Currency Risks for the Long Run?

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You may know that diversifying your investments outside the US can significantly reduce your risks, while increasing the potential returns. This is true because the different stock markets don’t go up and down at the exact same time, allowing a globally diversified portfolio to have shorter and shallower declines than a portfolio that is concentrated in the US stock market.

Global diversification into thousands of stocks in many countries and continents limits to an acceptable level the various risks, including: country risk, political risk, regulation risk and liquidity risk.

There is one risk that should be addressed separately: currency risk. This article will offer a separate discussion for short-term and long-term currency risks.

What is the short-term currency risk of international investments?

It is the risk of a significant strengthening of the local currency (US Dollar for Americans) compared to other currencies, whether temporary or long-term.

Can this happen?

Currencies tend to be less volatile than stocks, and are not correlated with the price of stocks. As a result, they are not expected to increase the risks of a globally diversified portfolio.

In addition, by holding a portfolio that is denominated in different currencies, short-term fluctuations are diversified. Note that whenever people use more of one currency compared to another one, this currency increases in value while the other declines. By holding a globally diversified portfolio, when some of the currencies you hold go down, others should go up.

All historic measures of returns include the currency impact. Historically, the international diversification of stocks proved to be very valuable, even when considering the currency impact.

What is the long-term currency risk of international investments?

It is the risk of a significant and irreversible strengthening of the local currency (US Dollar for Americans) compared to most other currencies.

Can this happen?

Let’s try to imagine such a situation. As the dollar strengthens, goods become more expensive in the US relative to other countries. At that point, Americans and others would start buying goods in other countries. The influx of dollars into other countries would make them more widely available, weakening the dollar and breaking the long-term strengthening-streak of the dollar. Academically, this is called “Purchasing Power Parity”.

As mentioned in the section about the short-term currency risk, historic evidence shows the contained long-term risk of currencies when combined with stock investments.

To Summarize

All of the risks that are specific to any individual country, including currency risk, are reduced to acceptable levels within the context of a globally diversified portfolio. Diversifying a portfolio globally reduces the risks specific to the home country (e.g. US), without introducing other bigger risks. This is both logical and has withstood the test of time.

Disclosures Including Backtested Performance Data

Make Volatility Your Friend

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Volatility is known as an undesirable thing that you should strive to minimize. This is very logical – when you invest your money, you want it to grow. You want to be able to take it out whenever you want or need and make a profit.

Unfortunately, investments that grow steadily with no declines provide very low returns. After considering inflation and taxes, you are left with very little gains, if any. Good examples are money market accounts, CDs and short-term government bonds.

Can you get higher returns? Yes, you can get much higher returns! But it comes at a price: volatility. Stocks, on average, provide much higher returns in the long run, but they also may decline in value. You may even lose your whole investment!

How can you avoid losing your whole investment? Luckily stocks as a group tend to grow in the long run. Globally diversified stock portfolios have never declined without recovering. Our desire to get things done as simply and cheaply as possible is what keeps companies growing.

As long as you keep your money diversified over many companies in different industries and countries, you are not likely to see it disappear. In addition, you would have to avoid mutual funds that research companies and try to choose specific stocks or the timing of investments, since the wrong decisions may lead to irrecoverable losses.

Can you avoid losing any money? If history is any indication for the future, yes! If you can hold on to your diversified investments through decline periods and make sure you sell only after full recovery, you are not likely to ever lose money.

The catch! The catch is that you might need money before your investments recover. You cannot control the timing and the length of declines of your portfolio. During long recessions, you may lose faith in stocks before they recover.

Is there a solution? There is a very good solution: diversify and study the history of your portfolio. There is no guarantee that the future will not be worse than the past, but by knowing how your portfolio reacted to catastrophic events, you can get a sense of how long severe declines tend to last. With that information at hand you can achieve two things:

  1. You can plan for a catastrophe worse than anything you’ve seen in decades, and keep some money in stable investments to support you through these periods.
  2. Whenever your portfolio declines, look back at history, recall why companies have always existed, and get ready for a recovery. The longer and deeper the decline, the bigger the recovery.

Can volatility be good? Yes! So far, we treated volatility as something that can negatively affect our investments, and found ways to minimize the chances for these negative effects. But I would dare to go one step further and claim that we need volatility. The high returns we get on our stock investments are a compensation for the volatility. If stocks ever stopped being volatile, the returns on investing in them would decline significantly. Much lower returns would compensate for the lower volatility.

The ideal practical world. Considering that high returns are compensation for high volatility, the ideal world is the one in which we can choose investments offering high long-term returns, and prepare for the volatility so well that it does not put us at any significant risk or stress. Fortunately this solution exists and is simple. Let’s review it:

  1. Choose the most profitable investment: stocks.
  2. Diversify them significantly, while including the asset classes that tend to grow the most and ones that are least correlated: small stocks, cheap stocks (“value”), international stocks and emerging markets stocks.
  3. Avoid any attempts to choose individual stocks that do better than average – you will have no way of being truly confident that huge declines will be followed by rapid growth.
  4. Learn the portfolio’s long-term historic behavior. Make sure to choose a long enough period that smoothes out anomalies. This is normally at least 25-30 years. Find the length of the longest decline of the specific portfolio you constructed, and prepare for worse than that.
  5. Keep enough money outside the stock market, to provide for you during the period of decline you chose to be prepared for.
  6. Put the rest in your diversified stock portfolio.
  7. Make sure you never deviate from your plan! The only reason to update your plan is changes in your own circumstances, not moves in the portfolio.

Smile! Now you are ready to get excited and smile whenever your portfolio goes down, including occasional significant declines – this is what keeps your pay so amazingly high.

Disclosures Including Backtested Performance Data

When is the Right Time?

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[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. 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

The Hydrogen Revolution!

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Oil prices are at a historic peak of over $60 a barrel. Both the individual at the gas pump and the stock market as a whole are affected. During times like these, you realize how dependent we are on other countries.

The ideal world. We should have a strong interest in reducing the dependency on oil for economic and non-economic reasons. Finding alternative sources of energy would make our lives better in many ways:

  1. In contrast to oil supplies, which are limited, finding renewable sources of energy would allow for a permanent solution to the energy needs of the world.
  2. Energy would be cheaper by avoiding the inflated prices of oil driven by the oil cartel, OPEC (Organization of Petroleum Exporting Countries).
  3. The US would not have to be beholden to the countries that produce most of the world’s oil.
  4. The US would not have to do business with countries whose governments, policies and/or practices Americans do not agree with.

These are huge incentives for us to find alternative energy sources, even if the initial cost is large.

The real world. In real life, many tend to focus on the short-term. It is hard for the government and corporations to spend so much money on research, with no real results for 10 years or more. Corporations are limited by their cash reserves and governments are elected for periods of 4 years, limiting their horizon.

The real world solution. There is a simple thing that can help us reach a solution, given real-world limitations. Paradoxically, it is high oil prices! The higher the oil prices, the more we will save by using alternative sources of energy, and the bigger the incentive to invest in developing them.

Seeing the magnitude of the current problem, it might be worth suffering from high oil prices in order to reach a sustainable solution. In the 70’s, when oil prices were very high, people came together to create more energy efficient appliances and cars to solve the problem.

The sustainable solution. The improvements of the 70’s weren’t enough. We are still dependent on oil, and the world’s energy consumption keeps rising. A sustainable solution requires using energy that is from renewable resources. A few examples are: wind, solar and hydropower energy. With these technologies, we may never lack energy.

Companies have been working on renewable energy sources for decades. As oil prices are rising, more companies and governments, including shorter-term thinkers, are spending many more resources on developing these alternative energy sources.

The need for a common solution. If we use a variety of energy sources, we would have to build different cars and appliances that can use the different types of energy. In addition, we would have to store energy and transport it in different forms before using it.

Another problem is that many of these sources are not available continuously. The sun does not shine at night and the wind does not always blow.

The common solution – hydrogen! In 1839, Sir William Robert Grove mixed hydrogen and oxygen in the presence of an electrolyte, and produced electricity and water. Later this invention was named fuel cell, and made it possible to transform our energy problem into a much more elegant one. The fuel cell allows us to use two of the most common elements in the world to create energy and pure water as a byproduct. It does not solve the energy problem, because it takes energy to isolate the hydrogen from the water, but it allows us to unify much of the process. Here is how it works:

  1. The first group of steps will vary depending on the renewable energy source used:
    1. Generate energy from one of many renewable sources.
    2. Using this energy, isolate hydrogen from water.
  2. The remaining three steps are the same regardless of the renewable energy source used:
    1. Store the hydrogen in some form.
    2. Transport the hydrogen to the location where the energy is needed.
    3. Use it to power vehicles and appliances requiring energy.

Now, instead of creating different versions of products for different sources of energy (e.g., solar, wind), we can design the products to accept only one source of energy: hydrogen.

If we use one product to solve the various problems, companies and governments can focus their money and efforts on a single solution to the energy problem. When compared to focusing on many different technologies, this creates a big incentive to join forces and pursue this goal.

Current work. An Internet search on “fuel cell” or “hydrogen energy” yields about 10,000,000 results. Sifting through a few of them would give you some idea about the amount of work currently being done. I was completely overwhelmed! A few links I found:

  1. International Association for Hydrogen Energy: http://www.iahe.org/
  2. Fuel Cell Europe: http://www.fuelcelleurope.org/
  3. US Department of Energy: http://www.eere.energy.gov/hydrogenandfuelcells/
  4. US Department of Energy: http://www.fueleconomy.gov/feg/fuelcell.shtml
  5. National Renewable Energy Laboratory: http://www.nrel.gov/clean_energy/hydrogen.html
  6. California Fuel Cell Partnership: http://www.fuelcellpartnership.org/
  7. National Fuel Cell Research Center: http://www.nfcrc.uci.edu/

It is nice to learn that NASA has used liquid hydrogen since 1970 for its space shuttles, and the crew could drink the byproduct – pure water.

Smile. Now you can smile whether oil prices go up or down! If they go down, you can be happy about the immediate financial relief; if they go up, governments and corporations get greater incentives to invest in developing renewable energy sources, which brings the long-term solution closer. It’s a win-win situation.

What does this mean in terms of the future of the stock market?

  • If oil prices go down, the stock market may go up rapidly.
  • If oil prices go up, the stock market may decline temporarily. In the meantime, the development of alternative energy sources will be accelerated, bringing a recovery that will permanently reduce the impact of oil prices on the stock market and the rest of our lives.
Disclosures Including Backtested Performance Data

When are Bonds Too Risky?

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In the previous article, ” When are Stocks Too Risky? ” (Hanoch, June 2005), you learned about the various risks of stocks and a way to use them without taking excessive risks. In this article you will learn about the various risks of bonds, and the ways bonds can be used without taking excessive risks. Let’s start by answering the question asked in the title:

When are bonds too risky? There are many risky ways to invest in bonds – many more than we would like to admit.

  1. Bonds as a long-term investment (including retirement) cannot effectively build your financial security. They provide low returns that result in minimal income after adjusting for inflation. The risk is not losing the dollar value of your investments, but outliving your retirement. When compared with carefully constructed stock investments described in the article mentioned above, bonds are too risky.
  2. Bonds cannot save us in case of an unprecedented global catastrophe . Historically bonds, as well as stocks, recovered from all declines and made up for the whole decline period. If you are losing sleep over the possibility of your stock investments being wiped out by a global catastrophe, you should know that bonds might not save you either. Most companies would be devastated and the government would lose its ability to tax people in order to repay its loans – bonds will lose their value.
  3. Any bond that is not backed by the government can lose significant value up to 100% in cases where the company that borrows your money fails and declares bankruptcy. This risk applies to all companies with no exception.
  4. Any bond not held to maturity can drop in value if interest rates go up, in order to make up for its lower return compared to new bonds.
  5. Any long-term bond has returns that are fixed for many years. If interest rates go up, the real returns of the bond go down. In certain cases, you might even lose purchasing power even if you hold your bonds to their maturity!

The first point above states that bonds cannot provide good long-term security. No matter what bond investment you choose, a carefully constructed stock portfolio (globally diversified, no stock selection or market timing and low costs) provides better long-term security that increases exponentially over the years.

What about short-term financial security? We know that stocks can be highly speculative in the short-term, making them useless for short-term security. Let’s find out whether bonds can be used to provide this security.

When are bonds safe enough? There is one case in which bonds can be safe enough: high-grade bonds, with a short maturity that are used solely to provide short-term security. All of these conditions must be true together, so I will detail each of them individually:

  1. High-grade (backed by the government with a limited amount of diversified corporate bonds)
  2. Short to intermediate maturity
  3. Only used for short-term security

These bonds tend to have limited fluctuations, making them ideal for short-term financial security. If you expect to use a large portion of your savings within the next few years, and there is no way you could delay the expense, you should not use stocks. A severe recession could leave you with a lot less in savings than you thought you had. When holding bonds, you are “paying for insurance” in the form of lower returns than company ownership (stocks), in order to know that the money will be there for you.

Are there alternatives to bonds that are better? There are many other alternatives to bonds for short-term security, including: checking, savings and money market accounts. All of these alternatives are either loans to the banks holding your money, or an aggregation of bonds and other short-term loans. They all offer lower returns with lower volatility, making them also viable for short-term security.

To summarize

Bonds are very important for maintaining short-term security. When using high-grade, short-term bonds you are likely to preserve your short-term security for the following reasons:

  1. Most of them are backed by the ability of the government to collect taxes, vastly decreasing the risk of default.
  2. Their short maturity makes them less affected by changes in interest rates.
  3. Their low returns are not a problem if their usage is limited to short-term needs, while leaving the long-term security to stocks.

No one guarantees that bonds will always provide perfect short-term security, but sticking to the ones mentioned above makes them likely to do so.

Disclosures Including Backtested Performance Data

When are Stocks Too Risky?

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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

Should you sell your declining stock?

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How many times have you asked yourself in the past, “Should I sell my declining stock?” This is one of the toughest questions investors have faced since stocks existed. If you could know that your declining stock will recover soon enough, you would have the potential of becoming rich from stock investments. Not only would you not sell the stock, you would want to buy a lot more of it. The deeper the decline, the more you would want to buy.

Unfortunately, any particular company could declare bankruptcy, resulting in up to 100% loss of your investment. There is no perfect recipe for deciding whether to sell a declining stock, making individual stocks speculative investments.

What if you could own thousands of stocks in many countries all over the world? When this portfolio declines, can you assume it will recover? You can own such a portfolio using index or asset class mutual funds. In the history of this portfolio, this globally diversified portfolio fully recovered from all declines within several years, as measured since the beginning of the decline.

These statistics are very comforting, but history, no matter how long, may not always repeat itself. Let’s try to think about what it takes for a decline to be irreversible. In order to do that, we need to understand what stock investments are and what makes them grow.

The history of companies. Many years ago, individuals and families grew their own food, sewed their own clothes and built their own houses. There were no companies, and people took care of their needs on their own. Over the years, people found out that they could specialize doing different tasks, and do them much more efficiently. Using machinery, it was easier to produce large quantities of goods.

With advanced transportation and communication, people were able to serve large numbers of people. This led to people grouping together to form companies that serve whole countries, continents and even the whole world.

As a company became large, it was usually impossible for a single person to provide money to operate it. The need to raise large amounts of money led to the formation of large groups of people who owned the company. In order to split the company ownership, they divided the company to many small parts – what we call “stocks”, and sold different amounts of them to individuals.

By dividing the company into small enough parts, any individual can buy today a part of a company for as little as a few dollars.

Why do companies go up in value? Companies buy materials and, using the work of individuals, create products that have a higher value than the materials and human resources used. Whenever a product is created with higher value than its components, it can be sold for a profit. This profit raises the value of the company. This is the natural state of a company that offers a product or service in need, and does it more efficiently than the individual consumer.

Can all companies decline with no recovery? In order for companies around the world to decline irreversibly, the process of specialization and mass production should reverse. More people would have to create products for themselves less efficiently. If you believe that a diversified global portfolio can decline irreversibly, you probably believe in people wanting to work harder for their needs.

What if there is a huge catastrophe? This is a question that often comes up when talking about risks of stocks. Any local catastrophe won’t affect a globally diversified portfolio significantly. The companies in unaffected regions may keep growing.

What about a global catastrophe? A global catastrophe could have an adverse effect on the portfolio. As before, let’s start by looking at history. Humans are amazing at dealing with problems. People dealt with the Great Depression, the World Wars, and extreme oil prices in the 1970’s. How did they do that? No matter how few people survive a catastrophe, they have the same human nature of wanting to provide for their needs as easily as possible. The re-creation of infrastructure with knowledge that already exists should stimulate rapid growth and the portfolio should recover more quickly than average.

To summarize

Humans prefer to get things done as easily and efficiently as possible. This preference should lead to the continuing existence and growth of companies. History measures support this preference.

History shows that people are able to recover from large catastrophes. Not only do they recover – they do so at an accelerated pace maintaining the long-term growth of companies and stocks. It happens with the use of existing knowledge, due to their continued preference to get things done as easily as possible.

Closing notes

This article presents good prospects for positive growth of stocks over the long run, assuming a globally diversified portfolio, with low costs across the board, no stock picking and no market timing. Other strategies could lead to different results. It does not imply guaranteed future returns with any strategy.

Disclosures Including Backtested Performance Data

What is the True Value of Desirable Real Estate?

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We have all heard about people that purchased properties 5 years ago and doubled the value of their homes. Some of you are in this group of lucky people. If you have any money to invest today, you might be asking yourself: should I jump on the bandwagon and double my own money in the next five years? Is this the new face of real estate or is the bubble going to burst?

After getting many requests to write about real estate as an investment (not as your primary place of residence), this article will look at residential real estate, with specific attention to desirable locations. It will start with a historic perspective, and then offer my personal observations.

Data

Growth. Below is the growth of real estate from 1975 to 2004. The first graph presents the US as a whole, California and New York. The second presents 3 locations in California.

2005-03 HPI USA

2005-03 HPI California

Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The average long-term growth and growth in the last year are presented below.

Location USA California New York Riverside-San Bernardino-Ontario, CA San Francisco-San Mateo-Redwood City, CA San Diego-Carlsbad-San Marcos, CA
Annual Growth 1975-2004 5.9% 8.2% 7.5% 7.37% 8.77% 8.42%
2004 Growth 11.2% 23.44% 12.6% 29.58% 13.77% 24.41%

Historically, real estate grew at an annual rate of about 6%-9%, depending on the location measured. In 2004, the growth rate reached 11%-30%.

Cycles. In the limited history available we can see 2 real estate cycles, averaging 15 years.

The recent recession in the 1990’s lasted up to 10 years from decline to recovery.

Mortgages. As home prices go up, more people are using adjustable rate mortgages, in order to afford buying a home. Some mortgages allow for payments that are much lower than the accruing interest rate for the first few years. After the fixed period, the loan amount is bigger and the payments increase rapidly.

With mortgage rates near long-term lows, and the federal rate increasing, mortgage rates should go up and increase the cost of borrowing. This, in effect, raises the price of the houses and makes them less affordable.

Investor activity. Investor activity had grown in the residential housing market, as noted in the December 14, 2004 meeting minutes of the Federal Open Market Committee: “speculative demands were becoming apparent in the markets for single-family homes and condominiums”. In March 1, 2005, The National Association of Realtors reported that investment home sales increased by 14.4 percent in 2004 compared to 2003.

Affordability. In recent years home prices grew much faster than income, making homes less affordable.

Supply vs. demand. According to data released on February 28th by the U.S. Department of Commerce, the supply of homes increased by 20.5% from January 2004 to January 2005. Sales in the US as a whole and in the North East declined, while they kept increasing in the West.

Change from January 2004 to January 2005
Region USA West North East
Sales -4.2% 16.6% -33.7%
Supply1 20.5% Data Not Available

1 Ratio of houses for sale to houses sold.

Observations

The US as a whole. In the past year, US home prices appreciated by 11.2%, nearly double the historic pace of 5.9%. There are several possible explanations for the accelerated growth in recent years. In 2000 to 2002 the stock market crashed, positioning real estate as a stable and secure alternative investment. In the meantime, interest rates reached 40 year lows, significantly reducing the cost of houses. As demand increased, house prices went up. This gave lenders the opportunity to come up with more sophisticated loans, letting people pay very little today and more in the future. These loans let people keep buying homes despite the high prices.

As the stock market is recovering, interest rates are going up, and the affordability is going down, real estate is becoming less attainable to many people. More of the buyers are investors and speculators who are hoping for continuing rapid growth, based on projections from recent history.

Based on 2004 supply vs. demand data and the other factors mentioned above, it shouldn’t be surprising to see the US real estate market resume its long-term pace, or even a slower pace for a few years.

High growth areas. In high growth areas, the recent trend is much more emphasized. The 2004 growth was up to nearly 30%, quadruple historic averages of about 7.5%. Many claim that it is due to physical boundaries that limit supply in some of these areas. They say that the US market as a whole may go back to historic averages, but not places with limited supply. Good examples are the San Francisco Bay Area and the coasts.

At first, this sounds convincing, but it implies a very unique future. The price difference between the coasts and the rest of the US will keep growing. Assume half of last year’s growth moving forward, or 15% compared to 6% throughout the US. With this difference in growth, the price difference will grow 3,500 times bigger in 100 years. If today a $100,000 house in Nebraska can cost $500,000 near the coast of California, the same house would have to cost $1,750,000,000 in 100 years compared to $100,000 (all in today’s terms). That would give the coastal homes the same value as 17,500 homes in Nebraska, and California would be full of billionaires.

My conclusion is that locations with limited supply that become popular can appreciate faster than other places, but this faster appreciation cannot be sustained forever.

Historically, US real estate as a whole did not decline for any calendar year since 1970. The high growth areas did decline during recessions. This goes along with the behavior of investments in general: in order to achieve high returns, you have to accept high risks. Unless history is changing, a slow down in the US as a whole, could bring a bigger slow down (or even a decline) in locations that appreciated more recently.

I am not predicting anything specific, but I do claim that sustaining the recent growth has to be based on fundamental increases in home values. Below are a few recommendations that are true for real estate as well as other types of investments:

  1. Invest in undervalued properties – not overvalued ones. As an investor, your goal is to make money. Don’t buy a property for more than you believe it’s worth. Make sure you have good reasons to expect future appreciation.
  2. Do not project the future based on the past few years, especially if they are out of line with long-term historic behavior. If you think recent history is expected to continue, make sure you have a clear idea why.
  3. Make sure you can afford to hold the property for a period longer than past declines. In high growth areas, the recent decline to recovery period was 10 years. In addition, there are very large transactions costs for buying and selling properties. If you can’t hold the property for 15 years or more, you could end up loosing purchasing power if you buy at a peak.

Note that this article refers to residential real estate investments. Specifically, buying a home as a primary residence has many additional economic and non-economic benefits, entailing different considerations.

Resources

1. Office of Federal Housing Enterprise Oversight (OFHEO)

2. New Residential Sales in January 2005, US Department of Commerce, February 28, 2005

3. Second-Home Market Surges, Bigger Than Shown in Earlier Studies, NAR (National Association of Realtors), March 1, 2005

4. Are Home Prices the Next “Bubble”?, Jonathan McCarthy and Richard W. Peach, Federal Reserve Bank

Disclosures Including Backtested Performance Data

Could High Oil Prices be Good?

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Oil prices are rising every day and it is hard to see the end of this trend. The problems in Iraq, Russia and Venezuela combined with the growth in China and India lead to decreased supply and increased demand. It seems like the world is running out of oil, which might bring world economies to a halt. Will it?

The current demand for oil surpasses the supply, but the world is not running out of oil. Oil is a commodity with cyclical behavior. History is full of examples where supply did not keep up with demand, and people believed that the inflated prices would never go down – but they did.

During 1973-1974, oil prices quadrupled in less than 6 months, and reached higher prices than today, when adjusted for inflation. What was the result of the peak in prices?

  • More fuel-efficient cars
  • Better insulation in homes
  • Improved energy efficiency in industrial processes

In the 80’s and 90’s, prices went back to the long-term historical average of around $20 a barrel, measured from 1869 until 2003. What happened to these energy efficiency improvements after the drop in oil prices? They stayed with us and will continue affecting the world throughout the future.

Can you think of possible scenarios resulting from today’s situation? We have gas-guzzling SUVs that will gradually be replaced by hybrid electric cars. In the longer term, hydrogen operated cars will turn one of the most abundant resources in the world into energy. The Environmental Protection Agency (EPA) will establish stricter rules for energy efficiency.

Like any problem that caused stock markets to go down in the past, there is no question of whether there will be a solution to the energy problems in the world – only when it will be. And the bigger the short-term problem, the stronger the long-term solution.

I would like to give special thanks to Jim Williams at WTRG Economics. I could not have compiled this article without his generous help and his detailed article Oil Price History and Analysis. Note that an updated version of his article is expected soon.

Disclosures Including Backtested Performance Data

Diversification at Work!

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US Stock funds with diversified positions lost 2.76% percent in the third quarter, based on preliminary figures from fund-research firm Lipper.

A portfolio of globally diversified stock funds (Long-Term Component by Quality Asset Management – QAM) achieved positive returns of 3.58%. If you are thinking that sophisticated prediction of the quarter was involved, you are giving too much credit to Dimensional Fund Advisors (the mutual fund company) or QAM. These are mutual funds that hold over 6,000 companies throughout the world, representing the different asset classes. Similar to index funds, they include all stocks that fall into set criteria that define the asset class, with no preference to one over the other.

What is the secret, then? Simple global diversification. As you can see in the chart below, different asset classes went up at different times. Specifically, emerging markets showed high returns, while international stocks went slightly higher, all which offset the negative performance of US stocks for the quarter.

2004-10 Q3Graph

Disclosures Including Backtested Performance Data