My family and I will be on vacation beginning Friday June 27th and extending to Saturday July Fourth. I hope to have a few posts for you even though I will be traveling.
If you are traveling for the Fourth drive safely!
Friday, June 26, 2009
Thursday, June 25, 2009
A Timing Opportunity for Your 529 Plan?
Since they have been around for more than a few years, I hope that everyone knows the basics of Qualified Tuition (529) Plans. A 529 Plan is an education savings plan operated by a state or educational institution. It is designed to help families set aside funds for future college costs. Section 529 is the part of the Internal Revenue Code which created these types of savings plans way back in 1996.
Here are some basics. There is a lot of literature out there which delve into the details but let's have a little review in order to set up the thrust of this post.
Ten Key Points
1. 529 Plans can be used to meet costs of qualified colleges nationwide. In most plans, your choice of school is not affected by the state of your 529 savings plan. Every state now has at least one 529 plan available. It's up to each state to decide whether it will offer a 529 plan and what it will look like, meaning 529 plans can differ from state to state.
2. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant. Although your contributions are not deductible on your federal tax return, your investment grows tax-deferred, and distributions to pay for the beneficiary's college costs come out federally tax-free. The tax-free treatment was made permanent with the Pension Protection Act of 2006.
3. Your own state may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals) in addition to the federal treatment. You should research what benefits residents receive for investing in your own state's 529 plan. If you don't get any benefits from your state, you have the pick of every 529 plan on offer.
4. You, the donor, stay in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the "non-qualified" withdrawal will be subject to income tax and an additional 10% penalty tax). This level of control compares favorably to a custodial account under the Uniform Transfers to Minors Acts (UTMA).
5. The ongoing investment of your account is handled by the plan, not by you. Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager.
6. If you want to move your investment around you may change to a different option in a 529 savings program every year (program permitting) or you may rollover your account to a different state's program provided no such rollover for your beneficiary has occurred in the prior 12 months. Hint: There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.
7. Everyone is eligible to take advantage of a 529 plan, and the amounts you can put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions.
8. 529 Savings Plans work much like a 401K or IRA by investing your contributions in mutual funds or similar investments. The plan will offer you several investment options from which to choose. Your account will go up or down in value based on the performance of the particular option you select.
9. Prepaid Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Independent 529 Plan is a separate prepaid plan for private colleges.
10. Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far).
You should compare each of the Savings Plans you are considering. It would also be worthwhile to compare the 529 Plan to a Coverdell Account,to Savings Bonds, to Uniform Gift to Minor Accounts and Uniform Transfer to Minor Accounts (UGMAs/UTMAs).
The major brokers such as Fidelity all have primers on 529 Plans. Look here for example. Or here is a link to Vanguard's 529 Plan.
A Timing Idea?
So you see that a 529 plan can be a powerful tool in funding a child's education! Now here is where a lesser known provision may provide a way to power-charge your Savings Plan.
The law allows you to make a five year gifting election to the plan. The normal limit is $12,000 annually. By using the election, you can make a gift of $60,000 in one year, just so long as you forgo additional transfers for the next 5 years. If this is for your child's account and you are married, your spouse can also make this election. So in one year you could transfer $120,000 out of your estate and into a child's education account where it compounds tax free.
Why may this be a very good time to consider this? The market has just fallen 57% from its top in Fall 2007 to March 2009 bottom. Today it is still over 40% down from that top despite the recent large rally. Some experts, like the highly respected Jeremy Grantham of GMO Advisors, believe the S&P500 is priced to return 9-10% annually over the next seven years. The well regarded, late market historian Peter Bernstein said of Grantham that he was the only advisor out there who he thought may be able to accurately predict long term rates of return. See here. In Summer 2007 Grantham was warning that we were in a risk bubble where everything was overvalued. Well, 57% off changes a lot of that! See here. If you believe Jeremy Grantham (and please do your own due diligence), now may be the time to make that five year election and take advantage of what the market is now poised to give you.
If you have a medium to long time frame left for your college savings and this sounds like an something for you, please discuss this issue of timing with your financial advisor or tax professional.
Here are some basics. There is a lot of literature out there which delve into the details but let's have a little review in order to set up the thrust of this post.
Ten Key Points
1. 529 Plans can be used to meet costs of qualified colleges nationwide. In most plans, your choice of school is not affected by the state of your 529 savings plan. Every state now has at least one 529 plan available. It's up to each state to decide whether it will offer a 529 plan and what it will look like, meaning 529 plans can differ from state to state.
2. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant. Although your contributions are not deductible on your federal tax return, your investment grows tax-deferred, and distributions to pay for the beneficiary's college costs come out federally tax-free. The tax-free treatment was made permanent with the Pension Protection Act of 2006.
3. Your own state may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals) in addition to the federal treatment. You should research what benefits residents receive for investing in your own state's 529 plan. If you don't get any benefits from your state, you have the pick of every 529 plan on offer.
4. You, the donor, stay in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the "non-qualified" withdrawal will be subject to income tax and an additional 10% penalty tax). This level of control compares favorably to a custodial account under the Uniform Transfers to Minors Acts (UTMA).
5. The ongoing investment of your account is handled by the plan, not by you. Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager.
6. If you want to move your investment around you may change to a different option in a 529 savings program every year (program permitting) or you may rollover your account to a different state's program provided no such rollover for your beneficiary has occurred in the prior 12 months. Hint: There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.
7. Everyone is eligible to take advantage of a 529 plan, and the amounts you can put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions.
8. 529 Savings Plans work much like a 401K or IRA by investing your contributions in mutual funds or similar investments. The plan will offer you several investment options from which to choose. Your account will go up or down in value based on the performance of the particular option you select.
9. Prepaid Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Independent 529 Plan is a separate prepaid plan for private colleges.
10. Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far).
You should compare each of the Savings Plans you are considering. It would also be worthwhile to compare the 529 Plan to a Coverdell Account,to Savings Bonds, to Uniform Gift to Minor Accounts and Uniform Transfer to Minor Accounts (UGMAs/UTMAs).
The major brokers such as Fidelity all have primers on 529 Plans. Look here for example. Or here is a link to Vanguard's 529 Plan.
A Timing Idea?
So you see that a 529 plan can be a powerful tool in funding a child's education! Now here is where a lesser known provision may provide a way to power-charge your Savings Plan.
The law allows you to make a five year gifting election to the plan. The normal limit is $12,000 annually. By using the election, you can make a gift of $60,000 in one year, just so long as you forgo additional transfers for the next 5 years. If this is for your child's account and you are married, your spouse can also make this election. So in one year you could transfer $120,000 out of your estate and into a child's education account where it compounds tax free.
Why may this be a very good time to consider this? The market has just fallen 57% from its top in Fall 2007 to March 2009 bottom. Today it is still over 40% down from that top despite the recent large rally. Some experts, like the highly respected Jeremy Grantham of GMO Advisors, believe the S&P500 is priced to return 9-10% annually over the next seven years. The well regarded, late market historian Peter Bernstein said of Grantham that he was the only advisor out there who he thought may be able to accurately predict long term rates of return. See here. In Summer 2007 Grantham was warning that we were in a risk bubble where everything was overvalued. Well, 57% off changes a lot of that! See here. If you believe Jeremy Grantham (and please do your own due diligence), now may be the time to make that five year election and take advantage of what the market is now poised to give you.
If you have a medium to long time frame left for your college savings and this sounds like an something for you, please discuss this issue of timing with your financial advisor or tax professional.
Monday, June 22, 2009
Compound Returns vs. Average Returns
A reader asked me to explain my comment in the previous post about investors only being able to eat compound returns not average returns. Simple enough.
Let's say a mutual fund quotes you an "average annual return" from date of inception of 7.0% to the end of 2008. Let's say that fund has been around for the extraordinarily long time of 109 years. Call it the "Methuselah Growth Fund". Well, what they are describing to you is a calculation done by the addition of the annual figures for its returns divided by the number of such observations, or 109. That's the simple part.
Now let's say that all those years ago that fund began with an offering price of $10 per share. "So", you say. "Lemme just plug that in to my TI calculator" as the beginning value and then let's take that annual return of 7% and multiply the year end value each and every year by 1.07. Or, even better just use a handy function provided by the calculator that will do the same thing. Much faster than 109 separate hand calculations!
"Whoa!" you exclaim. "That's not the value of the fund I'm showing! My data show it's WAY lower than that! What happened?" Well, I'll let you in on a little secret. Our fictitious Methuselah Growth Fund is a fund that tracks the return of the Dow Jones Industrial Average. What happened was that negative returns from time to time degraded the fund's performance. Sometimes these negative numbers were quite large. Minus 33% in 1937, minus 28% in 1974 and minus 34% last year for example. And as they deviate farther and farther from zero, the degradation in the compound returns becomes more pronounced. For example, a series averaging 5% that goes 15%, minus 10%, and 10% has a higher compound return (4.419%) than a series that goes 30%, minus 25%, 10% (2.361%).So, instead of that 7% return you were expecting, the actual compounded returns were 4.6%! This is the actual compound annual growth rate of the DJIA from 1900-2008.You can see all this graphically at the Crestmont Research site here. And the order of those returns doesn't matter, a fact you can prove yourself by playing around with the calculator.
So when I say that an investor "can't eat arithmetic returns", it just means that arithmetic returns are not what end up in the mailbox in the 401k statement. Compound returns do. And if that investment is at all volatile in its return series, the compound return -- what that investor can eat--will be much lower than the arithmetic return.
Let's say a mutual fund quotes you an "average annual return" from date of inception of 7.0% to the end of 2008. Let's say that fund has been around for the extraordinarily long time of 109 years. Call it the "Methuselah Growth Fund". Well, what they are describing to you is a calculation done by the addition of the annual figures for its returns divided by the number of such observations, or 109. That's the simple part.
Now let's say that all those years ago that fund began with an offering price of $10 per share. "So", you say. "Lemme just plug that in to my TI calculator" as the beginning value and then let's take that annual return of 7% and multiply the year end value each and every year by 1.07. Or, even better just use a handy function provided by the calculator that will do the same thing. Much faster than 109 separate hand calculations!
"Whoa!" you exclaim. "That's not the value of the fund I'm showing! My data show it's WAY lower than that! What happened?" Well, I'll let you in on a little secret. Our fictitious Methuselah Growth Fund is a fund that tracks the return of the Dow Jones Industrial Average. What happened was that negative returns from time to time degraded the fund's performance. Sometimes these negative numbers were quite large. Minus 33% in 1937, minus 28% in 1974 and minus 34% last year for example. And as they deviate farther and farther from zero, the degradation in the compound returns becomes more pronounced. For example, a series averaging 5% that goes 15%, minus 10%, and 10% has a higher compound return (4.419%) than a series that goes 30%, minus 25%, 10% (2.361%).So, instead of that 7% return you were expecting, the actual compounded returns were 4.6%! This is the actual compound annual growth rate of the DJIA from 1900-2008.You can see all this graphically at the Crestmont Research site here. And the order of those returns doesn't matter, a fact you can prove yourself by playing around with the calculator.
So when I say that an investor "can't eat arithmetic returns", it just means that arithmetic returns are not what end up in the mailbox in the 401k statement. Compound returns do. And if that investment is at all volatile in its return series, the compound return -- what that investor can eat--will be much lower than the arithmetic return.
Friday, June 19, 2009
The First Rule of Investing
“The first rule of investing is don't lose money. The second rule is don't forget Rule No. 1.” - Warren Buffet
I don't post this to be cute or trite. It is a simple law of mathematics that losses degrade portfolio returns and large losses can be fatal. Let's take a look at an example: the investor who gains 20% per year for three years in a row. What is his annual compound gain? Why 20% of course. Now let's throw in a mild 20% loss (bear markets are usually much harsher than this). What is his annual compound gain now? It's only 8.43%. LOSSES DO IMMENSE DAMAGE TO COMPOUND RETURNS, and compound returns are the only kind an investor can eat. (Arithmetic returns are meaningless.)
By now everyone should be saying to themselves "Hey! What about the kind of market losses we have seen recently? What of 50 and 60% losses?" Well those are of the fatal or near fatal variety. From the Financial Life-Cycle Planning blog(dshort.com), the following chart:
It takes a 25% gain to recover from a 20% loss. It takes a 33% gain to recover from a 25% loss. But when your loss is 50% you need to DOUBLE your money to be made whole. And when your loss reaches 60% you need a 150% gain to break even!
Unfortunately, these are the kinds of losses we have seen twice in the past nine years. No wonder investors are wondering how they are ever going to make them back up.
I believe that many investors would benefit by holding a portion of their portfolio in strategies that are uncorrelated to the broader markets: absolute return strategies. These smooth returns. In choppy markets they may also provide a way to gain positive returns, not just break even. Consult your financial advisor for discussion of vehicles that may be appropriate to your situation.
I don't post this to be cute or trite. It is a simple law of mathematics that losses degrade portfolio returns and large losses can be fatal. Let's take a look at an example: the investor who gains 20% per year for three years in a row. What is his annual compound gain? Why 20% of course. Now let's throw in a mild 20% loss (bear markets are usually much harsher than this). What is his annual compound gain now? It's only 8.43%. LOSSES DO IMMENSE DAMAGE TO COMPOUND RETURNS, and compound returns are the only kind an investor can eat. (Arithmetic returns are meaningless.)
By now everyone should be saying to themselves "Hey! What about the kind of market losses we have seen recently? What of 50 and 60% losses?" Well those are of the fatal or near fatal variety. From the Financial Life-Cycle Planning blog(dshort.com), the following chart:
It takes a 25% gain to recover from a 20% loss. It takes a 33% gain to recover from a 25% loss. But when your loss is 50% you need to DOUBLE your money to be made whole. And when your loss reaches 60% you need a 150% gain to break even!
Unfortunately, these are the kinds of losses we have seen twice in the past nine years. No wonder investors are wondering how they are ever going to make them back up.
I believe that many investors would benefit by holding a portion of their portfolio in strategies that are uncorrelated to the broader markets: absolute return strategies. These smooth returns. In choppy markets they may also provide a way to gain positive returns, not just break even. Consult your financial advisor for discussion of vehicles that may be appropriate to your situation.
Thursday, June 18, 2009
The Most Important Question in Financial Planning Today: The Inflation/Deflation Conundrum- Part I
A Note to Readers on Blogging Schedule:
I wanted to get out a few quick posts for you on some critical issues. That will mean rather frequent posts in the coming weeks. After that my intention is to post once a week on topics generally relating to the broader area of financial planning and a post related to the markets, investing or economics. We'll see how successful I am with that. :) For people who know me "dialing it back a bit" has always been somewhat of a challenge!
In my opinion the most important question faced by the financial planning community in the intermediate term may be the question of whether we face inflation or deflation in the broad economy. Why is that important? Because the portfolio elements that perform well in a deflationary environment (prices falling) are not those that do in an inflationary environment (prices rising). Should you try to account for this? That is a question you should discuss with your advisor. I concede that many advisors and their clients adopt a simple "all weather" portfolio approach. If a conscious choice, that is fine. Other advisors and clients may appreciate a more nuanced approach that incorporates a top down look. The choice is a stark one and may mean a great deal to portfolio performance over the intermediate term (3-5 years), perhaps longer. Let's take a look.
Unless you have been in a cave for the past 24 months, you know that as a response to the current crisis the government has undertaken unprecedented policy steps to stabilize the banking system in the United States. The explicit backing of the various bailouts and program resources provided to the financial system to date is calculated at $13.9 TRILLION. (FDIC, Summer 2009 Supervisory Insights) What this has done is merely offset the massive shrinkage that has taken place in the household sector. To wit, the Fed recently released its 1Q Flow of Funds data. According the Fed, household net worth is now off $14 Trillion from the peak in 2007. This includes real estate and financial assets (stocks, bonds, pension reserves, deposits, etc) net of liabilities (mostly mortgages). This does NOT include public debt obligations. Again, courtesy of the good folks at Calculated Risk and from the Fed:
This ratio was relatively stable for almost 50 years. We then experience a bubble in technology-media-telecom space—which busted—then a bubble in housing which, you guessed it, also BUSTED. Now we are left holding the bag.
This destruction of wealth is not inflationary in the least. It is highly deflationary. In the aggregate the household sector has $14 trillion less dollars for whatever eventual purpose they intended it, savings or consumption. That is real honest-to-goodness balance sheet whackage.
While it is true that all of this wealth would not be immediately convertible for consumption, the fact of the matter is that a significant percent (30% by some estimates) of every dollar of house appreciation was making its way back into the economy via mortgage equity withdrawal. That spigot has been turned off.
And vanishing stock market wealth is also one of the reasons that the savings rate in the U.S. has turned on a dime and is now possibly mean reverting to a new “normal” level. Look at this graph:
Look at those low savings rates during the "house as personal ATM" years. Most are barely above zero. Then as the housing market and stock markets deflated, it stayed low until markets reached crash levels and people woke up to the fact that they were 40% poorer on the whole. It then began to shoot up. Now it sits at about 5% of personal income. We haven't seen that figure for QUITE awhile. Some economists think that will eventually reach 8% or more! If so, even more money will be diverted from personal consumption. People need to mend their balance sheets. Debt is not being destroyed at the same pace as wealth so the ratio of debt to wealth climbs. The consumer's natural reaction is to pay down that debt and SAVE.
On June 17th we learned that the Consumer Price Index for All Urban Consumers increased increased slightly in May before seasonal adjustments, according to the Bureau of Labor Statistics. Since the Fed is obviously trying to reflate the economy that is the good news. The bad news is that over the last 12 months the index has fallen 1.3 percent. This is the largest decline since April 1950, some 59 years ago. That is deflation, pure and simple.
This deflation comes to you with the backdrop of payroll figures that are falling off a cliff. Here is one look at unemployment via Ritholtz'The Big Picture and courtesy of The Chart Store:
The headline unemployment rate is 9.4%. Employers are reacting to uncertain prospects going forward by laying off workers. It appears that rate may be slowing as jobs lost in May were estimated at only 345,000, a number that brought a sigh of relief to the markets. Only 345,000! Whether you believe that estimate or not that is an additional 345,000 workers who will not be bringing home a paycheck. A paycheck to spend. And before we get too giddy about the decline in contraction from six and seven hundred thousand jobs lost monthly, consider that 350,000 was just about as bad as it got during the last recession. So the figure is still awful. Just a little less so.
A crashing market. A deflating housing bubble. Massive layoffs. A revived tendency to save. All these exert huge deflationary pressure on the economy.
I wanted to get out a few quick posts for you on some critical issues. That will mean rather frequent posts in the coming weeks. After that my intention is to post once a week on topics generally relating to the broader area of financial planning and a post related to the markets, investing or economics. We'll see how successful I am with that. :) For people who know me "dialing it back a bit" has always been somewhat of a challenge!
In my opinion the most important question faced by the financial planning community in the intermediate term may be the question of whether we face inflation or deflation in the broad economy. Why is that important? Because the portfolio elements that perform well in a deflationary environment (prices falling) are not those that do in an inflationary environment (prices rising). Should you try to account for this? That is a question you should discuss with your advisor. I concede that many advisors and their clients adopt a simple "all weather" portfolio approach. If a conscious choice, that is fine. Other advisors and clients may appreciate a more nuanced approach that incorporates a top down look. The choice is a stark one and may mean a great deal to portfolio performance over the intermediate term (3-5 years), perhaps longer. Let's take a look.
Unless you have been in a cave for the past 24 months, you know that as a response to the current crisis the government has undertaken unprecedented policy steps to stabilize the banking system in the United States. The explicit backing of the various bailouts and program resources provided to the financial system to date is calculated at $13.9 TRILLION. (FDIC, Summer 2009 Supervisory Insights) What this has done is merely offset the massive shrinkage that has taken place in the household sector. To wit, the Fed recently released its 1Q Flow of Funds data. According the Fed, household net worth is now off $14 Trillion from the peak in 2007. This includes real estate and financial assets (stocks, bonds, pension reserves, deposits, etc) net of liabilities (mostly mortgages). This does NOT include public debt obligations. Again, courtesy of the good folks at Calculated Risk and from the Fed:
This ratio was relatively stable for almost 50 years. We then experience a bubble in technology-media-telecom space—which busted—then a bubble in housing which, you guessed it, also BUSTED. Now we are left holding the bag.
This destruction of wealth is not inflationary in the least. It is highly deflationary. In the aggregate the household sector has $14 trillion less dollars for whatever eventual purpose they intended it, savings or consumption. That is real honest-to-goodness balance sheet whackage.
While it is true that all of this wealth would not be immediately convertible for consumption, the fact of the matter is that a significant percent (30% by some estimates) of every dollar of house appreciation was making its way back into the economy via mortgage equity withdrawal. That spigot has been turned off.
And vanishing stock market wealth is also one of the reasons that the savings rate in the U.S. has turned on a dime and is now possibly mean reverting to a new “normal” level. Look at this graph:
Look at those low savings rates during the "house as personal ATM" years. Most are barely above zero. Then as the housing market and stock markets deflated, it stayed low until markets reached crash levels and people woke up to the fact that they were 40% poorer on the whole. It then began to shoot up. Now it sits at about 5% of personal income. We haven't seen that figure for QUITE awhile. Some economists think that will eventually reach 8% or more! If so, even more money will be diverted from personal consumption. People need to mend their balance sheets. Debt is not being destroyed at the same pace as wealth so the ratio of debt to wealth climbs. The consumer's natural reaction is to pay down that debt and SAVE.
On June 17th we learned that the Consumer Price Index for All Urban Consumers increased increased slightly in May before seasonal adjustments, according to the Bureau of Labor Statistics. Since the Fed is obviously trying to reflate the economy that is the good news. The bad news is that over the last 12 months the index has fallen 1.3 percent. This is the largest decline since April 1950, some 59 years ago. That is deflation, pure and simple.
This deflation comes to you with the backdrop of payroll figures that are falling off a cliff. Here is one look at unemployment via Ritholtz'The Big Picture and courtesy of The Chart Store:
The headline unemployment rate is 9.4%. Employers are reacting to uncertain prospects going forward by laying off workers. It appears that rate may be slowing as jobs lost in May were estimated at only 345,000, a number that brought a sigh of relief to the markets. Only 345,000! Whether you believe that estimate or not that is an additional 345,000 workers who will not be bringing home a paycheck. A paycheck to spend. And before we get too giddy about the decline in contraction from six and seven hundred thousand jobs lost monthly, consider that 350,000 was just about as bad as it got during the last recession. So the figure is still awful. Just a little less so.
A crashing market. A deflating housing bubble. Massive layoffs. A revived tendency to save. All these exert huge deflationary pressure on the economy.
Wednesday, June 17, 2009
Housing As An Investment: Responses
A party has pointed out- smugly I may add- that his father was quite successful buying houses in need of repair, fixing them up, and reselling them for profit. Surely I was wrong in thinking that houses could not be investments?
Answer: Your father owned a small business. The inventory for that business was old stock housing. Through a business process he altered the characteristics of the inventory to reach a finished product. Re-manufactured them if you will. He was not relying on the original state of the house itself to provide a return. He was using it as an input. The return came from his process, labor and skills. All the characteristics of a business venture.
Next, someone asked about the common practice in 2004-2006 to buy and flip houses. These people made LOTS of money she points out. Surely those were investments?
Alas I have to disagree. While such an activity bears some relation to investing as discussed in the article, what these people were doing was "speculating". They were traders, much as people left good dependable jobs in the late 90's to trade stocks online at their kitchen tables, these people used Deeds and other ownership interests to entice a "greater fool" to take the piece of paper off their hands for a higher price in a rising market. That is not "investing". Money was made, surely. Buckets of it by some. But it was not investing.
My point in the article is not that no one ever makes any money through house ownership. Some people surely do. In fact, *I* have made money buying dilapidated housing, fixing it and reselling it. That activity paid off all my wife's student loans and got us debt free early in our lives. But that activity was not investing and the notion of houses as "an investment" is just wrong thinking in my opinion.
Answer: Your father owned a small business. The inventory for that business was old stock housing. Through a business process he altered the characteristics of the inventory to reach a finished product. Re-manufactured them if you will. He was not relying on the original state of the house itself to provide a return. He was using it as an input. The return came from his process, labor and skills. All the characteristics of a business venture.
Next, someone asked about the common practice in 2004-2006 to buy and flip houses. These people made LOTS of money she points out. Surely those were investments?
Alas I have to disagree. While such an activity bears some relation to investing as discussed in the article, what these people were doing was "speculating". They were traders, much as people left good dependable jobs in the late 90's to trade stocks online at their kitchen tables, these people used Deeds and other ownership interests to entice a "greater fool" to take the piece of paper off their hands for a higher price in a rising market. That is not "investing". Money was made, surely. Buckets of it by some. But it was not investing.
My point in the article is not that no one ever makes any money through house ownership. Some people surely do. In fact, *I* have made money buying dilapidated housing, fixing it and reselling it. That activity paid off all my wife's student loans and got us debt free early in our lives. But that activity was not investing and the notion of houses as "an investment" is just wrong thinking in my opinion.
Tuesday, June 16, 2009
Housing As An Investment?
I have always been amazed at the notion that a person's or family's home was being bought "as an investment". I hope that recent events have forever disabused anyone in my generation from ever expressing such an inanity again. Homes are bought to provide shelter ("shelter services" as some economists refer to it), perhaps for comfort, or even vanity. But as an investment? No!
Back in 2007, near the top of the bubble, Robert Shiller, the economist from Yale and co-inventor of the Case-Shiller Housing Index was asked about the notion. He found it equally perplexing. From 1890-1990, he said, the return from residential real estate in the U.S. was nearly flat after inflation, showing appreciation of approximately 3% per year. From 1997-2007, he conceded, the pace had quickened, averaging a 6% gain per annum. Not to worry though, housing was about to revert to the mean he added. But he cautioned that wasn't a prediction, but a cool analysis of the historical record.
He should have called it a prediction.
From the blog Calculated Risk, the following:
This graph shows the price to rent ratio (Q1 1997 = 1.0) for the Case-Shiller national Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used.
Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is maybe 85% complete as of Q1 2009 on a national basis. This ratio will probably continue to decline.
This graph is based off the Case-Shiller national index, and the Census Bureau's median income Historical Income Tables - Households (and an estimate of 2% increase in household median income for 2008 and flat for 2009).
Using national median income and house prices provides a gross overview of price-to-income (it would be better to do this analysis on a local area). However this does shows that the price-to-income is still too high, and that this ratio needs to fall another 10% or so. A further decline in this ratio could be a combination of falling house prices and/or rising nominal incomes.
The reversion toward the mean has been swift and brutal. Having reached bubbly heights, the tendency of all asset classes to revert-- in this case housing-- has held true. It is still falling despite any talk you hear about "stabilization" or "green shoots".
Housing as "an investment"? Take T-Bills/Notes any day.
Back in 2007, near the top of the bubble, Robert Shiller, the economist from Yale and co-inventor of the Case-Shiller Housing Index was asked about the notion. He found it equally perplexing. From 1890-1990, he said, the return from residential real estate in the U.S. was nearly flat after inflation, showing appreciation of approximately 3% per year. From 1997-2007, he conceded, the pace had quickened, averaging a 6% gain per annum. Not to worry though, housing was about to revert to the mean he added. But he cautioned that wasn't a prediction, but a cool analysis of the historical record.
He should have called it a prediction.
From the blog Calculated Risk, the following:
This graph shows the price to rent ratio (Q1 1997 = 1.0) for the Case-Shiller national Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used.
Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is maybe 85% complete as of Q1 2009 on a national basis. This ratio will probably continue to decline.
This graph is based off the Case-Shiller national index, and the Census Bureau's median income Historical Income Tables - Households (and an estimate of 2% increase in household median income for 2008 and flat for 2009).
Using national median income and house prices provides a gross overview of price-to-income (it would be better to do this analysis on a local area). However this does shows that the price-to-income is still too high, and that this ratio needs to fall another 10% or so. A further decline in this ratio could be a combination of falling house prices and/or rising nominal incomes.
The reversion toward the mean has been swift and brutal. Having reached bubbly heights, the tendency of all asset classes to revert-- in this case housing-- has held true. It is still falling despite any talk you hear about "stabilization" or "green shoots".
Housing as "an investment"? Take T-Bills/Notes any day.
We Have Met the Enemy and He is Us
Besides needing to lose weight, floss, and pay more attention to our marriages lest we all end up divorced, it seems all of us need a shrink when it comes to investing, or at least the ability to call our “Life Line” for some correct answers. Why? Over the past 20 years investors in stock mutual funds have underperformed the S&P500 by 6.5% a year. (8.35% vs. 1.37%) Throw in inflation and the individual investor is under water for the past two decades!
And bond investing? Hoo boy, it seems we can’t get it right there either! Individual investors underperformed the Barclay’s Aggregate by 6.7% a year.
From the annual Dalbar study:
For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period. Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index.
Dalbar, Quantitative Analysis of Investor Behavior (2009)
It’s not just that we under-perform in bull markets. We under-perform in just about every type of market. According to Dalbar this under-performance has been going on as far as they have been tracking it. That period includes part of the largest bull market in history and two of the worst bear markets. We apparently make buy and sell decisions at the very worst of times. We sell at bottoms when we panic and buy at tops when the euphoria of strongly rising prices has long set in. From an inflation adjusted perspective it’s not that we would have been far better off in T-Bills, we came close to the type of returns generated by “Under the Mattress and Can in the Backyard” approaches to investing. Apparently we need help and lots of it.
What should the individual investor's takeaway be from this information? An investor needs a plan! And the conviction to stick it out when emotions are running high. Buy and hold is such a plan, although I personally don't prefer it. If an investor's timeframe is long enough (and that is the key) buy and hold can produce returns that are adequate for most purposes and most investors. Asset allocation (done correctly) is a plan. Active trading methods(done correctly, i.e. with individual security values triggering buy/sell decisions) is a plan. But what is needed most of all is a plan coupled with discipline, especially of the emotional variety. Either that or get out of the markets altogether and invest money elsewhere. Markets are susceptible to all sorts of swings and most people fool themselves when they say they can accept the risk of losses that are inherent in the markets. And that is why they grossly underperform.
And bond investing? Hoo boy, it seems we can’t get it right there either! Individual investors underperformed the Barclay’s Aggregate by 6.7% a year.
From the annual Dalbar study:
For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period. Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index.
Dalbar, Quantitative Analysis of Investor Behavior (2009)
It’s not just that we under-perform in bull markets. We under-perform in just about every type of market. According to Dalbar this under-performance has been going on as far as they have been tracking it. That period includes part of the largest bull market in history and two of the worst bear markets. We apparently make buy and sell decisions at the very worst of times. We sell at bottoms when we panic and buy at tops when the euphoria of strongly rising prices has long set in. From an inflation adjusted perspective it’s not that we would have been far better off in T-Bills, we came close to the type of returns generated by “Under the Mattress and Can in the Backyard” approaches to investing. Apparently we need help and lots of it.
What should the individual investor's takeaway be from this information? An investor needs a plan! And the conviction to stick it out when emotions are running high. Buy and hold is such a plan, although I personally don't prefer it. If an investor's timeframe is long enough (and that is the key) buy and hold can produce returns that are adequate for most purposes and most investors. Asset allocation (done correctly) is a plan. Active trading methods(done correctly, i.e. with individual security values triggering buy/sell decisions) is a plan. But what is needed most of all is a plan coupled with discipline, especially of the emotional variety. Either that or get out of the markets altogether and invest money elsewhere. Markets are susceptible to all sorts of swings and most people fool themselves when they say they can accept the risk of losses that are inherent in the markets. And that is why they grossly underperform.
And In the Beginning....
Welcome to "Durable Wealth", the blog about the creation, preservation and transfer of wealth! Through this portal I hope to share with you a lot of what I have learned in my 31 years of business experience, working both in the public and private sectors. I hope to share with you what works and what doesn't, over a wide array of topics, ranging from basic financial planning concepts such as the elements of compounding money, to complex issues such as intergenerational transfers. Along the way we'll discuss taxes, insurance, investing, economics and estate planning. But first we'll start by discussing a couple of topics most on people's minds these days: the stock market and housing. I have some very concrete ideas about these two issues and I hope that you will learn (right along with me) as I lay out some things for you to think about when you consider how what is happening today affects you, your portfolio and your children's future. Enjoy!
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