond owner interest for the use of the bond owner’s money today over the duration of the bond. But consider that ABC Company is not in the best of financial shape and would have to pay an interest rate much higher to attract an investor (who is concerned with ABC Co’s ability repay its debt, which is commonly referred to as “default risk”).

So ABC Company decides to pay to have its bonds insured with a monoline bond insurer for a fee, essentially “lending” its own credit rating to ABC Company’s bonds. Without the bond insurance, ABC would (in this hypothetical example) have to pay 8% interest on its bonds, but now that the bonds are “insured”, an investor might only be able to get 5% interest from ABC Co. since the risk of default is (allegedly) far less. ABC Company “pockets” the 3% difference, less the cost of the fee to the bond insurer.

So far, everybody’s happy, right?

• ABC Company is happy, it’s paying 5% interest instead of 8%;
• The investor is happy because the bond is “guaranteed” by a triple AAA rated bond insurer; and
• The bond insurer is happy because it charged and collected the bond insurance premium.

So what happens when the bond insurer goes belly-up? It’s a reasonable question these days and while it hasn’t happened (yet) don’t mistake the improbable for the impossible.

You see, the bond insurers have taken a bite of the sub-prime mortgage mess and the losses in this market segment may cause these insurers to lose their AAA rated credit status and even worse, may bankrupt them.

So in answer to my own question, very bad things would happen. Existing bonds would lose their insured status. New bonds would not be able to become insured, increasing borrowing costs for issuers.  Investors would, in many cases, lose money (principal)  on existing bonds that go into default. The shockwaves are so vast that it’s difficult to get your head around it. Our economy relies so heavily on credit that almost every industry will be effected by this in one way shape or form. Of course, as businesses are negatively impacted, employment will be as well.

The best primer I’ve found to help explain this potential meltdown can be found here. You can’t put your head in the sand on this one.

From wikipedia, “The yield spread premium (YSP) is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale par rate that the borrower qualifies for”. What that means in plain language: YSP is a mark-up on the interest rate charged to you over and above the rate a lender would be willing to receive.

Lenders provide rate sheets to mortgage originators (including mortgage brokers). If the originator closes your loan at a rate higher than shown on lender’s rate sheet, the lender pays a percentage of that amount (overage) back to the originator. This is over and above any other fees the originator may charge such as appraisal fees, underwriting fees, etc.

In a prepared statement to Congress in 2002, Professor Howell E. Jackson of Harvard Law School noted in relevant part that the “study indicates that the vast majority of borrowers pay yield spread premiums - on the order of 85 to 90 percent of all transactions” and that “the average amount of yield spread premiums is quite substantial, on the order of $1,850 per transaction, making these payments the most important single source of revenue for mortgage brokers.”

It’s reasonable to suspect the “substantial” YSP amount of $1,850 in the Professor’s study is woefully antiquated. Since this testimony was prepared before the housing bubble, let me give you an updated example for your review, using some reasonable NY/NJ real estate values.

• Hypothetical loan amount: $400,000
• Lender’s par rate per their rate sheet (the rate the lender would accept): 5.50%
• The rate you closed at: 6.25%
• YSP paid to originator: $12,000
• Difference in the total amount of interest paid by borrower on 30 year loan: $69,016.61.

The rule of thumb is for every 25 basis points (0.25) paid by the borrower over the par rate, 1% of YSP is created. So in the example above, about 3% YSP is created. Following the math, $400,000 X .03 = $12,000 would be paid to the loan originator.

As I understand it, there currently is no legal obligation to disclose the loan YSP to borrowers except on the final settlement statement at closing, when it is often too late to do anything about. I believe it is a moral and ethical duty to disclose prior to closing, but since greed trumps morality almost every time, I would urge you request this information before the closing date on your next mortgage.

Further, with many borrowers who bought homes in the bubble years 2003 - late 2007 looking for someone to blame, I wonder what would happen if they looked at the mortgage originator and lender as a prospective target? Perhaps an argument could be made that the lender/originator was “unjustly enriched” for failing to disclose YSP prior to closing. I have to believe that insurers writing mortgage brokers and lenders professional liability (malpractice) coverage are concerned with this. It wouldn’t take many of these actions to start an avalanche of litigation, especially for those in the most “bubbly” real estate markets of California, Nevada, Florida and New York. I’m certain there are litigators who wouldn’t mind trying.

Of course, where the YSP was disclosed and agreed to by the borrower prior to closing, I have no issue. I wonder just “how many” disclosures occurred prior to closing…

I do have one final question, but it is admittedly rhetorical: How can we objectively review borrowers’ legal counsel’s role here? While the closing documents are in preparation, this information is available. What action(s) did borrower’s counsel undertake to explain YSP to their clients? Yes, I know. This line of questioning is a slippery slope with no answer.

Think this post is over the top?  Check out this link.

About once every decade or so (as the economy dictates) the scam artists come out to prey upon people who’ve fallen into the very bad situation of possibly losing their home in a foreclosure event. Well, it’s that time again…

The web is replete with companies that promise to be able to “save” the home from foreclosure. Some even promise they’ll be able to keep the foreclosure off your credit report. In essence, they’ll say anything to have you buy one of their “kits” for anywhere from $995 (cheap!) to over $2500.

It’s snake oil.

Don’t trust this situation to anyone but yourself. Accept responsibility. Talk to your lender - they do not want your home. In most cases they will try to work with you to avoid taking back your home. If this doesn’t work, speak with a licensed attorney to protect your legal rights.

A quick video from Freddie Mac for your viewing pleasure.

Many people, myself included, like hybrid technology in theory. We like the idea of saving money every time we fill up and there’s a bit of thumbing our noses to the oil industry as well. I’ve been considering a new car purchase (my current vehicle is “only” 13 model years old - my wife chuckles every time I say that) and I’ve been thinking maybe it’s just getting time for a change.

So, with the lure of saving money at the fuel pump, I’ve started to consider vehicles with hybrid technology. Aesthetics aside, the Prius is the fuel economy champ, no surprise there. But my current interest is more in how much more is this technology going to cost me up-front and when will it (if ever) start paying for itself?

We need a few data points to calculate a good guess. With that in mind, consider the following:

The average person drives 15,000 per year. Yes, I know many people drive much more than that but let’s use it as a starting point, shall we? Many new cars average (including some of the ones I’m considering) about 20 miles per gallon. The current cost of gasoline (where I am in NJ) is about $3.00 / gallon. So you can calculate your annual total cost of fuel to be about: $2,250. The math is: Total miles / Miles per gallon (15,000 / 20 = 750 gallons consumed) * Cost per gallon ($3) = $2,250.

Now, let’s say that the hybrid vehicle you’re considering averages 30 mpg but costs $3,500 more than the non-hybrid alternative. When do we break even? Well, plugging in 30 mpg into the calculation above lowers our total annual fuel cost to $1,500 because we’re only consuming 500 gallons per year instead of 750 (15,000 / 30). That’s a savings of $750 / year at current gas prices. Our break-even period is about 4 1/2 years at this rate. Of course, that’s assuming that the cost of fuel will stay the same and not increase over that time period. Yeah right, how likely is that?

So let’s try increasing the cost of fuel to $4.00/gallon, shall we? Annual fuel cost, non-hybrid: (@ 20 mpg/$4) = $3,00o. Annual fuel cost, hybrid: (@ 30 mpg / $4) = $2,000. Annual fuel savings - $1,000. So, looks like the hybrid will pay for itself in about 3 1/2 years under this scenario. (Yes, I am ignoring the time value of money calculations to keep this relatively simple!) At $5.00/gallon gas, the annual savings is about $1,250 - but let’s hope we don’t see that too soon. The one thing, however, I think we can all agree on is that the cost of fuel will continue to increase over the next 5-10 years.

For outside sales people who spend their lives in their car, the savings can be dramatic. Consider: 30,000 miles per year, 20 mpg, $3/gallon represents a $4,500 annual fuel cost. Substitute a hybrid alternative (30,000 miles,30 mpg, $3): $3,000 annual fuel cost, savings of $1,500 per year. If the hybrid alternative is $3,500 additional up-front, it will pay for itself in fuel savings in a little over 2 years. If you update the cost of fuel to $4/gallon, the annual savings is: $2,000 and the hybrid break-even point is essentially 18 months. If you like to keep your cars a long time, the annual savings are almost staggering. Happy car shopping!

Looking to refinance your current note or mortgage? Here’s an interesting tool to estimate FICO credit scores.