Enlightened Financial Planning

The Bears Invade Shanghai      July 30th, 2015

With all eyes on Greece, a bigger and potentially more disturbing market disruption is taking place—in a much larger economy.  As you read this, the Chinese stock market is experiencing the kind of free-fall not seen since the 2008 drop in global markets.  Some are comparing it to the 1929 crash in U.S. stocks.


As you can see from the chart, the fall has been fairly dramatic, even if it has not yet taken share prices on the Shanghai Composite Index below where they were previous to a perilous bull run that began in February.  The fall has apparently alarmed the Chinese government, which has authorized extraordinary interventions.  Among them: twenty one Chinese brokerage firms have agreed to invest the equivalent of $19 billion in stocks, in an effort to create more demand.  The stock exchanges suspended initial public offerings so as not to put any more shares on the market.  The Chinese central bank has cut its benchmark lending and interest rate.  And the government itself, through its pension system, has now been authorized to play the market.


Perhaps the most ominous intervention, however, came when China’s market regulator decided that brokers should not force people who have bought stocks on margin to engage in forced selling in order to cover their debts. Instead, the brokers were told to extend additional margin loans that would be collateralized by investors’ homes. If the market continues to plunge, observers wonder, how will investors (or banks) liquidate those houses? Is it wise to spread the risk from the stock sector to real estate valuations?


The brokerage pledge to buy shares is reminiscent of 1929 Wall Street, when the great banking houses of J.P. Morgan and Guarantee Trust Company committed their resources to propping up the U.S. stock market.  That experiment was not a notable success; the Dow Jones Industrial Average fell 13% the following Monday and dropped another 34% over the next three weeks.  The Chinese intervention fund, led by Citic Securities Co. and Guotai Junan Securities Co., faces a similar uphill battle; the war chest represents only one-fifth of the Chinese market’s daily trading volume.


So far, Chinese investors have lost $2.7 trillion of stock value—the equivalent of six times Greece’s entire foreign debt.  Much of the pain has been borne by individuals, who own four-fifths of China’s stocks, far more than in Western markets where institutional investors are the dominant owners.  Many of these common folk borrowed money to buy their shares, contributing to a nine-fold increase in margin lending by brokerage firms over the past two years.  This dramatic rise in speculative investing has echoes both in the run up to 1929 and 2008, two periods when reckless betters (individuals in the earlier era, Wall Street in the latter) were able to borrow 90% of the money they “invested.”


Moreover, the margin loans carry annual interest rates as high as 20%.  Total margin debt, when you add up the brokerage firms, banks and informal loans, could amount to as much as $1 trillion.  As share prices fall, investors would be left with far less in stock value than the high-interest loans they owe—making repayment problematic, potentially putting $1 trillion worth of stress on the Chinese banking system.


It gets worse. Many smaller Chinese companies have financed their expansion by taking out loans against the value of their shares.  The companies have had to post additional collateral as the share value dropped down to the outstanding balance on the loan.  Additional market losses could put these companies in real danger of default, adding to the stress.


Nobody knows if the free-fall will continue to feed on itself, or if the government will somehow manage to slow the descent.  But highly-leveraged investing on a mass scale seldom ends well, as most of us remember from the subprime crisis when we had to reach into our pockets to make Wall Street whole again on its disastrous speculations.


Fortunately, none of this is likely to directly affect the portfolios of American investors, since foreigners account for only about 4% of the Chinese stock market.  But as the crisis deepens, and especially if the defaults start to mount, companies go under and the banks stop lending into the economy, you could see commodity prices fall on weaker demand, and there could be a hit to large American companies that do a lot of business in the Asian markets.  And it could be a long time before individual Chinese investors trust the stock market again.


By Bob Veres, publisher of Inside Information - the premier publication of financial industry trends and information for leading practitioners in the financial planning profession



Malware Protection      June 10th, 2015

Do you really need antivirus software on your home computers?   Yes.  The Internet is increasingly awash with creative malware that can severely damage your computer, destroy your files, and embed themselves quietly in your operating system, sending information that can be used by identity theft thieves, or allow hackers to turn your computer into a spam machine.

Antivirus software companies monitor the Web in real time.  They are constantly identifying new strains of malware and providing updates to their software that will look for the “symptoms” of every known virus, isolate it and allow you to remove it before it has a chance to damage your files, send compromising information or invite your friends and neighbors to purchase online porn.

Top10AntiVirusSoftware.com has just released its 2015 list of the most effective programs for preventing worms, trojan horses, viruses or malware from installing themselves on your computer.  The top-rated industry leader was McAffee Software, which can be purchased for $24.99 a year.  Other top-rated programs include Kaspersky ($29.99), BullGuard ($23.96), BitDefender ($19.95), Norton Antivirus ($59.99), AVG ($31.99) and ESET ($19.99).  (You can buy any of the programs at a discount at www.top10antivirussoftware.com/)

Understand that like all things in the software world, the best program in 2015 may not be the top-rated the following year.  And most importantly, recognize that you need to constantly respond to the free upgrades to your software, because some of the most creative programmers in the world are constantly plotting against you and your security.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.


The Other Dimension of Risk      May 28th, 2015

When it comes to investing in the stock market, the risk that everybody talks about is the ups and particularly the downs, the bearish periods when the market falls dramatically and keeps falling for months or even years. (Think: 2000-2002 or 2008)

The real damage isn’t the fall itself, but the fact that many investors watch the ongoing free-fall with increasing horror until they can’t stand the pain any more, sell out of the market at or near the bottom, and then lick their wounds on the sidelines and miss the recovery.  Over the course of this round trip, they lose real money, while those who had the fortitude to hang on recovered their losses.

Recently, professional advisors have begun talking about a different dimension of risk, which is just as insidious, just as potentially damaging to the wealth of their clients, but much-less-widely discussed. It’s called “frame-of-reference” risk.

Frame-of-reference risk can be defined as the risk that people will look at the performance statement of their diversified investment portfolio and notice that its return is falling short (sometimes far short) of the market index they’re most familiar with— typically the Dow or the S&P 500.  They abandon the diversified investment approach and concentrate their holdings in the local market right as the other investments they sold are about to take the performance lead.

To see why this is a risk at all, consider the bull market in tech stocks in the late 1990s.

The rate of return in the late 1990s and early 2000s of U.S. stocks compared with an ABCD portfolio consisting of equal parts U.S. stocks, foreign stocks, commodity-linked equities and real estate investment trusts—a diversified mix of risk assets, rebalanced each year.

In 1995, the diversified portfolio got walloped by the U.S. market—a difference of more than 16 percentage points.  In 1997 and 1998, the differences were even more pronounced: almost 23% and just under 30%.  This was a time when many investors were telling their advisors that the rules of investing had changed, that technology, clicks and eyeballs were the new standard by which stock values should be measured.

If they abandoned their diversified ABCD strategy at or near the bottom, in late 1999, these investors would have been concentrated in U.S. stocks in 2000, when the diversified approach beat the U.S. market by more than 22 percentage points.  They would have missed the great return of a diversified portfolio in 2002, when it outperformed U.S. stocks by 21%.  The next three years also saw the diversified portfolio beat a concentrated U.S. stock holding, as commodities, real estate and foreign stocks delivered solid returns.

The advantages of buy and hold are relatively straightforward—even if they’re not easy to appreciate during a market downturn.  But what, exactly, are the advantages of hanging onto a diversified portfolio?

One answer lies in the mathematics of returns.  Gains and losses are not symmetrical, and the differences becomes greater with magnitude.  A loss of 10% requires a modest 11% gain to get back to the original portfolio value.  But a 20% loss requires a 25% gain, a 30% loss doesn’t recover until the portfolio has achieved a subsequent 43% gain and a 50% loss doesn’t get back to even until the battered portfolio gone up 100%.

When a portfolio holds different asset classes, which move up or down out of sequence with each other (which, in the vernacular, are “not highly-correlated”), it tends to smooth out yearly investment performance.  Portfolios that deliver smoother returns don’t have to experience extreme recovery to stay in positive territory.  As a result, they will have higher terminal values than choppier portfolios, even if the average yearly return is the same.

Another answer lies in the idea of reversion to the mean.  When one asset class (like U.S. stocks) is soaring, and everything else is lagging, that means the soaring asset class is getting relatively more expensive than the others.  Eventually, prices will return to normal in both directions, and the other investments will have their day in the sun.  So when someone abandons a diversified investment approach after years of underperformance, she loses twice.  She has already paid the “penalty” (so to speak) for being diversified when diversified was losing to U.S. stocks.  Then, when she goes all-in on U.S. stocks, she loses the “benefits” that eventually follow when those other asset classes go up faster than the Dow.  The late 1990s and early 2000s were a perfect example of this.

This can be summed up neatly by looking back at the investor’s dilemma during the tech bubble.  People who held a diversified mix of the four asset classes—U.S. stocks, foreign stocks, commodity-linked investments and real estate—enjoyed a 13.05% average yearly return from 1994 through 1999.  They achieved a 9.96% return in the subsequent five years, from 2000 through 2005.

Were they happier with their higher return in the first five years?  No.  They were firing their advisors, because the U.S. stock market happened to be gaining 23.55% a year, and they felt like losers.  Were they unhappy with the lower 9.96% yearly returns the diversified portfolio delivered in the subsequent five years?  No; in fact, they were ecstatic, because their portfolios were outperforming at a time when the U.S. market was losing value.

Of course, many investors today are facing this frame-of-reference risk head-on.  The U.S. market has been booming since the bottoming out in March of 2009, while the rest of the world has been mired in a recessionary hangover.  Commodities—most notably oil, but also gold—have been retreating lately.  Real estate had a bad stretch after the Great Recession.  It’s easy to question the value of those other assets in a portfolio with the benefit of hindsight.  But with the benefit of historical perspective, the underperformance of broad asset classes usually reverses itself, and we never know exactly when that will happen.

At times like we are experiencing today, when the U.S. markets are enjoying a long uninterrupted run of good fortune, frame-of-reference risk starts to come out of the closet and threaten your financial health.  All we know about frame-of-reference risk is that, just like the more well-known volatility risks, it lures investors to abandon their longterm strategy at the wrong time—and when people give in to it, it becomes a net destroyer of wealth.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.



Will Social Security Be There When I Retire?      May 5th, 2015

Social Security’s future solvency has become one of the most commonly-discussed issues in retirement planning—and for good reason.  Gallup polls show that an estimated 57% of retirees rely on Social Security as a major source of retirement income—a number that has held steady since the early 2000s.  But when Generation X and Y individuals plan for their future retirement, they’ll often ask their advisor to assume that Social Security won’t be there for them 20 or 30 years down the road.

However, if you look closely at the numbers, you see a very different story.  Up until 2011, the Social Security system actually collected more revenues from workers’ FICA payments than it paid out—and that has been generally true since the 1940s.  Most of the Social Security benefits that people receive today are simply a transfer; that is, the money is collected from worker paychecks (and, of course, employer matches), spends a few days at the U.S. Treasury and then is paid out to recipients.  The surplus has been used to pay government operating expenses, and for seven decades, the government issued “special issue federal securities” (essentially fancy IOUs that pay interest) to the Social Security trust fund.

In 2011, the program crossed that threshold where benefit payments slightly exceeded the amount collected.  Why?   Because the number of beneficiaries, compared to the number of workers, has steadily increased.  In 1955, there were more than eight workers paying into Social Security for every beneficiary. Today, that number is closer to three workers for every beneficiary, and by 2031, if current estimates are correct, that ratio will fall to just over two workers supporting every retired beneficiary.

When Social Security Administration actuaries crunch the numbers, they have to take into account the shifting demographics, and then make estimates of fertility and immigration rates, longevity, labor force participation rates, the growth of real wages and growth of the economy every year between now and 2078.  After adding in the value of the government IOUs, they estimate that if nothing is done to fix the system, the trust fund IOUs will run out in the year 2033.  At that time, only the FICA money collected from workers would be available to pay Social Security beneficiaries.  In real terms, that means the beneficiaries would, in 2034, see their payments drop to 77% of what they were promised.

In other words, the money being transferred from current workers to beneficiaries through the FICA payroll program, assuming no course corrections between now and 2033, will be enough to pay retirees 77% of the benefits they were otherwise expecting.

The government actuaries say that if nothing is done to fix the problem over the next 63 years, this percentage will gradually decline to 72% by the year 2078.

So the first takeaway from these analyses is that today’s workers are looking at a worstcase scenario of only receiving about 75% of the benefits that they would otherwise have expected to receive.  This is far different from the zero figure that they’re asking their advisors to use in retirement projections.

How likely is it that there will be no course corrections?  There are two possible ways that this 75% figure could go up.  One lies in the assumptions themselves.  The Social Security Administration actuaries have tended to err on the side of conservatism, presumably because they would rather be pleasantly surprised than discover that they were too optimistic.  But what if the future doesn’t look as gloomy as their assumptions make it out to be?

To take just one of the variables, the actuaries are projecting that labor force participation rates for men will fall from 75.5% of the population in 1997 to 74% by 2075, while the growth in female workers will stop their long climb and peter out around 60%.  If male labor force participation rates don’t fall, and if female rates continue to rise, some of the funding gap will be eliminated.

Similarly, the projections assume the U.S. economy’s productivity gains (which drive wage increases) will grow 1.3% a year, well below long-term U.S. averages and certainly below the assumptions of economists who believe that biotech and information age revolutions will spur unprecedented growth.  If real wages were to grow at something closer to the post-Great Recession rate of 2% a year, then more than half of the funding gap would be eliminated.  If the current slump in immigration (due to tighter immigration policies) is reversed, and the economy grows faster than the anemic 2% rates the Social Security Administration is projecting (compared to 2.5% recently), then the “bankrupt” system begins to look surprisingly solvent.

A second possibility is that Congress will tweak the numbers and bring Social Security’s long-term finances back in balance, as it has done 21 times since the program originated in 1937.  The financial press often cites the fact that the total future Social Security funding shortfall amounts to $13.6 trillion, but they seldom add that this represents just 3.5% of future taxable payrolls through 2081.  Small tweaks—like extending the age to collect full retirement benefits from 67 to 68, raising the FICA tax rate by 3.5 percentage points or making the current 12.4% rate (employee plus employer match) apply to all taxable income rather than the $118,500 current limit— would restore solvency far enough into the future that today’s workers would be comfortable adding back 100% of their anticipated benefits into their retirement projections.

How likely is it that Congress will take these measures, in light of recent partisan budget battles?  It’s helpful to remember that older Americans tend to vote with more consistency than younger citizens.  The more you’ve paid into the system, the more you expect to at least get back the money you were promised.

The bottom line here is that if you’re skeptical about Social Security’s future solvency, then you should pencil in 75% of the benefits you would otherwise expect—rather than $0.  Meanwhile, as you approach the age when you’re eligible for benefits, watch for signs that immigration restrictions are loosening, the economy is growing faster than the SSA actuaries’ gloomy projections, more people are working during traditional retirement years or yet another round of tweaks from our elected representatives.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.


How to Make Good on Your Best Intentions      April 28th, 2015

Among many other things, your U.S. government keeps track of the most popular New Year’s resolutions (you can find them here: http://www.usa.gov/Citizen/Topics/New-Years-Resolutions.shtml), and the list is about what you’d expect.  At the top of the list is “lose weight,” followed by, in order of popularity:

Volunteer to help others

Quit smoking

Get a better education

Get a better job

Save money

Get fit

Eat healthy food

The Journal of Clinical Psychology, using a slightly different methodology, also found that “losing weight” was the number one resolution, followed by “getting organized” and “spend less, save more.”

But here’s the interesting part: the Journal found that just 8% of people are successful in achieving one or more of their resolutions in any given year, and 24% of us never succeed in achieving any of our resolutions year after year after year.

Why the high failure rate?  Using MRI technology, brain scientists Antonio Damasio and Joseph LeDoux studied what they called habitual behavior—that is, neural pathways and memories that become the default basis for our responses whenever we’re faced with a choice or decision.  These defaults, they found, are very difficult to change, and actually can be strengthened by efforts to “not do” things that feel natural or have been longstanding habits.

The lesson: Real change—actually succeeding in our resolutions—requires us to carve out new neural pathways.  We need to rewire our brains.

How?  Ray Williams, author of “Breaking Bad Habits,” offers a few suggestions that could dramatically raise your odds of success when it comes to resolutions.  First, he says, make your resolution specific and realistic.  Instead of resolving to “lose weight,” set a goal to lose 10 pounds in 90 days.  Then create a daily strategy for making that happen, taking small positive steps rather than expecting a big change to come over you all at once.  Many people quit their resolutions because the goals are too big and require steps that are too large—all at once.

Of course, you still have to actually take those individual steps, and it’s easy for them to get lost in the background noise of your daily life.  Williams recommends that if you’re truly serious about sticking to your resolutions, recruit an “accountability buddy” who you will have to report to on a regular basis.  You’ll find a way to get your resolutions on your own personal priority list, and do these things for someone else because you don’t want to admit that you failed to take the steps you promised to do.

It may also help to keep the goals in front of you—on your computer screen or tacked up in a place where you can see them.  This will remind you to ask yourself: what’s the one thing I can do today, right now, towards my goal?

Don’t give up when you slip—and you will. Simply continue working at your goal.

And finally: Recognize that creating new neural pathways in your brain is hard work—far more work than simply writing down a resolution.  Remember the failure rate, and gird yourself accordingly.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession