For Your Consideration

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.

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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.

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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?