"The greatest glory in living lies not in never falling, but in rising every time we fall." - Nelson Mandela
"Age is getting to know all the ways the world turns, so that if you cannot turn the world the way you want, you can at least get out of the way so that you won't get run over." - Miriam Makeba
I am currently visiting family in South Africa and aside from the great time it has been seeing family and friends it is also very interesting from an economic perspective. While it is never easy to make comparisons between the United States and an emerging economy the size of South Africa there are some very interesting metrics to look at.
The first is the level of debt. At 41% of GDP South Africa's debt level is relatively low in comparison to the United States whose debt level is at roughly 100% of GDP. Still the International Monetary Fund is applying pressure to South Africa to take measures to reign in the debt level The IMF said that, "in many sub-Saharan African economies, inflation control is vulnerable to food price shocks, given the importance of food in consumption baskets". This apparently is less of a problem in the United States as food is stripped out of the inflation number but the reality is very different and makes one wonder about the double standards of the IMF; one that applies to a large established economy and one that targets a small emerging economy. Certainly just as with business there is more risk lending money to a small economy but should the disparity be as large as this? When you look at Japan with a debt level of more than 200% you begin to wonder where the ceiling is for a large economy but as I have repeatedly written it can only be sustained as long as there is the perception the developed nation will be able to handle the debt.
Interest rates are also at all time lows in South Africa but at 5% they are more than five times higher than in the United States. A one year Fixed Rate Deposit in South Africa earns 5.75% while a one year CD in the United States earns 0.50%, so the rate here is over 100 times higher. If interest rates in the United States were to move anywhere close to these rates the entire economy would collapse and a very deep recession would ensue.
Demographics are also completely different with over 50% of the population in South Africa below the age of 25. In the United States 28% of the population is over 65 and the median age is 38. Furthermore the fertility rate has fallen to 1.88 in the United States which means that the population is actually shrinking. This aging population is placing enormous stress on the United States government retirement programs and in order to fund these the United States will be forced to increase the debt level. Now while South Africa has a massive advantage of a young workforce the main issue is that a huge number of these people are unskilled and unemployed. This drain on the South African GDP is being felt and is one of the reasons that the IMF is placing South Africa on a warning regarding its debt levels.
Politics is yet another area of worry for South Africa. Certainly the United States has political issues and it appears that the policies of the current government are not in line with the desired economic outcome, but at least it has political stability. South Africa, while political stability appears to be in place on the surface, there is still the threat that one of these days the ANC will scrap the constitution and rule with an iron fist and for this reason investors will always require additional return on their investment. With a lower level of political uncertainty the United States is perceived as a safer bet hence anther reason it can continue to issue billions of dollars of debt for next to no interest.
So while these are just a few data comparisons it is clear that until the global economy finds its footing the United States will be able to continue to issue debt. The question still remains as to how much they can issue before it becomes a problem. If rates were to rise to South African levels the United States debt service would balloon the budget deficit exponentially and that would make the world raise an eyebrow and demand a risk premium from the United States. While the loss of credibility seems a way off it will behoove you to pay close attention to the inflation rate as once it starts to rise watch out below.
Friday, October 25, 2013
Thursday, October 17, 2013
A Study in Retirement
"Retired is being twice tired, I've thought. First tired of working, then tired of not." - Richard Armour
"Retirement can be a great joy if you can work out how to spend time without spending money." - Author Unknown
We all want to be able to retire. The problem is that there are so many forms of retirement that it means a totally different thing to different people. To some the idea of retiring is akin to dying while to others retirement is the holy grail and should be grasped as soon as possible. One thing that we can all agree on though is regardless of whether you actually retire in the true sense of the word or not, we all want to have the financial strength so that the freedom to be able to retire is available to us. So the big question is how to get that financial strength and once you have it how do you protect it?
Well a lot of this is answered in my book How to Thrive in the Obama Economy (available on Amazon) and I do not plan to repeat it here but there are many schools of thought about how to protect your retirement and I will focus today on four strategies popular with the financial planners of the world.
The first is the Floor Leverage Rule. This strategy invests the vast majority of your investment portfolio into low risk investments and the remainder, roughly 15%, into very high risk investments such as a 3x fund. A 3x fund leverages the investment to such a degree that the returns and losses are magnified three times the underlying portfolio. So for example if you invested in a 3x S&P500 fund your returns would be three times greater than the current market returns. So in effect you would be up over 50% year to date on 15% of your portfolio. The key now comes through rebalancing as you would now allocate a large portion of the gains to the low risk portfolio bringing the whole position back into the 85:15 ratio again.
The second strategy is the 4% Rule Strategy. Using this strategy retirees set up an amount of the portfolio that they will use to fund their retirement per year. In an effort to keep spending sustainable throughout retirement the draw can be increased each year by an amount equal to or great than inflation. This of course brings in a myriad of issues such as what is the actual rate of inflation (refer to an earlier blog for an analysis of this) and what happens later in life when the portfolio is a lot smaller but you have the large medical bills associated with the elderly. In order to address this some advisers suggest drawing less in the beginning and more in the end.
The third strategy is based on behavioral finance and takes mental accounting to task in that it sets up the portfolio in buckets. Each bucket is drawn on at certain times in the retirement spectrum so for example you can start by drawing on the low risk bucket first as this allows your higher risk bucket of stocks time to mature and iron out the fluctuations. The question here is that as you get older your risk tolerance changes so you are constantly tinkering with your buckets and this can create havoc with your overall returns.
The fourth strategy is a utility strategy which takes the utility function of an additional retirement dollar and allocates a risk strategy based on this. In this strategy the basic economic principle that each additional dollar losses its utility is used. The theory goes that as you earn more money each dollar earned has less utility so that by the time you are earning $1 million a year, earning one more dollar is essentially meaningless. In this example the last dollar can be put to use in a very high risk investment as the impact of loss of this dollar is essentially nil while if it turns into another million it has a big impact.
The problem as you can tell in all of these strategies is that they are mostly based on allocations of stocks and bonds. As my book suggests this is too short sighted as the risks associated with limiting yourself to these two broad investment allocations results in a very high opportunity cost and opens you to large volatility. In addition using derivatives such as the 3x strategy will result in high slippage costs. These are the costs associated with running the fund and not tracking the index closely. In my experience the 3x funds have very high slippage and do not produce even close to the results that are expected meaning that you do not make as much as you expect when the markets run and lose more when they dive. Mental accounting is rife with problems as I do not know one person who uses this investment that is sufficiently disciplined to stick to the buckets. This type of person is constantly tinkering with the buckets either out of greed or fear and ends up under performing the market.
What is needed in my opinion is a strategy that combines the utility strategy with a broader array of investments such as hedge funds, commodities, real estate and other exotic style investments. Limiting yourself to the standard investment strategy will end up with the result that most of the population obtain and that is a sub par 2% annual compound rate of return. I am not joking the statistics show that this is the return that most retirees obtain. Looking at it that way either you should invest in Fixed Rate Deposits and earn 4% or at worst read my book but once again make sure that you take responsibility for your investment portfolio as the onus is now firmly placed on your shoulders since defined benefit plans became defunct and given the current manipulation of the markets 2% may end up looking very good!
"Retirement can be a great joy if you can work out how to spend time without spending money." - Author Unknown
We all want to be able to retire. The problem is that there are so many forms of retirement that it means a totally different thing to different people. To some the idea of retiring is akin to dying while to others retirement is the holy grail and should be grasped as soon as possible. One thing that we can all agree on though is regardless of whether you actually retire in the true sense of the word or not, we all want to have the financial strength so that the freedom to be able to retire is available to us. So the big question is how to get that financial strength and once you have it how do you protect it?
Well a lot of this is answered in my book How to Thrive in the Obama Economy (available on Amazon) and I do not plan to repeat it here but there are many schools of thought about how to protect your retirement and I will focus today on four strategies popular with the financial planners of the world.
The first is the Floor Leverage Rule. This strategy invests the vast majority of your investment portfolio into low risk investments and the remainder, roughly 15%, into very high risk investments such as a 3x fund. A 3x fund leverages the investment to such a degree that the returns and losses are magnified three times the underlying portfolio. So for example if you invested in a 3x S&P500 fund your returns would be three times greater than the current market returns. So in effect you would be up over 50% year to date on 15% of your portfolio. The key now comes through rebalancing as you would now allocate a large portion of the gains to the low risk portfolio bringing the whole position back into the 85:15 ratio again.
The second strategy is the 4% Rule Strategy. Using this strategy retirees set up an amount of the portfolio that they will use to fund their retirement per year. In an effort to keep spending sustainable throughout retirement the draw can be increased each year by an amount equal to or great than inflation. This of course brings in a myriad of issues such as what is the actual rate of inflation (refer to an earlier blog for an analysis of this) and what happens later in life when the portfolio is a lot smaller but you have the large medical bills associated with the elderly. In order to address this some advisers suggest drawing less in the beginning and more in the end.
The third strategy is based on behavioral finance and takes mental accounting to task in that it sets up the portfolio in buckets. Each bucket is drawn on at certain times in the retirement spectrum so for example you can start by drawing on the low risk bucket first as this allows your higher risk bucket of stocks time to mature and iron out the fluctuations. The question here is that as you get older your risk tolerance changes so you are constantly tinkering with your buckets and this can create havoc with your overall returns.
The fourth strategy is a utility strategy which takes the utility function of an additional retirement dollar and allocates a risk strategy based on this. In this strategy the basic economic principle that each additional dollar losses its utility is used. The theory goes that as you earn more money each dollar earned has less utility so that by the time you are earning $1 million a year, earning one more dollar is essentially meaningless. In this example the last dollar can be put to use in a very high risk investment as the impact of loss of this dollar is essentially nil while if it turns into another million it has a big impact.
The problem as you can tell in all of these strategies is that they are mostly based on allocations of stocks and bonds. As my book suggests this is too short sighted as the risks associated with limiting yourself to these two broad investment allocations results in a very high opportunity cost and opens you to large volatility. In addition using derivatives such as the 3x strategy will result in high slippage costs. These are the costs associated with running the fund and not tracking the index closely. In my experience the 3x funds have very high slippage and do not produce even close to the results that are expected meaning that you do not make as much as you expect when the markets run and lose more when they dive. Mental accounting is rife with problems as I do not know one person who uses this investment that is sufficiently disciplined to stick to the buckets. This type of person is constantly tinkering with the buckets either out of greed or fear and ends up under performing the market.
What is needed in my opinion is a strategy that combines the utility strategy with a broader array of investments such as hedge funds, commodities, real estate and other exotic style investments. Limiting yourself to the standard investment strategy will end up with the result that most of the population obtain and that is a sub par 2% annual compound rate of return. I am not joking the statistics show that this is the return that most retirees obtain. Looking at it that way either you should invest in Fixed Rate Deposits and earn 4% or at worst read my book but once again make sure that you take responsibility for your investment portfolio as the onus is now firmly placed on your shoulders since defined benefit plans became defunct and given the current manipulation of the markets 2% may end up looking very good!
Friday, October 11, 2013
The Skewness of Risk Tolerance
"The length of this document defends it well against the risk of being read." - Winston Churchill
"Only those that risk going too far can possibly find out how far one can go." - T.S. Eliot
Risk tolerance is a very interesting topic as it is embedded in the psychology of trading and investing. There are numerous studies done on the topic but what is often missed is the change in risk tolerance with the returns of the market. Investors can be placed into buckets by risk tolerance. In the first bucket are the conservative investors that never earn a large rate of return but are relatively well protected during years where the market performs poorly. In the other bucket are the high risk investors that press the envelope in an effort to beat the indices and make a large profit in a short amount of time. Now obviously each bucket has a very different risk tolerance but as a group this can swing from more risk to less.
When the market runs (as it is now) these high risk investors sway the risk tolerance of the overall group towards the high risk spectrum for the simple reason that their net worth moves up far faster than the conservative investor (not to mention that a lot of conservative investors jump across buckets as they hate to be left behind). This group therefore commands a greater portion of the market raising the overall group's risk tolerance. When a market correction occurs these investors lose far more than the conservative investor and so the group's risk tolerance retreats to a lower level when markets are down. Looking at this from the theoretical window it is easy to see the fallacy of their ways as quite clearly investors should have a higher risk tolerance after a market correction whereas in fact the opposite always occurs.
As an example look no further than Brazil where Batista the Brazilian billionaire has seen $34.5 billion wiped out in a matter of months. The reason is that in order to make $34 billion in a lifetime you have to take on enormous levels of risk. Now while most billionaires start to pare down their risk levels once they achieve levels such as these, Mr. Batista thought of himself as a superhero and continued pushing the envelope until finally everything fell apart at the seams. Worse still is that he had managed to suck in seasoned investment professionals such as Pimco, GE, Blackrock and Abu Dhabi's sovereign wealth fund to name just a few high profile investors. Shows you what a fast boat, fast cars and playboy models can do! It also shows you that often times following the supposed "smart" money is not the answer.
Looking at the market today it is clear that the risk tolerance levels are reaching very high levels. The signals are easy to spot; margin levels are at all time highs and market volatility is high while investor perception of risk is low. Margin refers to money borrowed by investors to finance additional stock purchases. Essentially the broker lends you money to add to your positions meaning that you take on ever more risk as every move in your portfolio magnifies the returns or losses. Risk perception as measured by the VIX shows a complete disdain for risk even in the face of the stalemate in congress. The reason that this fear is low is that investors after four bouts with similar congressional stalemates and debt ceiling raises have put the whole thing down to political posturing and are ignoring the seriousness of the outcome.
This is worrying from many levels but to me the market complacency is a signal that while investors believe that the outcome is inevitable (and it certainly seems like it is) if there is a change in perception another October crash could be in the works.
"Only those that risk going too far can possibly find out how far one can go." - T.S. Eliot
Risk tolerance is a very interesting topic as it is embedded in the psychology of trading and investing. There are numerous studies done on the topic but what is often missed is the change in risk tolerance with the returns of the market. Investors can be placed into buckets by risk tolerance. In the first bucket are the conservative investors that never earn a large rate of return but are relatively well protected during years where the market performs poorly. In the other bucket are the high risk investors that press the envelope in an effort to beat the indices and make a large profit in a short amount of time. Now obviously each bucket has a very different risk tolerance but as a group this can swing from more risk to less.
When the market runs (as it is now) these high risk investors sway the risk tolerance of the overall group towards the high risk spectrum for the simple reason that their net worth moves up far faster than the conservative investor (not to mention that a lot of conservative investors jump across buckets as they hate to be left behind). This group therefore commands a greater portion of the market raising the overall group's risk tolerance. When a market correction occurs these investors lose far more than the conservative investor and so the group's risk tolerance retreats to a lower level when markets are down. Looking at this from the theoretical window it is easy to see the fallacy of their ways as quite clearly investors should have a higher risk tolerance after a market correction whereas in fact the opposite always occurs.
As an example look no further than Brazil where Batista the Brazilian billionaire has seen $34.5 billion wiped out in a matter of months. The reason is that in order to make $34 billion in a lifetime you have to take on enormous levels of risk. Now while most billionaires start to pare down their risk levels once they achieve levels such as these, Mr. Batista thought of himself as a superhero and continued pushing the envelope until finally everything fell apart at the seams. Worse still is that he had managed to suck in seasoned investment professionals such as Pimco, GE, Blackrock and Abu Dhabi's sovereign wealth fund to name just a few high profile investors. Shows you what a fast boat, fast cars and playboy models can do! It also shows you that often times following the supposed "smart" money is not the answer.
Looking at the market today it is clear that the risk tolerance levels are reaching very high levels. The signals are easy to spot; margin levels are at all time highs and market volatility is high while investor perception of risk is low. Margin refers to money borrowed by investors to finance additional stock purchases. Essentially the broker lends you money to add to your positions meaning that you take on ever more risk as every move in your portfolio magnifies the returns or losses. Risk perception as measured by the VIX shows a complete disdain for risk even in the face of the stalemate in congress. The reason that this fear is low is that investors after four bouts with similar congressional stalemates and debt ceiling raises have put the whole thing down to political posturing and are ignoring the seriousness of the outcome.
This is worrying from many levels but to me the market complacency is a signal that while investors believe that the outcome is inevitable (and it certainly seems like it is) if there is a change in perception another October crash could be in the works.
Friday, October 4, 2013
Fiyon!
"Too infinity and beyond." - Buzz Lightyear a character in the Disney movie Toy Story
When my son was only 3 he loved the movie Toy Story. One of the lead characters was a space ranger named Buzz Lightyear. My son loved him and used to stand on the edge of the couch, hold out his arms like wings and as he would jump off the couch to fly like Buzz he would say the word Fiyon! This was his way of saying "Too infinity and beyond". Needless to say he never flew and neither did Buzz in fact when Buzz tried to prove he could fly he was fortunate in that he bounced on a ball and then hooked on the ceiling fan giving the impression of flying. His friend Woodie, exasperated says, "That wasn't flying, that was falling with style!"
Recently I watched a show about the concept of infinity. It was fascinating in that most of us while we understand that infinity is forever have no real concept of the actual term. Think about it for a second. Infinity - forever, hard to imagine. How can something go on forever? The idea is that the universe is forever but that is hard to believe, how can it go on forever? But the problem is, if it is finite then what is outside of the universe? Going even deeper, if you grasp the concept of infinity then there must be an infinite amount of infinities and therefore there must be an infinite amount of worlds and people and an infinite amount of you scattered around the universe. Pretty crazy stuff but the reality is that once you believe in infinity then anything that can happen is happening somewhere in the universe.
So bringing this concept back to the markets opens a plethora of possibilities. For this reason there is no reason to believe that the market can be supported by the Federal Reserve forever (as it appears some people believe). On the flip of that there is no reason to believe that the market will die tomorrow. Low interest rates could be with us for a far longer time than anyone could even imagine, driving stocks higher than anyone dares predict.
Now one thing that you can guarantee is that the market will crash. It has on numerous occasions and it will again. The question that traders try to predict is when? With the markets at precarious levels and the indexes being driven higher by the speculative stocks and momentum rather than value it appears that this could happen at any minute but that is just it, it could also keep churning higher for a few more years. It appears that the Federal Reserve will be lead by Janet Yellen next year and that means more printing not less. So with continued stimulus the market could continue unabated for the foreseeable future. The question is do you want to place a bet on this or not and my answer, as I detail in my book How to Thrive in the Obama Economy, is that this is not the time to try to fly as unlike Buzz you may not fall with style and that risk far outweighs the potential rewards. Find other avenues for your investments and stay out of the madness that is the stock market.
When my son was only 3 he loved the movie Toy Story. One of the lead characters was a space ranger named Buzz Lightyear. My son loved him and used to stand on the edge of the couch, hold out his arms like wings and as he would jump off the couch to fly like Buzz he would say the word Fiyon! This was his way of saying "Too infinity and beyond". Needless to say he never flew and neither did Buzz in fact when Buzz tried to prove he could fly he was fortunate in that he bounced on a ball and then hooked on the ceiling fan giving the impression of flying. His friend Woodie, exasperated says, "That wasn't flying, that was falling with style!"
Recently I watched a show about the concept of infinity. It was fascinating in that most of us while we understand that infinity is forever have no real concept of the actual term. Think about it for a second. Infinity - forever, hard to imagine. How can something go on forever? The idea is that the universe is forever but that is hard to believe, how can it go on forever? But the problem is, if it is finite then what is outside of the universe? Going even deeper, if you grasp the concept of infinity then there must be an infinite amount of infinities and therefore there must be an infinite amount of worlds and people and an infinite amount of you scattered around the universe. Pretty crazy stuff but the reality is that once you believe in infinity then anything that can happen is happening somewhere in the universe.
So bringing this concept back to the markets opens a plethora of possibilities. For this reason there is no reason to believe that the market can be supported by the Federal Reserve forever (as it appears some people believe). On the flip of that there is no reason to believe that the market will die tomorrow. Low interest rates could be with us for a far longer time than anyone could even imagine, driving stocks higher than anyone dares predict.
Now one thing that you can guarantee is that the market will crash. It has on numerous occasions and it will again. The question that traders try to predict is when? With the markets at precarious levels and the indexes being driven higher by the speculative stocks and momentum rather than value it appears that this could happen at any minute but that is just it, it could also keep churning higher for a few more years. It appears that the Federal Reserve will be lead by Janet Yellen next year and that means more printing not less. So with continued stimulus the market could continue unabated for the foreseeable future. The question is do you want to place a bet on this or not and my answer, as I detail in my book How to Thrive in the Obama Economy, is that this is not the time to try to fly as unlike Buzz you may not fall with style and that risk far outweighs the potential rewards. Find other avenues for your investments and stay out of the madness that is the stock market.
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