Planning Horizon: Review Benchmarks

The Economist

Some waggish but wise publication, perhaps The Economist, reported on the accuracy of predictions at various times in the future. Predicting what you can accomplish in a year is almost always an over-estimate; you can't possibly accomplish that much in a year. Predicting twenty years in advance has the opposite flaw; things will change so much in twenty years, the average person will almost invariably under-estimate the future. So, what's the best time for predictions? According to The Economist, it comes out to be about six years.

Five years seems somehow easier to remember, so let's state a principle of financial planning: review your goals every five years with some professional help. The young fellow needs to have a lawyer review his will, because he probably doesn't have one. He needs someone to take a hard and sceptical professional knife to the insurance salesmen who are currently circling their prey. And someone needs to review all of the government, tax and regulatory changes that will affect a young family. For most young people, the investment decisions about stocks and bonds are small because accumulations are small for everyone except professional athletes and entertainers.

If your investment pile is small enough, you can fool around a little. My father used to say the best thing that can happen to you is to lose some money when you are young. When you become tired of that, just make regular automatic deposits into a low-cost widely diversified no-load mutual fund that is very large, say, holding a trillion dollars in assets. It will pretty surely grow steadily in good times and bad, and serve as a warning benchmark for assessing all those fly-by-night investment managers who will besiege you when you accumulate enough money to be worth fleecing.

It's a pity to waste ten or so years of investment opportunity, however. Money at 7% will double in value every ten years. You will probably want to double your nest-egg as many times as you can, which is likely to have a ceiling at 10%, so figure doubling every seven years the rest of your life expectancy, and it is easily shown that frittering away those opportunities to double is a regular, pathetic, loss of opportunity for most of us between the age of sixteen and thirty. Take your hoped-for nest egg at retirement age and double it two and a half times, and you will see what a huge opportunity is regularly lost by just about everyone.

Your parents can improve on that by making investments on your behalf, starting the day you are born. That would cause five extra doublings of your investment accumulation at retirement. But plenty of people have learned the disappointments of betting on infant futures. If you can essentially afford to throw the money away as bad luck, go ahead and do it, but if you are risking someone's college education to do it, then you had better stay away.

A probably more serious debate can be generated by discussing the risks of giving money to teen-agers, who may then get all out of social control, throwing in your face, "It's my money and I'll do as I please". The main answer to that offensive discussion is to point out just what it is that most teenagers would do if they had the freedom to do it. Some frugal cultures like the Pennsylvania Dutch will give children some money, hide it secretly in a safe-deposit box without telling the child, and then reveal it when the child seems to be sensible enough to withstand the fever of a gold-rush. The worst outcome of all is to drain the incentives, depriving the child of reasons to work hard. Unfortunately, most teenagers now grow up in a suburb, where it is difficult to conceal the probable existence of assets.

http://www.philadelphia-reflections.com/blog/2127.htm

Unique Investment Requirements

Special Investment Situations

Let's announce the purpose of this preamble about special investment situations, right now. In the great majority of cases, the mission of investment management is simply stated: make as much money as possible, and then retire on it. But two extreme situations lead to conclusions about investment policy which differ so radically from each other, it might pay to ask at the beginning whether they somewhat apply to our own cases. One would be that mythical individual who is so rich he can realistically be indifferent to investment outcomes. At the opposite extreme is the non-profit institution which is totally dependent on a steady stream of endowment income, theoretically into perpetuity, but in any event without interruption. The non-profit's contribution to society is limited by the amount of investment income it can generate, while by contrast the tycoon is so well off that for him life will go on, about the same, whether he invests well or poorly, or indeed at all.

Philanthropies

Our society recognizes that unique dependence of non-profit institutions on their investment income, and confers an exemption from taxes to philanthropies. So the investment income of nonprofit companies has two unique features: it needs to be steady, and it has no concern about taxes. Taken together, these two conflicting features grow out of tensions between the rich and comfortable who support the philanthropy, and the sense of entitlement of the artists, writers and performers, who as a group are usually paid lower wages. But not invariably. Entertainers are sometimes able to exploit their celebrity to the point where they can be the most highly paid people in the whole work force. This paradox sometimes creates social dissonance within philanthropies, between the rich trustees of an opera company seated in the boxes let's say, and the equally rich soloists standing on the stage. The stagehands, moderately overpaid because of unions, reflect the class warfare sentiments of a century earlier; the only stakeholders actually pinched by economics are the general audience, seated in the back rows of the auditorium unless they stay home during a recession. Such organizations are uniquely well advised to have a steady income from bonds at all times, to keep the place running during recessions. Otherwise, bonds are often a poor investment.

Tax-exempt bonds

The hostilities and discontents of various components of the opera family are not the usual source of main difficulty for the investment manager of such a philanthropy. His grief arises from the need to "meet his payroll", week after week. The stock market may rise and fall, the popularity of the performances may ebb and flow, the stagehands may go on strike. But the business manager must meet the payroll in good times and bad. Consequently, the business manager has an incentive to invest in bonds because of the steady income they generally provide. The opera company does generate ticket income; many other philanthropies have no income at all except for investment income, much exaggerating the need for steadiness from that source.

Berkshire Hathaway

At the other end of the spectrum, some extremely wealthy persons have essentially no need for income at all, at least income derived from major sections of their assets. For such persons, the question arises, why pay income taxes if you don't need income? If the assets are large, the management burden may become large as well, and there may be very little point to this administrative effort except that the government says it must be done. Persons in this happy situation often invest in assets like Canadian forests whose income is only foreseen in the far distant future, or in Berkshire Hathaway for example which deliberately generates no income or income taxes. In the case of Maharajahs or other obscenely wealthy people there may even be no point in accumulating extra assets, or income, or the investment managers needed to select it. Even a modestly wealthy person gets into this situation when he becomes extremely elderly or extremely sick; he can't spend any of it, so why have it?

But not so fast. A comparatively young person, well educated and earning a comfortable income, may have no need for investment income for years to come, but he will certainly need it sometime. When he can afford to retire, he eventually does so, and at that moment his investment portfolio abruptly switches from a vague nuisance into his main source of his income. His investment outlook therefore should switch from that of a Maharajah to that of a single-client investor with a payroll to meet. Too many advisors ignore this fairly common situation, and advise a standard average portfolio design from age 20 to age 70, from the days when the client is a clerk to the day he becomes chairman of the board, some day even to being an invalid fed with a spoon. But it's hard to see the logic of investment rigidity throughout these life changes. To modify the revenue approach is not to "play the market" or to engage in market-timing. It is to adapt your behavior to your position in life.

This flexibility particularly applies to one's tax situation, which can vary from one extreme to the other throughout life. There is no sense in paying taxes on investment income, unless the money is then spent. If there is no current need for spending money, there is no sense in paying taxes on investment income. Let the investment income accumulate untaxed unless there is no other income to spend. The consequence of this simple rule is that there are significant disadvantages to buying high-dividend stocks, at the same time that certain investment advisors are recommending nothing else. It is claimed that high-dividend stocks out-perform the market, which may sometimes be true. But it is always true that if the dividends are not spent in the same tax year they are distributed, the tax on the earnings they represent would accumulate untaxed if you had bought non-dividend stock. Eventually, such accumulations are taxed when the stock is sold, but ordinarily at a significantly lower tax rate. The present apparent advantage of high dividend stock performance is mainly a result of abnormally low interest rates, which presumably will not last indefinitely. While this situation continues, it creates relatively little new taxes for the retiree spending up his investment income; it is the young person in his earning years who should be wary of unnecessary taxes of this sort.

http://www.philadelphia-reflections.com/blog/2128.htm

Perpetuities

Jonathan Edwards

Although some churches and mummies are well preserved after thousands of years, and no doubt a few corporations do last a century, the fact is most of them don't last very long. Most new corporations go bankrupt within ten years, and only one (General Electric) of the original thirty members of the Dow-Jones Industrial Average existed in 1900. Members of the Dow may seem the biggest and best, but in fact live on a slippery slope. Not-for-profits, like churches, may do somewhat better, although the handful who approach perpetual status may be rare exceptions. One big reason not to leave a major bequest to any of them, may well be that most will not survive. While we are on this subject, the same reasoning applies to the stock in for-profit corporations. Since few of them thrive for more than seventy-five years, the idea of buying their stock, holding it forgotten in a safety-deposit box, and passing it on intact to heirs, is probably doomed to investment failure. The oldest stockholder company in America is called the Proprietors of West Jersey, founded in 1676 but still meeting once or twice a year. It would be moderately interesting to know how well this investment performed over the years, but Google sounds like a better bet offhand. Just don't hold it too long.

Cotton Mather

There may be a connection between success as a non-profit and success in the merciless marketplace. Those who have compiled statistics will tell you that steadily withdrawing more than 4% a year from an endowment portfolio, sooner or later leads to a day when there is nothing left. Most trustees expect better results than that, and most managers of non-profits will need more than that, no matter how big the pile was when they started. Sooner or later, markets will decline, mistakes will be made, and the endowment will be exhausted by "emergency" withdrawals which relentlessly withdraw more than 4%. This pitiful decline might be avoided by gathering the managers of influential non-profits together, giving them a stern lecture, and somehow forcing them to live within their means, but offhand nothing sounds more futile. Jonathan Edwards and Cotton Mather were said to be good at haranguing. But since it must be obvious that non-profits usually survive by constantly soliciting fresh endowment funds, what would be the matter with taking a direct approach to that goal. Why not just state in advance that the institution is only intended to do its good work for say fifty years, and then it must turn its residuals over to somebody else? Not many endowments have been limited to a lifetime of fifty years, but in those who have done so, the experience seems to be that most of them immediately set about to raise additional funds to keep the institution from disappearing. The American Enterprise Institute in Washington, for example, started out dispensing about a million dollars a year; last year it dispensed over $30 million. Whether he intended it or not, the message Mr. Olin transmitted was not that think tanks are only good for thirty years. He told his executors in effect, "You have some seed capital with which to start a think tank. Whether it lasts longer than fifty years, is now up to you."

http://www.philadelphia-reflections.com/blog/2131.htm

Taxes as a Form of Consumption

Refund-Check

About half of the American public pays federal income taxes, and among the half who don't, a great many receive a green government payment check, meaning they have negative income taxes. The tax assistance companies, H. and R. Block and the like, had little for their offices and staff to do in January, February and March until someone hit on the idea of processing "fundable tax credits" for a fee. That is, the lower-income segments of the population get the promise of an April tax "rebate" as the consequence of tax-form preparation, so H. and R. Block just loans them the money, discounted for fees and interest. It keeps staff busy, generates revenue. Hardly anyone in the upper income half of the population is aware of all this, so there is little political friction. This whole system of income redistribution quite effectively keeps the two halves of the population sitting in the same chairs at the tax-preparation offices, but in different months of the year; one half getting paid, the other half coughing up the payments.

Tea Tax

It thus becomes possible for two inflammatory slogans to bandy about, without starting fistfights or revolutions. The first was overheard at a local bank, one stranger remarking to another, "Has it ever occurred to you that taxes are a form of consumption?" To which the other person replies, "Yes, and taxes are the largest expenditure I make." A nation which once went to war over a two-cent tax on tea is remarkably passive about the ways things have evolved, but this essay is not devoted to unfairness. Prepare to hear how the upper income brackets might reduce their taxes, whether that counts as decreased consumption or not. Whenever you tax something, you get less of it; if you tax public income more, the public will earn less. So, this little essay is serious when it proposes that we all earn less, so we can get taxed less. And being taxed less, we need save less for our retirements.

Taxation

The general principle is this: income is usually taxed in the year it is earned, with some exceptions, rebates and deferrals. The exceptional situations are often referred to as "loopholes" and therefore live in political jeopardy. However, if a person spends the money or dies while these deferrals continue to exist, the income may escape taxation entirely. In a sense, the largest loophole of all lies in the present fact that nearly half the population pays no income taxes at all, so saving income earned under those circumstances may lead to investment capital, which is later spent during highly taxed periods of that same person's life. Money earned by a child, usually on investments donated by a relative, is an example. Since at present, a child may receive annual gifts of $13,000 tax-free, as much as a half-million dollars can be accumulated in this way, always at the risk that laws may be changed and, further, at risk of spendthrift abuse by a psychopathic child. Whether these are wise risks for a parent to take, depends in large part on what sacrifices are made for the purpose, especially loss of parental restraint of unwise spending. A much more serious argument grows out of the possibility that money in the hands of children who lack experience in deferred gratification may actually provoke recreational drug use, or other sociopathic behavior.

Finally, lack of planning may create opportunities as much as planning does. A person who has paid little attention to financial planning may arrive at an advanced stage where life expectancy is considerably shorter. Savings at that point may be divided into money on which deferred taxes must be paid when you spend it, and money on which taxes have already been paid. More savings will be consumed if the individual triggers deferred tax liabilities, than if he just uses up money on which taxes have already been paid. Therefore, if he ignores lifetime habits and spends after-tax capital first -- the whole nest egg will last longer. But none of this deferred-income tax issue can compare with the problem of income on which taxation has been completely forgiven at the time it was spent, the so-called tax expenditures. The largest such tax expenditures are on the interest of home mortgages, on employer-paid (but not self-paid) health insurance, and employer-paid retirement income. Of these, the least consequential are the retirement income, because the tax is merely deferred, not completely forgiven. The two biggest items are home mortgages, which lie at the root of the 2007 financial crash, and employer-paid health insurance premiums, which triggered the Obama health proposal of 2009. The Obama plan purports to rein in health costs, but is estimated by the Congressional Budget Office to cost the Treasury $100 billion a year.

The essential point for accountants to focus on, is that tax expenditures are all counted as revenue when any non-accountant can see they are expenses. For political speech-making purposes, this distinction is vital and no opponent will let another politician wiggle out of it. And the beauty part of it is that it also spotlights three of the most besetting evils of modern politics: the tax exclusion of employer-based health insurance, the home mortgage interest tax exclusion, and the "earned" income tax credit. The first of these is responsible for our health insurance mess, and the other is responsible for our home mortgage crisis; the two main political problems of the day are suddenly plopped into the limelight, just when a lot of people are looking for ways to hide them. Furthermore, this bombshell was fired by a panel of the four outstanding tax economists of the nation, each of them roundly denouncing them as unthinkable ideas that never should have been born in the first place. Alan Greenspan, famous for unintelligible speech, simply said all of these tax expenditures, every one of them, should be eliminated immediately. One would hope that is clear enough. Martin Goldstein, formerly chairman of President Reagan's Council of Economic Advisors, agreed. As did former Governor Engler of Michigan, widely acknowledged to have rescued his state from impending bankruptcy. Senator Nelson, a Democrat from Florida and chairman of the committee, positively beamed with pleasure. It was hard to think this was anything but a turning point in history; let some political candidate disagree, and he can expect to have his audience shown a videotape of this succinct epic in the history of Senatorial hearings. These greybeards said, in what was obviously an unrehearsed moment, just eliminate these three terrible ideas in one stroke, and the national deficit will be reduced by a trillion. That's what they said, and it's easily proved that they had said it.

http://www.philadelphia-reflections.com/blog/2129.htm

Designated Lifetime Funds

Social Security

Except for Social Security, most retirement funds are not required to be tax-sheltered ("Federally Qualified"), but one would be foolish not to take advantage of the option where possible. Ordinarily, just about every other form of saving must first net out federal taxes. The debts of state governments ("municipal bonds") are free of federal but not state taxes, but reflect that benefit by paying a lower interest rate; any overall advantage must be calculated individually, and quite often it is non-existent. Mandatory taxable income, more-or-less mandatory tax-exempt income, and optional; that's your choice, except for the decision to put them in a federally qualified pension fund. Most people just throw the ownership certificates into a safe-deposit box and forget them. This article suggests you create three funds, whether in a lock-box or brokerage account, and mentally rename them by overall purpose. There's not much you can do about tax status, but you have a little latitude about how and when you spend the the money. It can make a certain amount of difference, because increasingly it is true that investment performance is affected by taxes and fees. Friends, neighbors and classmates may tell dazzling stories about astonishing investment luck, but if you want to have the best performance in your social circle over the very long haul, you would be well advised to focus on taxes, transaction costs and fees. Especially fees.

Saving Bonds

When Grandpa gives a brand-new grandchild a hundred dollars, it can be spent on a new rattle or it can be invested. Rattles usually win, but occasionally it gets invested; what it's worth when the newborn finally dies will mostly depend on two things: how old he is when he dies, and how young he was when he started the investment. To make it easy to calculate, let's assume a life expectancy of 85 years, and an interest rate of 7%; that seems to imply a value of $40,000 at the time of death. That seems to imply a value of zero if he dies without spending any of it, and a value somewhere around $30,000 if he pays current income taxes. But if he pays $100 a year for the lock-box, he will only have $20,000 left after expenses. And if he pays fees for his checking account, or receives only nominal interest for a savings account, he may end up with nothing at all. Since that's the usual outcome of most cases of Grandfather gifts, perhaps the choice of a rattle isn't so reprehensible. The whole investment process is too expensive to bother with, until the sum involved is several thousand dollars. At fifty times the hundred dollar gift we started with, the investment is $5000, and its final result is a retirement fund of two million dollars. Yes, the arithmetic can be argued with, and yes, lots of things can go wrong in 85 years. Maybe a one-million dollar benefit is more likely, but no one can dispute that it's a pretty easy way to die a millionaire instead of a pauper.

All right, that's your Contingency Fund. It's taxable, but almost everyone can start it pretty young and forget about it for long periods of time.

Tax Fund

The Tax Exempt Fund gets created when you start to work, even for a few days as a teen-ager. Several percent of your earnings will be withheld for the Social Security program, which requires that you apply for a Social Security number. If you wish, you can start depositing up to a set limit of your earnings as a tax-exempt fund for retirement, currently called an IRA or a 401-k fund. Your income taxes for the current year will be tax-sheltered, up to the amount taxed on the amount you contribute. It's a good thing to get one of these funds started as soon as you are legally able to do it, so the mechanics are completed while the amounts are still small. The suggested funds are the ones with the smallest administrative costs, which will probably be no-load index funds; if the fund you choose has more than a trillion dollars under its control, you are probably reasonably safe. Try to keep depositing automatically, right up to the maximum amount allowed by the law, right up to the day you die if they will let you, and select the option of automatically re-investing any dividends. Until these vehicles were created, just about the only tax-exempt investments anyone could buy were tax-exempt municipal bonds, and life insurance. Both of these vehicles have some major disadvantages; the IRA and 401-k mechanisms allow you to apply the tax exemption to just about any investment you choose, so they are just as good as anything you can buy, plus having the advantage of being tax sheltered. If anyone proposes investments other than IRA/401-k before you exhaust the limits of these, that person has some serious explaining to do; at the very least get a second opinion. It will be a rare person under the age of forty, perhaps an entertainer or professional athlete, who has money left to invest after fully exhausting the tax exemptions. That's because the typical young person takes on the burden of buying a house or paying for private education for children, and there just isn't enough money to go around.

Life Insurance

Life Insurance is a comparatively poor investment, and it is an even worse investment if it is purchased without investigation or comparison shopping. Some insurance companies, like Northwestern Mutual, have considerably better results than the average, and some other very large, very famous "leading" life insurance companies have pretty inferior results. Life insurance does provide some tax exemption, however, which varies a little between states as a result of the McCarran Fergusson Act of 1945. However, the legislation does produce tricky features, like tax-exempting either the owner or the beneficiary of the policy, but not both. The entire first year premium is ordinarily paid to the salesman as a commission, and sometimes the commissions continue for life. But that is only part of the incentive which the life insurance salesman has for selling excess coverage. The other incentive is worth serious pondering: a main source of life insurance profits derives from the large number of clients who pay premiums for a while, and then drop the policy without collecting on it. The deplorable national statistics on temporary job loss, personal bankruptcies, and divorce carry implications of considerable weight for the purchase of life insurance; investment is limited to what you happen to have, but life insurance is based on projections of what you hope to have, or what you fear.

http://www.philadelphia-reflections.com/blog/2132.htm

Playing The Cards As You Are Dealt Them

A century ago it began to be usual to expect to earn a living for most of your life, certainly for most of your life after you finish school. But at the turn of the Twenty-first century, it is becoming more accurate to say that life is divided into thirds, one for school, one for work, and one for retirement. It seems hard to believe this trend can continue much further, with two thirds of the population either in school or just loafing. Sooner or later there is surely going to be a revolution in the education industry, and a second one in the retirement entitlements of fairly healthy people who could be working but are not. At the moment, planning consists of devising strategies for coping with uncertainties about just where the boundaries will fall for individuals or couples; that's the topic on the table. But it is impossible to avoid mentioning that the largest unemployed labor pool is soon going to be the group from age 65 to age 85, and it is this group which is going to have to supply the unaffordable manpower required to care for a huge future population aged 85 to 105. At the other end of the working-years border, the education industry seems already starting to force the issue. College tuitions have been raised to approximately double their actual underlying cost, with the surplus internally redistributed as scholarships to more than half the students. That increases the pool of students able to afford college, but it only conceals for a few more years the recognition that we are graduating more students than the workforce can absorb, and must eventually stop doing it. After all, very few of our Founding Fathers went to college, while Benjamin Franklin the greatest overachiever of them all, only finished the second grade.

At the moment however, the greatest opportunity for individuals to re-align their assets with their life expectancies, is to retire later or to go to college less, thus stretching out individual earning years by as much as ten percent. Our society could pour more money into medical research, but once we have achieved a cheap effective cure for cancer and Alzheimer's disease, the demand for research will soon experience a cooling of public enthusiasm. And individuals have the ability to make appreciable reductions in their living costs by re-defining what is a luxury and what is a necessity. This essay confines itself to planning the finances to match revenue to need, as currently defined by public opinion.

Let us assume a young person begins to work at an average age, accumulates as much after-tax assets and as much tax-sheltered retirement income as possible, retires at an average age, and lives for an average life expectancy. Since these times and amounts cannot be precisely predicted, they should be conservative. Thirty years of retirement is more than most people currently get, but may even be an underestimate of what the average person can expect. Thirty years of no earned income will require a nest-egg of two million dollars at retirement time if annual expenditures of $100,000 are expected. That's pretty generous, but half that amount is not certain to provide luxury living at $50,000 a year, and still requires a million-dollar nestegg. Cutting that in half a second time confronts people with $25,000 income based on half a million in savings. Most people cannot expect so much assets to accumulate, and most people would have a marginal existence on $25,000.

It simplifies planning somewhat to narrow the time-spans. If a person is within ten years of his life expectancy, he can probably safely spend every penny of his savings if there is some sort of insurance or cost averaging annuity for his age group. Above a certain asset level, this would take the form of an average terminal-years fund, plus a contingency fund. However, there would assuredly be hardship cases who cannot manage such a minimum and would require a subsidy. Estimating in advance just what proportion would require subsidy is difficult, but the magnitude essentially will determine whether this approach is feasible or not. If not, we would essentially be in the position of a third-world country, taxing the working population to pay for this subsidy, and thus crippling the economy. Long before this was tolerated, the education industry would have experienced some harsh treatment designed to force a larger proportion of students back into the work force.

http://www.philadelphia-reflections.com/blog/2134.htm

Investment Consequences

Baby Boomer

One of the main risks anyone takes by investing is the risk that market conditions may not ideally match their age bracket; there may be wars, depressions and inflations at just the wrong time. Given enough time, conditions will generally recover, but the baby boom did follow one generation throughout its lifespan. And wars and famines may not just affect the economy, they may personally snuff you out. On the other hand, the steadily increasing life span of the past century gives most people three family generations to consider, when for centuries most people only personally knew two generations, and for centuries before that, only one. Generally speaking, huge demographic changes take place so slowly the law of averages dominates it, and if you are suddenly snuffed out by a rare disease, well, that can't be helped.

Investment is generally a process of taking surplus idle money from one period of life and making it grow until a period of heavy spending is reached; the working third of life funds the third spent in retirement. Paying for school is usually the gift of one generation to another to enhance its employability and social stature, displacing dowries and the clergy in the process. Scientific education for the most part did not exist until 1860.

Nest Egg

The size of the starting investment nest egg is crucial; it can make a huge difference, but mostly doesn't. A frugal early life will enhance it; frugal habits are apt to be permanent. Generally speaking, leveraged investing is unwise, although there are periods of time when interest rates are so abnormally low that leveraging is tempting. Unfortunately, periods of low interest rates are generally followed by high rates, accompanied by ruinous declines in the value of the loan or bond principal. For the most part, long periods of stable interest rates are best for everyone in the economy, most periods of volatile interest rates are only safe for professionals, and long periods of extreme interest rate volatility are safe for the average investor only when his age bracket gives him a secure job when interest rates are low, and good fortune gives him lots of cash when interest rates are high.

http://www.philadelphia-reflections.com/blog/2135.htm

Is Stock Trading Passe?

Gordon Moore

Moore's Law is named after Gordon Moore, who pointed out that computer chips seemed to double their speed every few years, an important issue affecting the cost of computers and the heat they give off while operating, and so on. In fifty years, there have been enough doublings of speed to make it often irrelevant whether they get any faster for the job they are intended to do. No one really cares whether a blink of an eye gets any quicker. The question is beginning to arise whether it makes any practical difference if the trading of stocks gets faster.

Returns on U.S. Stocks

At the moment, it's widely quoted that 70% of stock trades on major exchanges are now conducted between two unattended computers; it won't be long before 100% are. All of the inefficiencies of trading pits, with shouting and shoving, winking and maybe some front-running, will vanish into the humming of progressively smaller electric machines. Kinks will appear then get ironed out, perhaps after another Long Term Capital episode or two. The cost of trading will become vanishingly small, essentially a chess game between mathematics wizards. But volatility will smooth out, and costs will become negligible. So far as we can see, that's the end of the line, beyond which a computer speed sixteen times as fast serves no extra purpose.

But John Bogle, who invented the index fund and grew Vanguard to several trillions in assets, amused himself recently in front of a bedazzled audience. Several large funds, maybe even a lot of them, are taking what looks like a static mass of sleeping stocks and trading them internally at a rate of thousands per second, hoping to make a tiny fraction of a penny per trade individually, and a whole lot of profit for the managers in aggregate, while giving the appearance of standing still. Is this a good thing or a bad thing? Hard to say. John Bogle seems to imply it might even be a bad thing. Whatever it is, it is not the end of the line.

John Bogle

For completeness, look at the opposite end of this spectrum. Once more, it is John Bogle who points out that the price of stock can be divided into its earnings, its dividends, and its speculative volatility. Total earnings for the past century have averaged 9.1%, but if you strip off the effect of price-to earnings variance, you have an investment return of 8.8%, essentially the same in the eyes of normal people. The way an investor could strip away the P/E volatility -- is to buy the whole company. When you own the whole company, public opinion stops influencing the price. Holding companies can do that, as can private equity funds, and even Warren Buffett. If you are playing this game, all you need is a big-enough holding company with honest management, or at least one independent method for estimating a fair price. If you are a value investor like Warren, buying the company for a P/E ratio well below 12.5 and holding it forever, you ought to achieve a return which significantly exceeds 8.8%. If you are an investment bank on Wall Street, you may buy the stock cheap, fix it up, and sell it rather soon for a much higher P/E ratio. Either way, there are transaction costs and taxes only twice, when you buy it and when you sell it. An investment company can do all kinds of things, but an individual investor should know enough to adjust his buying (of shares of these intermediaries) to a youthful stage of life, and his selling to his retirement years. It cannot be claimed the quirks have been completely worked out, but it's a start. Come back in a few years and see what has been added to this idea to make it air-tight.

http://www.philadelphia-reflections.com/blog/2177.htm

Bonds--Do They Have A Future?

Relic of the Past?

Ever since we finally went off the gold standard completely during the Nixon Administration, the Federal Reserve has adjusted our money supply to create a fairly steady 2% inflation. If inflation is ever less than 2%, the Fed puts more money into circulation. Since many bonds are paying less than a 2% dividend, everybody who buys and holds them at par will lose money in "real" terms. That is, everyone who buys bonds when they are issued and sells them when they mature, will lose spending power. Since they fluctuate in the meantime, it is possible for a trader to buy them when they are undervalued by the market. That trader will possibly make money, but only because someone else lost money. Something like that occurred during the recent financial crash bailout, when interest rates declined from 3% to 2%, but were repurchased by the Fed as "Quantitative Easing", effectively giving speculators a 33% profit at government expense. But that doesn't happen often, and just guess who lost the money the speculators made. There is also that daunting question: when the time comes for the Federal Reserve to disgorge them, just who is going to buy all these cheapened bonds? In Japan, bonds paid a dividend of less than the current inflation rate for more than a decade; it's hard to think of a reason why the same thing could not happen in America, so it's also hard to imagine a reason why buy-and-hold investors should not abandon bonds, perhaps suddenly all at once, at some unknown time in the future. At that point, many of them will resolve never to try that, again. The whole idea is troubling.

It's particularly troubling in view of the lack of success, so far, of TIPS. These vehicles are new; perhaps the algorithm is set to ignore minor inflation and will over-respond to more major inflation, ultimately rewarding those who buy them. But at least so far, they are a disappointment. Furthermore, TIPS are quite cleverly designed to be inflation-protected, while unfortunately inflation usually does not follow a straight line but is volatile, or saw-toothed; the jury is still out. But the jury better hurry up, because investors are looking for net income after expenses, which include brokerage costs, taxes, and inflation. A long-term bond might have to pay a dividend approaching 4%, just to emerge with the same net value it started with; after five years of 4%, you could be 20% behind. And yet, the bond market with or without inflation protection is far larger than the stock market, and compares in size with any other kind of market. Who buys them, especially in these huge quantities?

Somebody must maintain statistics which answer this question, but as a guess, the main buyers are insurance companies, endowments, annuities, hedge funds, banks. The great argument for bonds is safety of principal, and although safety is in question anywhere there is inflation, whenever the topic is cash flow, safety is definitely an issue. Cash shortages are what cause bankruptcies, which are mainly useful in providing time to liquidate underlying wealth to pay restless creditors. The management of a non-profit organization must meet its payroll out of cash flow, so non-profits protect themselves from dissolution by having a regular flow of nominally secure bond dividends. Since most for-profit organizations also experience variable periods of time without profits, the situation is not greatly different from permanently nonprofit. That's particularly true if the for-profit organization has a vocal, activist stockholder group, who will protest fiercely if the management retains abundant cash. For such a predicament, holding bonds creates safety by some definition. The price of that safety is the long-term average loss on the bond portfolio; conversely, the net loss is the cost the company could afford to pay the activists to go away.

To restate the characteristics of the willing bond purchasers, they are governments and nonprofit entities, who have no common stock revenue alternatives, but regularly face a need to raise money. They also include borrowers and lenders at nominal interest rates like banks and insurance companies, who can afford to ignore inflation because their own liabilities are in nominal dollars, or come due at a date certain. And then, there are a host of beneficiaries of special-interest bond provisions, like "Flower bonds", state and municipal governments, foreign aid, student aid, etc. As an overall statement, natural bond buyers are those who either do not possess an equity (common stock) alternative to offer, or else are shielded in some way from inflation and tax costs of buying bonds. Speculators and traders are excluded from the discussion, because fixed-income trading is a zero-sum game, something you teach your children to avoid.

Things in the bond market were not always so bad; Robert Morris, Jr. was a genius for devising this market in 1784. But the equity market was then not so well developed, life expectancies were shorter, and inflation was not guaranteed by the Federal Reserve. The income tax had not been invented. It was possible to enjoy the promised benefits of lending in those days, for decades or even lifetimes. It was much harder to find investments of superior performance, without getting involved in business management. Meanwhile, the bond market just got huger and huger. Modifying or dismantling it in logical ways would have enormous disruptive effects. So enormous, we have just adopted the stance of kicking the can down the road.

Are we waiting for the bond market, the bond vigilantes, or speculators to find some vital vulnerable flaw, and topple it all into the ashcan of history? Or is there some better plan that no one has mentioned?

http://www.philadelphia-reflections.com/blog/2195.htm

Poor Richard's Wealth

Benjamin Franklin

I rise to offer yet another toast to Benjamin Franklin. Like our two leading candidates for the Presidency of the United States, he leaves us uncertain whether he was a rich man pretending to be poor, or a poor man pretending to be rich. To clarify this mystery, I have mainly examined the circumstances of his retirement, and the contents of his last will and testament.

Although he reports that on arrival in Philadelphia at the age of seventeen, he spent his last pennies on a loaf of bread, he was able to retire from the printing business at the age of forty-two, planning to spend the rest of his life as a gentleman at ease. He was able to do so because he had assembled over fifty partners in the printing trade, scattered from Boston to Georgia; today, we would say he had sold franchises to his business. When he came to retire, he arranged to be paid off in eighteen installments, which ought to have lasted him to the age of sixty. That was well past the usual life expectancy at the time, but we can now see it would apparently have run out while he was still in London, acting as our ambassador to Parliament, leaving him without support for the last twenty-four years of his life. Apparently this was the reason for his seeking postmasterships, and acting in some overseas business capacity for Robert Morris, then one of the richest merchants in America.

Assuming he may have run out of money when he was sixty, we look to his final estate to see how he made out in his second career, whatever it was. His assets were in three general categories: land, bonds, and hard money. He bequeathed eleven houses, mostly in Philadelphia, to various relatives. He assigned ownership in thousands of acres of land in Nova Scotia, Georgia, and Ohio. Just what a bond was in Eighteenth century America is not exactly clear, but bonds of at least ten thousand pounds sterling were distributed, as well as ten thousand pounds of hard assets. And he forgave a large and undefined number of unpaid debts.

Poor Richard's

He gave George Washington his gold-handled cane, which had been given to him by the Duchess Du Pont, for unknown reasons. His modesty was famous, but can be questioned when he gave one of his portraits to be hung in the Council Room of the government of Pennsylvania. He gave his sister a portrait of a French King, with four hundred and eight diamonds set in its frame. He instructed her not to make the diamonds into jewelry, because that would be ostentatious. And he instructed that his funeral be plain and simple, although it turned out to be one of the most elaborate parades and ceremonies of the age.

After a few months, Franklin reconsidered his will and wrote a famous codicil. Revoking the gifts to his grandchildren, he ordered that a thousand pounds be set aside for each of the cities of Boston and Philadelphia. His proposal was that this money be loaned to graduating apprentices in order to help them start their businesses, and after a hundred years he envisioned it would amount to hundreds of thousands of pounds, after two hundred years, it would be worth millions and could be used for public improvements. These funds were indeed established and the loaning did begin. Unfortunately after hardly fifty years had elapsed, so many apprentices had failed to repay their loans the experiment was discontinued. What had seemingly been lacking was sufficient will of the trustees to collect the loans with vigor.

Poor Richard may have been born poor at more than one time. But he certainly didn't stay poor, very long. A toast to Ben Franklin, on his birthday, in his club.

http://www.philadelphia-reflections.com/blog/2200.htm