6 Problems with Dividends for Income

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If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data

Maximum Wealth with Your Home

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You may know people who gained nicely from homeownership. This article analyzes a critical element for sustaining the high growth: leverage using mortgage loans.

Is This Article for You?

This article assumes that you desire to maximize the growth rate of your investment in your home, at the price of higher short-term risk in the early years. The risk is very real: many people lost their home or went bankrupt by incorrectly analyzing their risks or simply panicking during a downturn in real estate or stocks. To add to the difficulty, real estate cycles are typically longer than stock market cycles, testing the patience of the most disciplined investors.

Note: To make the article tangible, specific cases are provided. Actual numbers can vary wildly depending on the specific home and timing, but the principles should apply to many cases.

No Leverage: Let’s start with non-leveraged returns. Real estate returns with no mortgage loans are typically moderate. For example, you may obtain combined returns + savings of 6.2% on owning your own home instead of renting it, assuming:

  • 4% appreciation (U.S. real estate growth in the long run)
  • 4% saved rental payments (a common ratio)
  • -0.8% property tax of ~1.1% after tax-deduction
  • -1% repairs

Such returns are nice relative to bond investments, but are below stock returns. 

With Leverage: With a mortgage, the results improve. With the addition of an 80% loan with a 5% interest rate (below the average of the past 20 years), you get an additional gain of (6.2% – 5%) x 4 1 = 1.2% x 4 = 4.8%, for a total of 11%. This is more in line with some stock investments.

Notice that the returns change dramatically depending on the mortgage interest. If you can get today a loan with a 3.5% interest rate, the increased returns thanks to the mortgage, jump to (6.2% – 3.5%) x 4 = 2.7% x 4 = 10.8%, providing a total of 17%, competing with most stock portfolios.

Key point: The returns above are returns on the amount invested. If you bought a $1M home, and put down 20% ($200k), your 17% return is $34k. While this is a great return on the amount invested, taking the loan makes financial sense only if you can invest the rest of your money and expect higher returns than the interest paid when averaged over the life of the loan. This applies to any money you have, whether it is the full remaining home value ($800k), or any smaller amount. If you spent the rest of the money, or invested in bonds with low returns, your financial position will be worse than not taking the loan and keeping the money invested in the house. Here are a few examples for returns depending on the return on the rest of your money:

Year-1 Returns on $1M house with $200k down payment and the remaining $800k invested elsewhere, and 6.2% return on money investment in home

$800k investment Return calculation Total return Loan Benefit
You spent the remaining $800k (34k – 800k) / 1M -76.6% -82.8%
You kept the money in cash (34k + 0) / 1M 3.4% -2.8%
You earned 3.5% in bonds (same as loan interest) (34k + 3.5% x 800k) / 1M 6.2% 0%
You earned 10% in stocks (34k + 10% x 800k) / 1M 11.4% 5.2%
Your earned 17% in stocks (34k + 17% x 800k) / 1M 17% 10.8%

While such gains are appealing, they cannot be sustained by taking a 30-year mortgage, and keeping it until it is fully paid off. They assume that the loan as a percentage of the home value (called loan-to-value, loan/value or LTV) stays at a fixed 80%, when in fact the returns drop quickly, as the mortgage is paid off. There are two things working to reduce the loan-to-value:

  1. Principal paid: A 30-year fixed mortgage is paid off over 30 years, meaning that every year some of the principal is paid off, reducing the loan balance. This decreases the nominator of loan/value.
  2. Home appreciation: Increases the denominator of loan/value.

The following table shows the decline in returns over the years:

Returns on investment in home with 30-year fixed mortgage, 3.5% interest
Assumptions: 4% appreciation, 4% saved rent, 0.8% after-tax property tax, 1% repairs
Year Principal Paid 2 Home appreciated 3 Loan-to-value 4 Returns 5
0 0% 0% 80% 17%
1 1.9% 4% 75% 14.3%
2 3.9% 8% 71% 12.8%
3 6% 12% 67% 11.6%
4 8.1% 17% 63% 10.8%
5 10.3% 22% 59% 10%
10 22.6% 48% 42% 8.1%
30 100% 224% 0% 6.2%

Problem: Within a few years, most of the leverage benefit is erased

For example, the return after as little as 5 years is much closer to the non-leveraged return than the 80%-loan return (10% vs. 6.2% non-leveraged and 17% leveraged).

Solution 1: Add a second loan: either a mortgage or a HELOC (home equity line of credit)

This is a good solution for a few years, since it increases the leverage (loan/value) without losing the benefit of the low rate on the remaining loan balance. There is a negative to this approach: the rate on a second loan tends to be higher than a primary loan, and the rate on a HELOC is variable, adding to the risk and cost of the HELOC as rates go up. While this negative is moderate in the first few years, when the balances are low, it becomes much more meaningful as the years go by, and the second loan or HELOC become large. At that point, you are typically better off refinancing (Solution 2 below).

Solution 2: Refinance to increase the mortgage

This solves the shortfalls of adding a loan (Solution 1 above), but requires accepting a new interest rate, even if it is much higher.

Key Point: If you are eager to lock a 30-year mortgage at today’s low rates, the benefit is likely to be outweighed by the declining leverage. Solving this problem requires accepting future, potentially higher, rates.

Optimization 1: adjustable-rate mortgage (ARM)

Since you are not likely to benefit from holding the same mortgage for many years, you can consider an adjustable-rate mortgage (ARM). Such a mortgage guarantees a certain rate for a limited period – typically 3, 5, 7 or 10 years, and later adjusts annually. By retaining the risk of rising rates, you are compensated through a lower initial fixed rate.

Choosing the optimal ARM term:

  1. When rates are high, you can choose a shorter lock, to get the lowest rate, since rates are likely to decline at some point, anyway making a refinance beneficial.
  2. When rates are low, it can be beneficial to lock the mortgage for longer at the price of a higher fixed rate.
  3. An important subcase: When rates are low because real estate declined substantially, and in an attempt to help real estate recover, you may choose a shorter fixed period, since (1) rates may keep being reduced while real estate keeps declining, allowing you to refinance with better terms, and (2) once real estate declines stop, the reversal may introduce unusually large gains early on, reducing your leverage quickly, and leading to a quicker refinance.

Optimization 2: interest-only adjustable-rate mortgage (IO ARM)

A variation of the ARM loan is interest-only ARM. With such a loan you pay only interest for the first few years, keeping the loan balance fixed. This has the benefit of slowing down the decline in leverage. The leverage declines only through the appreciation in the home value. An IO ARM typically carries a slightly higher interest rate, and, depending on how you invest the loan proceeds, can make sense.

More potential issues: While keeping a high mortgage balance can help maximize your wealth, it is not advisable or possible for most people, even if they desire to do so:

  1. Cannot Qualify for Loan: As you seek increasing loan amounts, you may not qualify for the loans based on your income.
  2. Excessive Risk: Any additional borrowing to invest increases your short-term risk. This is pronounced with rates that may adjust higher. A careful risk analysis is necessary to determine the short-term risk, before focusing on the potential long-term benefit. The risk analysis should address factors such as loss of job, a stock market crash, a deep and long real estate decline, and a spike in interest rates, to name a few.
  3. Refinance Labor Too Great: The work for a refinance every 1-3 years, to keep the leverage high, may not be appealing to many homeowners.

Once you reach your capacity to borrow, buying additional real estate as an investment would often be inferior to simple investing in a globally diversified stock portfolio, in terms of returns (with no leverage) and in terms of complexity.

Owning a more expensive home will typically cost you money

Once you realize the benefits of leveraged homeownership, you may ask if you can make more money by owning a more expensive home. The answer is “no”. Let’s review the scenario from the top, modified to exclude the saved rent, to calculate the growth in the amount spent on the extra home value. We get: 4% appreciation – 0.8% property tax after tax-deduction – 1% repairs = 2.2%, as the return without leverage. While this is a positive return, it is far worse than other investments, losing you money compared to the alternatives (and even compared to the typical inflation).

As long as mortgage rates are higher than 2.2% over time, leverage would only hurt the returns (for example with an interest rate of 5%, any leveraged returns would be negative, based on: 2.2% growth – 5% cost of borrowing = -2.8%.

From a financial standpoint, you would be best to own the cheapest home that fits your needs.

Summary

Homeownership (vs. renting) can turn from a moderate investment to an appealing one with the help of leverage, but the leverage has to be high (80%) to get the benefit. Even a mild reduction in leverage erases most of the appeal. For the few who (1) can qualify for loans to keep the leverage so high, (2) can afford the short-term risks, and (3) have the desire for such a plan, the potential gains can be substantial.

1­­ 6.2% – 5% is the gain in the home value (6.2%) beyond the cost of the loan (5%). 4 is the multiple of the down payment that is borrowed. With an 80% loan, the down payment is 20%, and the multiple is 80%/20% = 4.

2 The principal paid is calculated using a loan amortization formula by a financial calculator.

3 Home appreciation at 4% per year, for example, in year 5, the appreciated home value is: 1.04 raised to the power of 5 = 1.22, and the appreciation is 22%.

4 The initial 80% loan-to-value is adjusted by: (1) multiplying by the reduced loan balance, and (2) dividing by the increased home value. For example, in year 1, the loan-to-value is: 80% * (1 – 1.9%) / 1 + 4%) = 80% * 0.981 / 1.04 = 75%.

5 The returns are calculated similarly to the base case described in the “With Leverage” section above. For example, in year 1, the leverage multiplier is: 75% loan / 25% down payment = 3, and the returns are: 6.2% + (6.2% – 3.5%) * 3 = 6.2% + 2.7% * 3 = 14.3%

Disclosures Including Backtested Performance Data

Will the Retirement Boom Lead to a Stock Bust?

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Some people expect demand for stocks to decline given the large wave of Americans approaching age 65. This article questions this expectation.

Investment professionals often recommend that investors shift their investment allocation from stocks to bonds as they approach retirement age. The combination of the spike in people approaching retirement age, and growing longevity, may lead you to expect a big shift of demand from stocks to bonds. Below are several reasons why this big shift may never happen.

Bonds are too risky for the long run

While bonds reduce the short-term risk of stocks, they carry a risk of their own. The combination of inflation with increased longevity can erode the value of bonds, introducing the risk of running out of money, slowly and painfully. There are three ways to reduce this risk:

Work longer

People in good health, and with moderate assets, are likely to work longer. They may spend similar time in full retirement as retirees 50 years ago. They will do so by spending most of their increased longevity working, full time or part time.

Spend less

Those with health conditions that prevent them from working and without substantial assets will have to limit their spending to their social security income and whatever resources they have. Either they will reduce their spending early on in retirement, or they will gradually reduce their spending as they deplete their assets.

Invest in stocks, if you have the money

Those with substantial assets relative to their spending will benefit from the option to sustain a low withdrawal rate from their savings in retirement. When you can commit to a low withdrawal rate, stocks (globally diversified) are safer than bonds. Specifically, the risk of depleting the investments due to withdrawals during severe declines is very small. For those who happen to live long, the risk of stocks tends to keep declining, while the risk of bonds tends to grow.

Annuities do not solve the problem

Annuities are simply a window into bond investments (since insurance companies put money backing annuities in stable investments such as bonds), but with high administrative costs. They add the longevity protection and, in some instances, inflation protection, and reduce the income paid in order to finance these protections. Just as a retiree would not put substantial assets into bonds to finance increased longevity, he/she would not finance the bulk of retirement income using annuities.

Literature Support

A paper by the Congressional Budget Office (CBO), published in September 2009, provides evidence to support this article’s claims, with many interesting angles on the topic.

Summary

As people live longer, they have a choice between working longer, reducing spending, or investing more in stocks. Investment advisors and individuals are gradually realizing that bonds are too risky for financing the increased longevity. This realization may accelerate at times with elevated inflation.

http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/105xx/doc10526/09-08_baby-boomers.pdf

Disclosures Including Backtested Performance Data

Is the Present More Important than the Future?

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Some people believe that the present is far more important to them than the future. This article argues that this is not true for most people.

Say you believe that the future, 5 years from now, is substantially less important to you than today. Please answer the following questions:

  1. Did you hold a similar belief 5 years ago? If yes, read further.
  2. Do you believe that the present is at least as important as 5 years ago?

If you answered “yes” to the last question (as most people would), there is a contradiction: 5 years ago you believed that the future 5 years away (i.e. today) will be substantially less important, yet, today, you disagree. This means that you had trouble accepting the importance of your future needs, and there is a good chance that you are acting the same way today.

More considerations:

  1. While the present is tangible and certain, you have to be sure that you will not be around in 5 years in order to ignore this future. I haven’t met any person aggressive enough to ignore the possibility of living beyond a certain age.
  2. Humans keep living longer. Please don’t underestimate this effect, and be wary of naming any age that you are certain to never reach.
  3. Future needs are easier to finance thanks to the likely growth of your investments over the years (twice as easy after 6 years with 12% real growth, and 4 times as easy after 12 years).

Conclusion

You can assess for yourself the importance of the present compared to the future, but be aware of a psychological bias that may lead you to prefer the present too much, simply because you discount future suffering compared to present suffering.

Disclosures Including Backtested Performance Data

Why you should Hold Bonds in a Taxable Account

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Bonds are typically less tax efficient than stocks, leading to a common recommendation to hold bonds in retirement accounts and stocks in taxable accounts. This article challenges this advice for certain investors.

This article applies if you follow a plan devised by Quality Asset Management, or:

  1. You optimize your use of bonds: Income during stock declines and no other use.
  2. Your stock investments are highly diversified globally, with no market timing and no individual stock selection.
  3. Your stock investments have high average returns and a low turnover (i.e. limited annual sales of stocks; e.g. index mutual funds).

Bonds are less tax efficient than stocks

The notion that bonds are less tax efficient than stocks is the basis for the idea that bonds are a better investment to shelter from taxes, by putting them into retirement accounts. This notion is correct as seen in the table below:

  Bonds (mainly interest) Stocks (mainly capital gains)
Taxation frequency Done every year Mainly deferred to sale. Index funds hold each stock for a number of years on average.
Tax rate Ordinary income tax rate Mainly long-term capital gains

A deeper analysis can challenge the conclusion above.

Considering investment horizon

Given that you use your bonds whenever there are stock declines (assumption #1 at the top), as soon as you experience a stock decline, you would withdraw the money, and would not be able to put it back in. This would result in losing the retirement account tax benefit forever, due to a single stock decline.

There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading.1

Comparing tax amount instead of tax rate

While the tax-rate of bond investments is higher than stocks investments, there is an offsetting factor. The average growth rate of stocks is much higher than bonds, magnifying the total tax amount , and offsetting the benefit of the low tax rate . A full analysis may become complex, given the combination of long-term gains and short-term gains, dividends and capital gains distributions. Instead, I will provide a simplified example to demonstrate the point:

  1. The tax on a bond fund with 5% interest at about 40% tax rate (federal 35% & state 10% minus a deduction of state taxes from federal taxes) is 2%.
  2. The tax on a stock fund with 15% growth taxed at 10% tax rate (federal 15% & state 10% minus 15% for the fact that taxation is mostly deferred) is 1.5%.

The faster growth of the stock investment keeps raising the tax amount. If we start with a $10,000 investment, here is the tax amount over a few years (under the assumptions above):

Tax on $10,000 investment in bonds vs. stocks Difference
Year Bonds (5% growth 2% tax) Stocks (15% growth 1.5% tax)
Principal Tax Principal Tax
1 $10,000 $200 $10,000 $150 -$50
2 $10,300 $206 $11,350 $170 -$36
3 $10,609 $212 $12,882 $193 -$19
4 $10,927 $219 $14,621 $219 $0
5 $11,255 $225 $16,595 $249 $24
6 $11,592 $232 $18,835 $283 $51

The faster growth of the stock investment resulted in a higher tax amount within 5 years, despite the lower tax rate.

While this example ignores some variables, and has simplified assumptions, it demonstrates the point that higher growth can result in higher taxes, even when the tax rate is lower and most of the taxation is deferred.

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.

1 Say you need $10k from bonds during a stock decline. You can do the following:

Taxable account: sell $10k stocks

Retirement account: sell $10k bonds, buy $10k stocks

Once your stock portfolio recovers, you can move the stocks in the retirement account back to bonds (sell $10k stocks, buy $10k bonds).

Disclosures Including Backtested Performance Data

How can you Maximize the Benefit of Bonds?

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Bonds are an excellent tool for limiting the negative impact of stock declines. This article will help you assess if you have a clear plan in place to make the most of your bonds.

It is common knowledge that bonds are a useful tool for retirees to help with current income given the high volatility of stocks. At the price of slower average growth, you get the peace of mind that your income will be there through the ups and downs of stocks. Let’s assess your use of bonds.

How did you use your bonds in the 2008 decline (choose the closest option)?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.
  2. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.
  3. I kept the percentage allocation to bonds fixed.
  4. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

How does each choice affect your financial security?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.

This is an intuitive option that many investors chose. It grows your short-term security in case the decline continues. There are two problems with this choice.

Every sale from stocks at a decline locks in the losses, and hurts your financial security for the rest of your life. Your long-term security is devastated.

A less apparent problem is: You gained no benefit from your bond allocation! The only reason to hold bonds is to avoid realizing losses in your stock portfolio. You did the opposite – not only did you not avoid selling stocks for current income; you accelerated the sales at the worst time.
  1. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.

This is a great improvement that avoids turning the temporary declines into a lifelong devastation. Most of the stock allocation is kept in place to enjoy the recovery.

It still has the problem of selling from stocks to cover living expenses instead of bonds. See the second paragraph in the frame in #1 above.

  1. I kept the percentage allocation to bonds fixed.

This is the disciplined approach according to common knowledge: keeping the allocation to stocks and bonds fixed at all times. It results in selling bonds and reinvesting in stocks after the stocks declined (“buy low”). If you followed this plan in 2008, you can be proud of yourself – you were probably one of the best investors out there.

  1. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

This approach maximizes the benefits of bonds. The reason to hold bonds is to avoid realizing stock losses. By making a full switch to bond withdrawals during stock declines, you completely avoid realizing stock losses. If you followed this plan in 2008, you are probably a rare investor who optimized the use of his/her bonds.

Conclusion

Whatever your intention for bonds is, make sure that your plan reflects it, and that you follow the plan during the worst declines. If you didn’t protect your interests perfectly, you need to come up with a more adequate plan, or a plan that you have the strength and discipline to follow.

#3 and #4 make good use of bonds, with some benefit to #4, given that it optimizes the use of bonds.

The main problem with a diversified stock portfolio is the risk of depleting it through withdrawals during steep declines. A bond allocation can help you avoid realizing large losses during stock declines. A plan that optimizes this benefit calls for withdrawing strictly from bonds, when and only when, your stock portfolio declines.

Disclosures Including Backtested Performance Data

Buffett Talks about Investment Options

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Warren Buffett, the most successful investor in the world, and one of the wealthiest people in the world, writes an annual letter to the shareholders of the company he manages: Berkshire Hathaway. The 2011 shareholder letter (http://www.berkshirehathaway.com/letters/2011ltr.pdf) had a valuable section about the basic choice for investors. This section, almost perfectly, mirrors my view on investment choices1. Since he expressed our ideas so eloquently, I kept the quote with almost no breaks. I highly recommend reading the whole text slowly and carefully, even repeatedly, if needed. If you can get the many messages and nuances throughout the text, you may gain a great sense of comfort by the time you are done.

 

“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

“From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

“Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

  • “Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

    “Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

    “Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

    “For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

  • “The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17 th century.

    “This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

    “The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

    “What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while .

  • “Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

    “My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

    “Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

    “Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

    •  

    I hope that reading these messages from the most successful investor in the world, with no sugar coating, can give you some comfort in my strong focus on these principles.

     

    1 Our main point of divergence is his focus on a small collection of companies with a bias towards the U.S., versus my focus on global diversification with a strong representation of fast growing countries and companies.

    Disclosures Including Backtested Performance Data

Part of my Salary is only $10,000!

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Please read the following statements:

  1. Part of my salary is only $10,000. My salary is so low!
  2. This car is really cheap – its doors and wheels cost only $3,000!
  3. My investments have done poorly. Over the past 10 years, part of the return was 0%.

Do you see a problem with these statements? They provide a judgment on partial information – a portion of a value. The full salary could be $100,000, the car could cost $50,000 and the investments could have doubled, in which case all of the judgments above are wrong.

While you may be confused reading such statements, the article that appeared on the front page of the business section of the Los Angeles Times, “The 3 Bears”, on January 8, 2012, made statements similar to #3 above.

I am not judging the quality of the referenced article as a whole (it had some good information), but a specific set of data that was presented in an eye-catching way in the beginning of the article.

The article showed 3 long time periods in which the price of the Dow Index did not go up much (or even declined in one case).

While the information is correct, it is not useful. The change in the price of an index or a stock represents only a part of the return to investors, since it ignores dividends.

The table below shows the calculated returns of the Dow Index based on the years presented in the article (price change only), compared to the total returns of the Dow Index (including dividends). The returns of the globally diversified portfolio offered by QAM, Long-Term Component, were added when available.

Period Length Annual Returns
Dow Index, no dividends Dow Total Return Long-Term Component
1929 – 1950 22 years -1.1% 4.2% N/A
1967 – 1982 16 years 1.8% 6.6% N/A
1970 – 1982 1 13 years 2.1% 7.1% N/A
2000 – 2011 12 years 0.5% 2.8% 8.8%

You can see in the table that the total return of the Dow Index was substantially higher than the price-only return that was represented in the article. These total returns are not spectacular, but are significantly higher than the near 0% that was mentioned in the article.

Furthermore, I would argue that both measures are not relevant to a practical investor. There is no reason to invest in a concentrated portfolio of 30 of the slowest growing companies (being very large) in a single country that is the slowest growing country in the world (a result of it being the most developed economically). Instead, you can invest in thousands of stocks, large and small, all around the world. An example of such an investment is Long-Term Component, and you can see the significantly higher returns during these tough periods.

Last, while the referenced article emphasized the long stretches of poor returns for the price (excluding dividends) of certain stocks, it failed to mention that these periods all started with very high valuations (P/E ratios). Today, the P/E ratios are below average, meaning that we are not likely to enter a long period of poor returns for prices, even when measured excluding dividends.

Conclusion

I encourage you to be very careful of biases that appear in some articles. While these biases may get the attention of readers, they can create great financial harm to you, if you draw the wrong conclusions from them. A specific bias to be wary of is presentation of partial returns that do not include dividends.

Disclosures Including Backtested Performance Data

Are you Subject to the Status Quo Bias?

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Imagine the following: You are a retiree with $10M in a diversified stock portfolio. You sell $50k each quarter ($200k per year) to generate current income. Your portfolio declined by 50% in the recent quarter. Please answer the following questions with likelihood between 1 and 10 (ignore the time spent on acting on your decision):

  1. You need $50,000 to cover quarterly expenses. How likely are you to sell an extra $50,000 to lock-in the current value given the potential for further declines?
  2. You have an old employee retirement account that has $50,000 invested in bonds. How likely are you to keep the bonds in place (as opposed to selling and reinvesting in stocks)?

STOP. Make sure you have a response in place, before reading further.

People have a tendency to keep their current behavior in place, even when the change would improve their lives. This Status Quo Bias is seen in various domains of life, including investing. The rest of this article will help you recognize and avoid it.

If your answer to #2 is higher than #1, meaning you are more likely to do #2, you are probably subject to the Status Quo Bias. In both scenarios, the difference between agreeing with the statement and not, is having $50,000 extra outside of the stock portfolio. Your preference for financial security may affect your responses, but is likely to keep them similar to each other. Specifically:

  1. If you are looking to maximize your short-term security, you would want to sell the extra $50,000, as much as you would want to keep the bonds in the retirement account in place.
  2. If you are looking to maximize your long-term security, you would want to avoid an additional sale from stocks, to avoid locking in a 50% loss on the additional $50,000, and let the amount recover with the stock portfolio. By the same token, you would want to move the bonds in your retirement account to your stock portfolio, so they can grow with its recovery.

To clarify further, taking action #1 and not #2 is very similar to taking action #2 and not #1. Phrased differently taking either action would yield similar results (keeping $50,000 away from the stock portfolio).

There is one financial difference, though: #2 refers to a retirement account. Given the tax benefit, you would want to consume money from that account last (under most scenarios), making its time horizon longer than the taxable account. Therefore, cash is more valuable in the taxable account, since the stock investment has less time to recover from any further potential decline. This means that you should have a preference to do #1 over #2, meaning your answer to #1 should be higher than #2.

Why would you prefer #2, if it goes against your financial interests?

Because #2 does not require any action, while #1 requires taking an action. People have more regret as a result of actions than inactions.

How can you limit the impact of the Status Quo Bias?

In every financial decision, focus on the end result, not the process. Imagine reality after you implemented the decision. Picture all changes that result from the decision. This will remove the focus on the action/inaction. Only after picking the best financial result, evaluate whether any effort required would outweigh the financial benefit.

How would you follow these ideas in the example above?

In the example above, if you desire to keep your cash/bond allocation unchanged, it may be best to take the following two actions: (1) invest the bonds in the retirement account in stocks, while (2) selling the equivalent amount from your taxable stock portfolio (assuming you can do so without realizing gains – likely given the recent 50% decline).

Given the low withdrawal rate for ongoing expenses, it seems that the short-term risk is small, making it smart to try to maximize the long-term security. If that is your preference, you would choose to transition the bonds to stocks, and not sell extra stocks from the taxable portfolio.

Disclosures Including Backtested Performance Data

Can you Forecast Your Portfolio’s Future?

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How would you like a reliable forecast of your stock portfolio’s returns? While countless magazines, radio shows & TV programs are devoted to the task, most attempts are fruitless. This article points to one measure that can help in a specific case: a low Price/Book ratio when analysts predict a stock market crash.

First let’s define “Book” (or: Book Value) in the expression Price/Book (P/B in short). Book Value is the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated.

P/B measures how much people currently pay for the assets of the company, and can be seen as a measure of how cheap it is. When the P/B is high, the company can be viewed as expensive and when it is low, the company can be viewed as cheap. The intuition is simple: the company has a given set of assets determining its book value. For the given book value, a high P/B results from a high price, and a low P/B is the result of a low price.

Your first instinct may be to hold more stocks when their P/B is low and fewer stocks when their P/B is high. There are several problems with avoiding stocks at times of high P/B:

  1. The P/B can be high and increasing for a number of years, before reverting. Avoiding stocks could result in missing substantial gains for years. For example, 2004-2007 were 4 years with relatively high P/B for both of QAM’s stock portfolios. At that time both portfolios more than doubled. Even at the lowest month of the 2008 decline, the portfolio did not decline below the 2004 level, so even if you were perfect at buying back the portfolio at the lowest month, you would have still missed gains.
  2. When the P/B is high, it may decline gradually, more slowly than the increase in company book values. This would result in prices never declining as a result of the high P/B.

There is also a problem with over-investing in stocks (using borrowing-to-invest) at times of low P/B:

  1. A low P/B can decline for a while before reverting. This could be accompanied by a severe decline in your portfolio. While the risk declines the lower the P/B, you should always be prepared for a severe decline. This does not contradict the following: If you get/save money while your portfolio has a low P/B, it is very wise to add it.

While it is impossible to time the market simply by tracking the P/B of a portfolio, there is one case that may be helpful to note:

When there is great fear of a substantial stock market crash, and the Price/Book of your portfolio is relatively low, e.g. under 1, the likelihood of a multi-year deep decline is not unusually high.

While we do not have long-term data of Price/Book values, during the limited history available (since 1998 for QAM’s portfolios), we see that significant market declines typically started at times with high Price/Book ratios, not low ones.

This is also logical, supporting the limited statistical evidence. When the price of a company is lower than the value of its assets, you would expect the company to be appealing to the buyers of its stock. Each company is different, but for a diversified portfolio holding many different stocks in different industries, the claim is more likely to hold.

When do people fear a multi-year decline, despite a low P/B? When there is high uncertainty, and fear of a recession, stock prices tend to decline. Once in a while, the decline keeps going to the point of a low P/B. Specifically, as the price declines, if the book value does not decline at the same speed, you get a lower P/B. Many investors and analysts fail to notice or acknowledge how cheap stocks have become, and keep predicting multi-year market crashes despite the low P/B, leading them to sell stocks.

Why does this happen? Investors focus on portfolio prices, since they represent the current value of their savings. The Price/Book value is a less intuitive measure that gets neglected. When there are uncertainty and gloomy predictions, prices tend to drop. People tend to view their investments’ appeal based on these predictions, and worse, based on recent performance. The idea that a company that costs $100 one day, and $80 a month later is 20% cheaper, unless its book value also dropped, is not intuitive enough to follow.

How can we use the claim above to help your investment results? When you hear an investment professional predicting a multi-year decline, look at the P/B of your stock portfolio. If it is low, this may be a case of irrational panic. As long as you are prepared for a decline at any time (through holding bond/cash reserves, or by limiting the withdrawal rate from your stock portfolio), you have a chance of having nice returns by holding onto your investments, until the fear goes away. If you have money to add to your stock investments you may even make excess returns.

Disclosures Including Backtested Performance Data