General

You can pay for a service in one of two ways – which would you choose?

1. $100 per year forever
2. $2,000 once

Answer: It depends on your opportunity cost. What is opportunity cost?

Opportunity Cost: The cost of an alternative that must be forgone in order to pursue a certain action.

Before you struggle to understand the sentence above, let’s continue with our example. If you pay $2,000 immediately, you forgo the opportunity to invest $2,000 and enjoy its growth (minus the $100 annual service fee).

The decision depends on the potential growth of the $2,000. Specifically, if you can gain at least $100 per year, or 5% (=$100/$2,000), you would be better off paying $100 forever, pocketing the extra growth.

Note a few important factors:

1. Consider the taxes on the growth of the money. More specifically, consider the taxes on selling $100 of the gains per year. If the gains are taxed at the long-term capital gains rate of 20% (the rate after 2010), you need to make $120 or 6% on your investment, to break even.
2. There could be an additional small tax component: the tax on capital gains distributions – internal sales within the mutual funds. This is usually harder to quantify and is relatively small (but not negligible).
3. If the $100 fee for the service may go up, your investment would have to make up for the growth in the fee. This would depend on the service contract.
4. When considering paying $100 per year forever, you should check what the word “forever” means. It usually does not really mean forever. It could mean the shorter of the life of the service receiver and the service providing company.
   An extreme example of a surprisingly short period is TiVo service. A few years ago, you could have chosen to pay a monthly fee for TiVo or a one time fee for the life of the TiVo player. Since TiVo players can stop functioning or the owner might want to upgrade to a new model, e.g., a larger hard drive or high definition quality, the life could be as short as 3-5 years.
   The shorter the service period, the more beneficial it is to pay the periodic fee as opposed to paying the large amount upfront.
5. If you choose to make the periodic payments and invest the money instead, the investments may fluctuate in value. If they are a part of a large long-term investment, it is not a big problem – over your lifetime the performance of your investments may not be extremely far from their long-term average. If the service term is short and the money is invested specifically to generate the income for the service fee, there is a real risk that the investment will experience severe declines right when you need the money. Please take this risk into account.

Fortunately, in many cases there is a clear preference for one over the other.

Example . If you invest in a diversified stock portfolio, you may reach an average of 8%+, creating a preference for the ongoing payments in the example above, after factoring investment taxes.

Buying with a periodic payment plan . Let’s say you are looking to buy a car. In this case, the basic decision can be simplified. Usually the interest implied by the payment plan is stated in the contract. If the interest is lower than the after-tax growth of your investments, you may choose to make the payments and incur the interest.

One word of caution: you need to make sure that you put the money in the more profitable investment. Otherwise, it is pure borrowing with no alternative gains to show for it.

Mortgage . A similar approach applies to mortgages. If the gains on your investments are higher than the mortgage rate, you might choose not to pay off the mortgage too quickly. Since taking the mortgage while having stock investments is considered borrowing to invest, the mortgage is tax-deductible (even above $1M – please consult with your tax advisor). Therefore, you may not need to consider the tax impact on your investments.

Note that this decision is very serious because the amounts tend to be very high. Therefore, you should do such a thing only if you have plenty of extra money to let you go through recessions without a problem. In addition, if there is any risk that you will panic and sell your investment during a recession, don’t even think about taking a mortgage to invest. In general, this approach can be extremely risky if you don’t have a very clear understanding about what you are doing and don’t have plenty of extra money. In addition to having plenty of extra money and being very savvy, you need to make sure to invest conservatively by being globally diversified into many companies and avoiding any stock picking or market timing. I do not recommend this approach without the help of an investment advisor that specializes in such decisions and provides constant handholding throughout all recessions.

Repairs . You may have a leaky roof and you are not sure whether to repair it or replace it. The replacement cost is an immediate outlay, while the repair cost is a smaller payment that can prolong the life of the roof for some period. This may be tougher to decide because you cannot know how long the roof can last after the repair. In addition, the replacement has the benefit of peace of mind and pleasure of a new roof.

Whatever your considerations are, the potential gains of the money kept invested instead of spent on the new roof is a factor that is important to consider.

Summary

If you invest in a globally diversified portfolio with no stock picking and you are strong enough and financially stable to hold on to your investments throughout recessions, you can buy certain things in payments instead of an immediate outlay of the full cost. Contact your investment advisor to find out the long-term performance of your investments, take off a few percentage points for the investment risk and taxes and you can get an estimate of your opportunity cost. Purchases you can make at a lower interest than your opportunity cost may be worth their interest cost.

By making a few calculations and having a conservative investment plan, you have a recipe for making good money through simple financial decisions.

Disclosures Including Backtested Performance Data

Whether you are looking for someone to manage your life’s savings, or you already have someone, you want them to always have your interests in mind. You cannot afford to question the professional’s interests and you need to have full trust that the person is on your side.

If this foundation does not exist, you will not only lose sleep worrying that your money is in the wrong hands, you will also question every recommendation given to you. This is a practical concern, because you may decide not to follow the professional’s advice at the most critical times. If you do decide to follow the advice, you cannot be sure who the advice is helping more: you or your advisor. For example, if you have a losing investment, the decision about whether to hold onto the investment or sell it hoping for a better alternative can have a large impact on your finances. You cannot afford to question the advice given to you.

There are many titles for professionals providing investment advice. Two main ones include broker and investment advisor. Let’s review their obligation to you:

Broker: Brokers are legally required to offer suitable investments. This seems like a good requirement, but the law gives them significant freedom to:

1. Not disclose fees.
2. Not disclose conflicts of interest.
3. Not get you the lowest cost trades and products.

Brokers can do your trades expensively in order to increase their employer’s revenue or their own income. They can (and often do) sell expensive mutual funds offered by their employer to their clients. These can cost you too much money and have poor returns. Your broker may even steer you towards expensive products that have well hidden fees, including individual bonds.

Brokers are compensated directly by their employers, not by you. As a result, they have in the first place their employer’s interest in mind when giving you advice. Many are good and intelligent people, but they may be pressured by their employer to sell you products that maximize the company’s revenue.

A common compensation arrangement requires that you pay a commission for transactions. This creates a potential for a conflict of interest that is difficult to resolve – the only way for such a broker to earn a living is to get your commissions, but it is usually in your best interest to minimize the number of transactions done in your account.

The Securities and Exchange Commission (SEC) requires that your broker provide you with the following written disclosure: “Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours.” Please consider the implications.

Investment Advisor: Registered Investment Advisors (RIAs) are legally obligated to act as fiduciaries. They have to provide objective financial advice and to put your interests before their interests. They are legally obligated to disclose their fees and any conflict of interest they may have. They also should get you the lowest cost trades, unless it is not in your best interest.

You may prefer to work with Independent Fee-Only Advisors – advisors that only charge a fee for service and report only to you. Specifically, they do not charge commissions for selling you products. This can help ensure that they make money when they make you money, not when they trade, ensuring that they get paid for helping you.

Registered Investment Advisors are obligated to provide the SEC (Securities and Exchange Commission) an annual update with information about their business. They file a form called “ADV” – a form that you should have seen before if you are working with an investment advisor. You are encouraged to review it.

There are many other titles out there. The following one is important to note:

Financial Advisor: A title commonly used by brokers, giving the impression that they are professionals who provide you with financial advice. Unfortunately, brokers and other salespersons are legally allowed to use this title, despite the fact that their first obligation is to their employer and not to you.

Wealth Manager, Private Client Specialist: There are many more titles in use. Whatever the title is, make sure to ask: “Do you have a legal obligation to act in my best interests?” Some of them do, some don’t – the titles don’t help answer this question.

Notes:

1. Making sure that your advisor is legally obligated to be on your side is only the first step in the evaluation. There are many other conditions you should set before you let people advise you regarding your life’s savings. You should have a strong sense of trust and comfort with their knowledge. They should be upfront and open about all questions regarding their business, their investment principles and all possible costs to you. They should have time to talk to you and explain things in simple words. You should be very selective when dealing with such an important topic.
2. This article is not intended to provide comprehensive advice regarding selection of advisors – it only touches on a few important issues.

To Summarize

You should ask all people that provide you with financial advice: “Do you have a legal obligation to act in my best interests?” If the answer is no, you should be very careful when following any of the person’s advice and consider hiring someone who is legally obligated to always be on your side.

Disclosures Including Backtested Performance Data

This article presents the effects of holding unplanned cash in an investment portfolio and the benefits of optimizing the cash level.

Let’s first discuss planned cash. Every investor needs cash in order to meet daily expenses during severe declines of the investment portfolio. This amount should be decided upon before putting any money in the stock market, because sharp declines can come at a surprise leaving no time for last minute planning.

Once you set aside the amount of planned cash, your goal should be to minimize the amount of extra cash in your investment portfolio. This excess cash is a well-known investment phenomenon. It can come from many different sources, but they all can be summarized by the following definition.

Cash Drag : the negative effect on a portfolio’s performance due to holding cash beyond the amount specified in the Investment Plan.

Each of the following is a reason to minimize your Cash Drag:

1. You already defined the amount of cash needed for your short-term security and set aside this amount. Any extra cash is eating away at your long-term growth.
2. If you don’t plan how much you will leave in cash and therefore don’t have a set amount that is consistently available, you cannot count on a set amount to be there when you need it most.

We shall identify a few categories of Cash Drag. For categories you can control, the impact will be presented. The cash will be assumed to earn 6% less than the stock portfolio (e.g. 3% vs. 9%). In addition the impact will be expressed in terms of loss for a retiree with a portfolio of $1,000,000.

Cash inside mutual funds: All mutual funds carry cash to meet potential daily redemptions. There is no way to avoid this amount altogether, but you can minimize this by choosing index funds that tend to have a low percentage of cash.

Cash for liquidity: Cash that brokers and investment advisors hold inside investment accounts for upcoming management fees and transactions. This can be completely eliminated, if the investment professional plans right. These amounts tend to be relatively small, but not insignificant. 2% excess cash for this purpose would reduce your total returns by 2%x6% = 0.12%, lowering the 9% growth to 8.88%, or costing the $1,000,000 retiree $1,200 per year.

Cash waiting for the right investment opportunity: Investment professionals and individuals that try to pick promising stocks have to leave cash available for the right moment. These amounts tend to be significant and can run as high as 30% or more. The impact of 30% in cash, would be 30%x6% = 1.8%, lowering the 9% total growth to 7.2%, and costing the retiree $18,000 per year.

Cash allocated to protect from an anticipated recession: This is the most dangerous category of Cash Drag, for two reasons: the size of the cash allocation and the attempt to time the market. Some people allocate large amounts of cash when a recession is anticipated. A not uncommon allocation of 50% costs the investor an average of 50%x9% = 4.5%, lowering the 9% annual growth to 4.5%, costing the retiree $45,000 per year!

The impact is magnified by the timing component. In nearly all cases, the allocation to cash happens after the beginning of a decline or well before it, and the allocation back to stocks usually happens after the surge in stock prices is over.

When making the allocation after the decline began, you immediately realize a loss. For example, many stock portfolios frequently decline by 10% from their recent peak. Anyone that gets nervous about the future of the portfolio, and allocates 50% to cash, would realize an immediate 50%x10% = 5% loss, or $50,000 for our retiree!

When reverting the allocation to stocks after the recovery began, you give up these gains. People that experienced a dramatic shock by the 2000-2002 recession, waited for a long time to put money back into stocks. A retiree that had 50% in cash and waited until the end of 2004 to put the cash into stocks would have given up more than 100% growth in a portfolio like Long-Term Component. If our retiree had $500,000 of the $1,000,000 portfolio in cash, this would amount to losing $250,000!

To Summarize

No matter how adventurous you feel, how strongly you believe in your predictions or how fearful you are of a recent decline turning into the worst recession you’ve ever seen, please be very careful with your money. This is not a $20 gamble in Las Vegas – you are gambling with your life’s savings. The most conservative approach to investing involves planning in advance for severe scenarios. Once your plan is ready, keep it in writing, and stick to it without gambling on stock increases or recessions.

Disclosures Including Backtested Performance Data

Your time horizon has a significant impact on how you can invest your money. You probably heard two general statements about time horizon:

1. Young people in their twenties, with enough income to cover their expenses, have a very long time horizon for their savings, and therefore can take large amounts of risk.
2. People near retirement have a very short time horizon, because soon they will not have earned income and they will be financially dependent on their savings.

This article presents an approach to evaluating the time horizon of any person regardless of their age.

Your time horizon is the time until you will need to use your money. Each person may have several time horizons for different parts of their savings.

The first sentence is the basis for the claims in the two examples above. The second sentence states that you should not lump all of your savings into one time horizon. You can optimize your financial security by listing the expenses you might face in the future and specifying the time until each amount is needed.

A few cases might help exemplify this approach:

1. A 22 year old person starting a new job may have a short time horizon for amounts he might need to live off of, in case he loses his job. The period considered should be a conservative time period needed to find a new job in case of a recession. Other amounts may have a long time horizon.
2. A 65 year old man that is about to retire and has no guaranteed income other than social security, has a short time horizon for amounts he will need in the next few years to complement the social security income. Additional amounts that will not be needed for many more years have a long time horizon.
3. A 65 year old woman, with a guaranteed retirement that should fully cover her expenses, has a long time horizon for all of her savings. Be cautioned that if there is any risk to the “guaranteed” retirement income, some savings should be kept for possible short-term needs.
4. An 85 year old woman, with a need for $100,000 per year, $5,000,000 in the bank and no other sources of income, has a short time horizon for amounts that are needed for living expenses in the next few years and a long time horizon for the rest of the money, which is most of the $5,000,000.

The difference between these cases and the two cases presented above is the separation into several time horizons based on the different financial needs. Specifically, not all young people have a long time horizon and not all retired people have a short time horizon. In addition, stating a short or a long time horizon for the total individual’s savings creates injustice in most cases. Most people have a short time horizon for certain amounts and a long time horizon for other amounts.

Why is this important? Amounts that you may need in the next few years should be invested conservatively outside the stock market, since any stock portfolio can decline significantly for several years. The price you pay for conservative investments is lower expected returns than stock returns. The investments may even lose value compared to inflation, but it is a price that has to be paid.

Amounts that you can leave untouched for several years can be invested in a diversified stock portfolio. This is based on the assumptions that you will not sell the portfolio at a decline and you can wait enough years for a recovery from long declines. The reward for this patience is higher expected returns.

Because of the tradeoff between low volatility and high returns, you want to make sure that you minimize the risks of amounts you need in the short run, and maximize the returns of amounts you need in the long run. The best way to do this is to categorize the savings into individual amounts based on the future needs of the money.

Caution! The process above can help you determine the optimal investment approach for the disciplined and systematic investor. It assumes the following:

1. You periodically review your savings to make sure you have correct allocations for short-term and long-term needs.
2. You invest your long-term money in a way that is likely to grow in the long run. This means that you avoid trying to choose specific stocks, since any single stock can decline irrecoverably. It also means that you buy and hold onto the investments without trying to time the ups and downs of the market – another behavior that may lead to irrecoverable losses. If you have the urge to choose specific stocks or time the market, do so with amounts that you are willing to lose altogether (infinite time horizon).
3. You are committed to hold onto your long-term investments through all declines. The reason you can afford to invest in the stock market is your ability to wait for recoveries. If you suspect that you might sell your stock portfolio after a decline because of a fear of no recovery, you would be better off avoiding the stock market altogether.

To Summarize

Time horizon is a critical element in investment decisions. By correctly identifying the time horizons of your savings, you can maximize your financial security in the short run and the long run, without any conflict between the two.

Disclosures Including Backtested Performance Data

[Updated Data February, 2011]

If you are familiar with my previous articles, you can guess that this article is not going to discuss predicting when certain stocks will go up. Multiple research projects have shown that most people who time their stock purchases do worse than people who buy a diversified portfolio and stick to it.

This article will propose a timeline for adding new money into your stock portfolio. Several cases that you might encounter during your lifetime are:

1. Depositing money into your retirement accounts.
2. Adding spare income into your regular investment account.
3. Receiving a windfall including inheritance, lottery winnings or other large amounts.

The discussion in the article will be limited as follows:

1. When is the money needed? A stock portfolio should be limited to long-term investments. If you need the money in the next few years, the answer to “when is the right time?” is “never”. Every investor should use a written plan that finds the right balance between short-term security and long-term security. Maintaining solid short-term security at all times is the basis to any investment in the stock markets.
2. How is the money going to be invested? The more diversified your portfolio, the less volatile it should be, and the more money you can afford to put into it. This article assumes a globally diversified stock portfolio that avoids market timing and individual stock selection, with 9% average growth. In other cases you are facing significant additional risks.

Under these assumptions, the answer is simply: add the money as soon as it is available!

The answer follows from a combination of reasons:

1. Stock markets statistically grow . If history is any indication of the future, your money is more likely to grow than decline in any given period.
2. We don’t know what the stock market will do in the short-term . At certain times, the stock market seems highly overvalued, and you expect it to crash any day. The problem is that you cannot predict reliably when or if it will happen. If you think you can, try to remember if you said in March 2000 – not earlier and not later – “This is the peak, I should sell now!” If you were one of the few that did, ask yourself if you want to bet your money on predicting it again.

How should you add the money in different cases? We can bring this down to a pretty exact science, with individual treatment for each case:

1. 1. Depositing money into your retirement accounts, up to an annual cap .
      1. Ideally, you would want to deposit your full paycheck into your retirement account, until you have reached the annual cap. You can simply ask your employer to allocate 100% of your salary to your retirement account, after you verify that the deductions will automatically stop as soon as you reach the annual cap.
      2. If you cannot afford contributing the legal limit, you would have to change the allocation to 0% as soon as you reach your limit.
      3. If you are self-employed, you can deposit the full amount on January 1st!

      Note that the result is equivalent to enjoying an increased limit on the retirement deposits!

      Also note that you may need to spread the deposits over time to leave money for daily living expenses. The timeline above is the ideal one assuming no such restriction.

   2. Adding spare income into your regular investment account . Ideally you would add the money as soon as it is available. An exception is when you expect to have another deposit before your first addition grew to cover the transaction cost. The minimal time gap could be estimated as: transaction-cost / amount-to-deposit / (percent-average-annual-growth / 100).

For example, if you want to add $2,000 into QAM’s portfolio, you should wait if other amounts are available within the next: $24 / $2,000 / (9 / 100) = 0.13 years = 49 days.

Please note that this is a rough estimate that ignores compounding of growth and the fact that amounts can bear interest while waiting for investment; both would increase the resulting period. If you are QAM’s client, this calculation can be done for you when needed.

Full proof of the formula and the exact version are available upon request.

1. Receiving a windfall including inheritance, lottery winnings or other large amounts . In all these cases you receive a large amount of money, and the thought of a severe market decline right after you invested it may be painful for you. Because it is more likely that the portfolio will go up, the recommendation to invest the total amount at once still applies. Even if the portfolio severely declines right after you deposit the money, it is just a matter of time until it recovers and goes much higher. Gambling against stock markets going up is very risky business and you are statistically more likely to lose than win.

How can you use the announcements about “sales” of the portfolio?

The article, “Celebrating the Gloomy Days” (Hanoch, February 2005) demonstrated two things:

1. Statistically, after severe declines, you are more likely to see larger than average gains.
2. History shows that no past pattern presents increased likelihood for declines, not even recent extreme growth.

QAM’s monthly client emails announce “sales”, which are declines in the portfolio. Normally you should invest all of the amounts that you designate for long-term investments immediately. In cases where you haven’t done it for whatever reason, this can be used to remind you to act soon after the announcement came out and to potentially experience larger than average gains.

Please remember that the opposite is not true! You cannot predict when a portfolio will decline based on past statistics. Therefore, you should not wait to deposit an amount because there was no sale announcement in the most recent email, or because the portfolio increased extraordinarily recently. It may continue for years before a decline will occur, or the portfolio may simply increase more slowly for a while, never declining below the current level.

To summarize

If you are holding a globally diversified portfolio with no individual stock selection or market timing, and you have money available for long-term investments, large enough to justify the transaction costs, it is usually best to add it all at once with no delay.

Disclosures Including Backtested Performance Data

In the article, ” Which is Safer for Retirement: Bonds or Stocks? ” (Hanoch, Nov. 2004), stocks were compared to bonds as an investment vehicle for retirement. The comparison was done using historic data and found stocks to be safer under certain conditions. You might ask yourself, “Are there certain circumstances, not seen in the past, that could make stocks too risky?”

In order to answer this question, we should first understand what stocks and bonds are and how they relate to each other.

What is a stock? A stock represents company ownership. When you own a stock, you own a part of a company. The company gets to use your money for its expenses with the goal of generating profits beyond the money spent. You are directly affected by the company’s success: profits increase your investment value, while losses decrease it.

-> In the rest of this article, the terms ” stockholder” and ” owner” will be used interchangeably.

What is a bond? A bond represents a loan to a company (or a government). When you lend the money, you get a commitment to be paid back on a certain date and receive fixed interest.

As long as the company does not completely fail, you should get back the loan with the interest by the payoff date. No matter how successful the company is, you will get the exact predetermined amount: no more, no less.

-> In the rest of this article, the terms ” bondholder” and ” lender” will be used interchangeably.

How do stocks and bonds relate? The company takes loans hoping to increase its owners’ investment. The company owners get the profits left after the company pays for all of its expenses, including loans.

Note the order: loans are paid off first; only the remaining profits are given to the owners. By getting paid first, the lenders enjoy greater security than the company owners in case of failure. The price for this increased security is limited profit: If the company enjoys great success, they still get the same fixed amount back, while the owners enjoy the additional profits.

Why do owners get paid better than lenders? When choosing between two investments with the same returns, people prefer the investment offering lower risk. In order to accept higher risk, people require higher returns. Since ownership involves higher risk than lending, it is compensated by higher returns.

When are stocks too risky? Stocks are too risky compared to bonds in most cases! Specifically:

• Any individual stock is too risky compared to a bond, since any company can fail and declare bankruptcy. Usually, in such a case, the assets of the company can help repay part or all of the loans, but the owner may lose the total value of his/her investment.
• Any stock or group of stocks held for limited periods of time can experience slow periods in which they are able to pay off loans, but are not profitable. In some of these cases the owner’s investment can drop in value significantly.

When are stocks safe enough? There is one case in which stocks can be safe enough: a globally diversified group of stocks held for a long period of time. These two conditions are so important that I will repeat them separately:

• A globally diversified group of stocks,
• Held for a long period of time. (In the example below, 3 years were needed in the past.)

How do these conditions increase the security of stocks to an acceptable level? Let’s assume that the universe of stocks all over the world grew more slowly than bonds over many years. In this new reality, the risk-taking owners would get paid less than the low-risk lenders.

If lenders were offered higher returns for taking less risk, no one would want to be an owner. Masses of people would sell their stocks and buy bonds. This would create a corrective chain of events:

• The increased supply of lenders (bond buyers) would make it easier for companies to get loans, allowing them to offer lower rates on new bonds. The returns on bonds would decline .
• The lower cost of loans would decrease the expenses of companies and, as a result, would increase their profitability. The returns on stocks would increase.

As long as people keep their nature of demanding higher returns for taking higher risks, the universe of stocks in the world should provide higher returns than bonds, if held long enough.

Note that the historic data does not guarantee that future declines will not be longer, and other portfolios may (and usually do) experience longer declines. The logic in this article should give you comfort that future declines compared to bonds should be limited in time.

To summarize

Human nature makes it likely that a globally diversified stock portfolio held for the long term should be the one case where stocks are not too risky. This gives people an opportunity to create great wealth, without taking excessive risks.

This article is an important supplement to historic data of a globally diversified stock portfolio. No one guarantees that any particular portfolio will not behave worse in the future, but it is reassuring to see how human nature should limit the length of underperformance of stocks.

Disclosures Including Backtested Performance Data