Inflation has increased this year, but there is a silver lining: Most taxpayers can count on getting at least a small dose of relief for 2012.

Each year, the standard deduction, federal income-tax brackets and many other tax numbers are adjusted to reflect inflation.

“Indexing for inflation has become an established part of our tax system, and it’s likely to be a part of the tax law for the foreseeable future—even as Congress debates changes to the tax rates themselves,” says George Jones, senior federal tax analyst at CCH Inc.

How much relief depends on details of the taxpayer’s return.

Even so, Mr. Jones says inflation adjustments mean that a hypothetical married couple filing jointly with a total taxable income of $100,000 “should pay $190 less income taxes in 2012 than they will on the same income for 2011 because of indexing of their tax bracket for 2012.”

A single filer with taxable income of $50,000 “should owe $95 less next year due to the adjustments to the income-tax rate brackets between 2011 and 2012,” he says.

Among the changes as announced recently by the Internal Revenue Service:

• The standard deduction, which is claimed by nearly two-thirds of all taxpayers each year, will increase. For a single individual, the basic standard deduction amount for 2012 will rise to $5,950 from $5,800 this year. For married couples, it will rise to $11,900 from $11,600. There are additional amounts for those who are 65 or over, blind or both.

• The personal-exemption amount will increase to $3,800 from $3,700.

• The annual gift-tax exclusion will stay unchanged at $13,000 next year. This refers to the amount you can give away to anyone you wish—and as many other people as you want —without any tax considerations. For more details, see the IRS website.

EXTENSION: For most taxpayers who got six-month filing extensions earlier this year, the deadline was Oct. 17. But the Internal Revenue Service postponed the filing deadline until Oct. 31 for certain taxpayers affected by Hurricane Irene and other natural disasters.

For information, go to the IRS website.

Send your questions to us at askdowjones.sunday03@wsj.com and include your name, address and telephone number. Questions may be edited; we regret that we cannot answer every letter.

Article source: Wall Street Journal

 

Inflation is typically a hot-button political topic, but it is important to note that the ‘real’ rate of inflation is different for everybody.  The reason for this is because all products & services do not rise & fall in price equally, and people all purchase products and services in different proportions. Most people pay attention to the published consumer price index, which is based on a defined “basket” of goods and services.  This basket is intended to represent an “average” urban consumer, but is not necessarily representative of everybody.

Generally speaking, commodity products (Bricks & Sticks) such as oil, gold, food, and building materials tend to rise in price over time.  Generally speaking, monetary inflation impacts commodities first.  The reason for this is because commodities are purchased in large amounts with cash on a regular basis.  This means that as more cash moves through the economy, the first place it typically lands to drive up prices is commodities.  Over the long-term his price rise tends to be linear, unless a market bubble temporarily pushes prices up or crashes down prices.

Conversely, technology products (Bits & Bytes) such as computers, cell phones, televisions, smartphones, etc tend to decrease in price over time for a relative level of technological performance.  Another way this phenomenon manifests itself is when new technology products are introduced at the same price as the prior generation, but with more features or better performance.  In this case, the price per unit of performance is decreasing even though the total price may be staying the same.  The dramatic price declines of technology are a primary driver new business models that consistently emerge, based on new digital economics.  Consumers benefit greatly from the technology curve, since it allows them to consistently buy things that are better for the same amount of money or less.

The average level of market inflation is based on a presumed mix of commodity products that are increasing in price and technology products that are decreasing in price.  (This average is publicly reported through the Consumer Price Index, which has a fair number of its own quirks concerning how inflation is comprehended)  The way that this phenomenon translates into our life is that the level of inflation we personally experience depends on our pattern of consumption between commodity and technology products.  By and large, a person is more susceptible to inflation when the relative amount of commodity products they consume is higher.

In this way, inflation typically impacts people of lower incomes the most significantly.  The way that this happens is by inflating the cost of commodities such as housing, food and energy.  Since people of limited means typically spend a larger portion of their income on housing, food, and energy it means that they feel the effect of inflation much more sharply.  Conversely, people who spend a lower portion of their income on housing, food, and energy are less directly impacted by inflation since their personal basket of consumption is weighted more toward technology products that naturally deflate.

Since individual people don’t have the ability to affect market prices, it is not possible to change the level of market inflation.  However, since each of us has the power to choose how we consume products & services, we DO have the power to change the level of our personal inflation.  When oil prices increase, we have the ability to carpool, purchase a more fuel efficient car, move closer to work, or use public transportation.  Conversely, we can also choose to shift more of our purchase decisions toward products and services that benefit from advances in technology.  These types of changes are not always desirable, but they do give us power to influence the impact of inflation on our lives.

In this way there is a personal rate of inflation for both me and you that we can influence at the margins.  In the torrid journey of life, it is easy to become upset about inflationary government policies that push-up prices.  And in many cases, this anger is well founded.  However, it is not something that any of us have the power to directly change.  Each of us only have the power to change the decisions that we make as individuals.  In that way, the most important change to make is one that changes your personal situation and the situation of your family.

 

One of the ideas that has become quite pervasive within the minds of investors is the notion of a “good stock” or a “good property” to own.  This notion stems from a general desire on the part of most people to own things of quality.  In our personal life, this frequently manifests itself as a desire to own a comfortable home, and a reliable automobile.  Quality gives us a feeling of safety and security.  Thus, it seems completely natural to want our investments to be the stock of a high quality company, the bonds of a high quality corporation of government, or a property that is desirable in both its quality of construction and location.  The problem with this view is that it only provides one half of the information that you need to determine whether an investment is a good deal.

The second half of this investing puzzle is price.  Put bluntly, the quality of a stock, bond, or property investment only matters in relation to its price.  This means that a ram shackled, blighted property can be a phenomenal deal at a certain price.  The stock of media darling companies such as Apple, Google, and Amazon can all be terrible investments at a certain price.  It is certainly true that high-quality investments can frequently justify a higher price than lower quality investments.  However, it is equally true that any investment can be a spectacular deal if the price is right.

The key for investors is to determine when the price of a high-quality stock, bond, or property is over-valued, or conversely when the price of a lower quality stock, bond, or property is under-valued.  Any investment is a good deal at one price, and a poor deal at a different price.  Unfortunately, it is frequently very difficult to determine exactly where these two boundaries are drawn for any particular investment.

When estimating the appropriate price for a particular investment, there are two relevant factors that need to be considered.  The first is the expected future price, the second is expected future cash flow, and the third is taxes and inflation.  When combined, they will create a holistic picture of the value for any particular investment.

Expected Future Price

• In the world of stock and real estate investing, this is referred to as appreciation.  Fundamentally, it represents the expectation that the future price of an investment will be higher than the price you paid to purchase it.  This is frequently referred to as the ‘buy low, sell high’ philosophy.  For most investors, this is the primary source of value that they see.  Stock market tickers report the price of securities, and the Multiple Listing Service reports the price of properties.
• However, the ubiquitous availability of price information frequently causes people to over-emphasize price appreciation as a source of value.  It is most certain that price appreciation is an important source of value for investments, but it is certainly not the only value vector.  The fact that so many people focus on market prices has made them become very volatile over the past few years.  Values for stocks, bonds, and real estate have all fluctuated significantly.  This has made future price appreciation very difficult to predict.
• In addition to all of this, there is one further characteristic of price that investors must take into consideration.  In order to capture the benefit of price appreciation, you must sell the investment.  This means that watching the value of your stocks or real estate skyrocket means absolutely nothing unless you sell and lock-in the gain.  Thus, in order to realize the full gains from future price appreciation, it means that you must sell at the right time.  In practice, this is very difficult to do and frequently results in selling while values are still going up.

Expected Future Cash Flow

• Another key characteristic of what makes a good vs. bad deal for investors is the cash flow that is produced.  In the case of stocks, this comes from dividends.  In the case of bonds, this comes from interest payments and the future return of the bond face amount.  In the case of real estate, this comes from rents that are paid by tenants for the use of your property.  The importance of cash flow to the value of an investment is that it represents a current, tangible return.  Typically, investments that produce the best cash flow don’t always have the best appreciation.  However, they also tend to be less volatile since the price tends to be more highly correlated with the rate of cash generation than the market expectations for future price increases.
• The way that most investors articulate the future cash flow of an investment is through its yield.  In simple terms, the yield of an investment represents its annual cash flow divided by the price paid for the asset.  In the case of stocks, the “dividend yield” is the annual dividends divided by the current market price.  In the case of rental real estate, the “capitalization rate” is calculated by dividing the annual net operating income of the property by the purchase price.  In the case of bonds, the discounted future value of all payments is compressed into an internal rate of return, which is articulated as the bond yield.
• In most cases, the rate of cash generation for an investment is much less volatile than the market price of that investment.  Stocks that pay dividends tend to adjust their dividend rate at a much slower rate than the market value gyrations of its price.  Rents from income properties tend to shift much more slowly than the value of the property.  Bonds typically feature a fixed interest and repayment price, with their market value being determined by the movement in yield rates for similar instruments.  When market yields increase, the price of bonds currently on the market go down.  When market yields decrease, the price of bonds currently on the market go up.

Taxes and Inflation

• The final key characteristic that differentiates good vs. bad investments is inflation and taxes.  Inflation represents the erosion of you investment’s purchasing power and taxes represent the amount of your gains that need to be paid to the government.  One of the oldest and most important concepts in finance is that “It’s not what you make, it’s what you keep” … fundamentally, this means that the “real” rate of return for your investments is much more important than the “nominal” performance.
• Starting with inflation, it is important to understand that when the amount of money in circulation expands more quickly than the amount of goods and services being traded, it creates upward pressure on prices.  For some asset classes, the effect of inflation is relatively benign, for others it is beneficial, and for some it is devastating.  By and large, property values tend to be lifted in proportion with inflation, while cash flows from dividends and rents are also increased by inflation.  Some stocks move up with inflation, but certainly not all.  On the other hand, bonds with a fixed interest rate are destroyed by inflation since it de-values the interest payments.  Conversely, fixed-rate debt that you owe is wiped away by inflation as the dollars you use to re-pay the loan become less valuable.
• Another key characteristic to understand is taxes.  Different types of income are subject to different rates of taxation.  Generally speaking, income that is earned from a job encounters the most taxes.  Income that is earned passively encounters less taxes, and income earned from capital investment encounters the least taxes.  Astute investors also understand the impact of legitimate business deductions, non-cash expenses such as depreciation, and deferring capital gains through a 1031 exchange to reduce their tax burden down to the legal minimum.  In many cases, it is tax advantages that turn a good investment into a great investment.

Ultimately, it is the responsibility of each person to determine what constitutes a superior investment deal.  Since people have different appetites for risk, there will always be a variety of investors bidding for a variety of assets.  What is most important for the individual investor to do is take an honest assessment of their personal investment tolerance and make decisions that incorporate all of the major value factors.  By balancing the future price, future cash flow, inflation risk, and tax characteristics, it will allow you to build a strong portfolio of optimized deals.

 

In a press release from the Federal Open Market Committee released on September 21 indicates that by June of 2012, the Federal Reserve is going to simultaneously sell $400B worth of shorter-term securities and purchase $400B of longer-term securities.  Some refer to this decision as “operation twist.” The expected effect of this maneuver will be to place downward pressure on longer-term interest rates.  The Federal Reserve is expecting that the average maturity of bonds in their portfolio will rise from 75 months currently to approximately 100 months by the end of 2012.

The extended impact of this decision will be felt through the economy for many years to come, so it is critically important to understand exactly what the decision really means.  Since the active part of “operation twist” will spur a second-level effect, we are prefer to think of it as a “double twist.” Specifically, we expect for there to be two stages in the double-twist.  The first will be when the systematic shift toward longer-term treasuries in the Fed portfolio takes place, and the second will be when past monetary expansions roll through in the form of continued, persistent price inflation.

Double-Twist: Stage 1

The first part of the double-twist is what has already been communicated by the Federal Reserve.  Specifically, the simultaneous purchase of longer-term treasuries and mortgage backed securities while shorter-term securities of the same type are being sold.  The Federal Reserve is estimating that market uncertainty over the global economy will keep short-term capital in US treasuries for a significant period of time, and that selling their short-term treasuries will have a minimal impact on short-term interest rates. When this initiative was announced, it did very little to calm jittery markets, and key indexes continued their downward trajectory.  It is most likely that the reason for this is because market concern is not in regards to the price of credit, but rather in regard to the fiscal problems of the United States government that are not on any meaningful path to resolution.

The government is currently spending approximately $1.5 Trillion dollars more per year than is collected in revenue.  All of this additional debt is either purchased by the Federal Reserve or must be floated out on the open market. To date, the Federal Reserve has purchased a massive amount of US government debt, which has had an inflationary effect on prices for goods and services.  The reason for this is because when the Federal Reserves buys Treasuries from the open market, it pays for them with a credit to the bank’s reserve deposits.  This ultimately means that the net amount of money in circulation increases.  Furthermore, the banks who just sold their bonds to the Fed can now loan out the money they just received at a 10 to one ratio.  Thus, large purchases by the Federal Reserve have the ability to create large amounts of inflation very quickly as the amount of money in circulation grows faster than the amount of goods and services in the economy.

Double-Twist: Stage 2

Now comes the second act of operation Twist, which we contend turns it into a double-twist.  As the Federal Reserve actively works to suppress the interest rate of longer-term securities, it is effectively locking in long-term monetary inflation and negative real interest rates.  This is resulting because the Fed is printing money to subsidize low interest rates while that new money floods into the economy, pushing up prices.

By reducing the amount of short-term treasuries held by the Federal reserve, this decision is effectively locking-in negative real interest rates and inflation as long-term policy.  This is especially true since the Fed will now need to take more aggressive action if it wishes to reduce the money supply in response to price inflation that is likely to result from its repeated injections of capital into the market.

Consider that if the Fed primarily owns short-term treasuries, it can simply let those notes mature and naturally pull money out of circulation as those notes are repaid.  However, if the majority of Fed holdings are longer-term treasuries, the only way that they can pull money out of the market is by selling these treasuries.  When these sales happen, it will suppress the price.  When the prices are pushed down, it will increase the net rates.  When the rates of these treasuries increases, it will also increase the interest rate of associated credit such as mortgages.  When the price of credit increases, it will suppress the price of credit based assets such as housing.  This will create a major head-wind against whatever form of economic recovery is beginning to emerge.

Since the Federal Reserve will be very reluctant to take an action that actively suppresses the economy, it is highly likely that they will simply allow prices to continue inflating.  This will place significant pressure on people who rely on pensions, government assistance, bonds, and fixed-income retirement programs.  By shifting the Fed portfolio toward longer-term securities, it is locking-in this effect.

What Double-Twist Means For You

The extended impact of this maneuver is that people who purchase cash producing assets with fixed-rate debt will be made wealthy.  The way that this effect will take place is through price inflation that pushes up the cash flow and price of these assets while the cost of capital remains fixed by the interest rate.  The way that you can benefit from this effect is by gaining ownership of assets that produce cash flow and are financed with fixed-rate debt.  The most typical way to take advantage of this effect is with rental real estate.  The effect can also be captured to a lesser degree by acquiring stocks that pay high dividends from their earnings.

In both cases, the important part is to own assets that will have their value and cash flow pushed upward by inflation.  This will put the impact of inflation in your favor, as the purchasing power of cash, debt, and fixed-income payments is eroded.  In this manner, the debt you use to purchase your assets will be eroded by inflation while the value and cash flow from your assets are enhanced.  In the current environment, this is possibly the best path to wealth that exists for investors who are not corporate insiders or affiliated with prominent politicians.

 

How can you lower your portfolio’s risk in a world of rolling government-debt crises? Start by taking a deep breath. Then, see if you need to do some tinkering—but not too much.

With Europe in turmoil, investors are so eager for a “safe haven” that this week they were willing to accept a return of only 0.01% a month to hold Treasury bills. Such yields on short-term Treasurys are barely a sliver above their all-time lows, even as Uncle Sam’s own debts may be teetering on the brink of default.

Fears are rampant that the U.S. may lose its triple-A credit rating, that the economy will stay stagnant, that inflation will eventually surge and that the dollar will wither. Lately, U.S. Treasurys and the dollar have rallied mainly because other nations are in even more of a mess.

Amid such uncertainty, you can’t reduce one set of risks without raising others. If, for instance, you buy gold, you lower the risk that a collapsing dollar will crush your wealth. But you incur other hazards by paying all-time-high prices for an asset that generates no investment income, lacks intrinsic value and has a weak record of combating inflation. Other hedges carry other risks and trade-offs.

Thus, making a sharp course correction may cut your exposure to the U.S. dollar or inflation—but if today’s fears don’t materialize, or the future turns out to be full of its customary allotment of surprises, then your sudden shifts may turn out to hurt you. So moderation is the key.

Normally, explains Laurence Siegel, research director at the Research Foundation of CFA Institute, U.S. investors should tilt toward holding assets denominated in dollars, since their future spending also will be dollar-based. “However,” Mr. Siegel says, “today’s extraordinarily low yields on dollar assets drag the solution the other way—toward international diversification.” If, for instance, you normally keep 20% in non-U.S. stocks, you might begin raising that to 25%.

Some heavy-hitting investors are beginning to move in that direction, even in their own portfolios. “Going into the crisis, all my [personal] safe money was in U.S. Treasurys,” says Howard Marks, chairman of Oaktree Capital Management in Los Angeles, which manages more than $80 billion. “Now, it’s in the debt of a variety of countries, on the assumption that some of their currencies may well gain versus the dollar.”

Likewise, Todd Petzel, chief investment officer at Offit Capital Advisors in New York, says his firm is spreading its clients’ assets into short-term securities issued by non-U.S. governments. Mr. Petzel favors countries with low levels of debt and a wealth of natural resources, such as Australia, Brazil and Canada.

Relatively new mutual funds make it easier for small investors to spread bets—again, in moderation.

WisdomTree Dreyfus Commodity Currency and WisdomTree Dreyfus Emerging Currency are exchange-traded funds offering exposure to foreign currencies that, so far at least, have been relatively unscathed by the government-debt crisis. Commodity Currency provides exposure to money issued by Australia, Canada, Russia, New Zealand and four other countries that are major exporters of raw materials; Emerging Currency offers Brazil, China, India, Israel and eight other developing nations.

SPDR DB International Government Inflation-Protected Bond and iShares International Inflation-Linked Bond are ETFs that hold the debt of more than a dozen governments world-wide, designed to keep pace with inflation in those countries. Such a fund could offer partial protection against a decline in purchasing power in the U.S.

The debt of developing countries is no longer cheap, but it still may offer some diversification. The iShares JPMorgan USD Emerging Markets Bond ETF holds debt denominated in U.S. dollars, while Market Vectors Emerging Markets Local Currency Bond is a basket of government securities issued in Brazilian reis, Chilean pesos, Russian rubles and so on.

But remember: While many emerging-market nations may have better fiscal outlooks than the U.S., they still are risky. (If lending to Russia doesn’t make you nervous, someone needs to check your pulse.) The currency funds may spread your overall portfolio risks, but they distribute income only once a year and aren’t a substitute for cash.

“If the markets get scared again and there’s another flight to quality,” says Larry Swedroe, director of research at Buckingham Asset Management in St. Louis, “then the dollar will go up and kill your unhedged foreign bonds just when you most want them to keep you afloat.”

If you do move any money in response to the debt crisis, move small amounts slowly. A future that seems this inevitable may not even happen—precisely because it seems so obvious. As Mr. Marks asks: “Is the world less safe than it used to be? Or was it never as safe as we thought it was? Maybe the risks were higher before, when nobody was conscious of them.”

—
intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj

Article source: Wall Street Journal

 

People who are familiar with the popular board games of checkers and chess understand that there are vast differences between the two, even though they are played on the same board.  Checkers involves a simple, linear game where the objective is to capture all of the opposing players through simple jumps and reach the other side of the board so that a player can be “Kinged” and move both forward and backward on the playing board.  When the game shifts to chess, dynamics change drastically.  The game of chess involves different movements for different pieces.  There are also a handful of specialty moves.  Furthermore, victory is not one of simply eliminating all of the opposing pieces.  Winning a game of chess hinges exclusively on capturing the opponent’s “King” and does not require that you capture more pieces than the other player.

The complexity of strategy increases by many orders of magnitude when moving from checkers to chess.  Even though the playing board is the same, the games are completely and totally different.  Checkers is simple, linear, and easy to understand … similar to the financial advice that most people receive.  Frequently this advice is somewhere along the lines of go to college so that you can get a job, save 10% of your income in a stock account, and you will have a comfortable retirement with your stock account, pension, and social security.

On the other hand, we have the game of chess where strategies vary wildly based on individual game situations and super computers are placed into competition against master players to test the quality of their strategic thinking.  This more closely resembles the current financial world.  Real estate values have taken a beating, stocks have only experienced a partial recovery relative to pre-recession levels, the Government is running unheard of deficits, the Federal Reserve is printing new money out of thin air, pensions across the country are in danger of collapse and Social Security expenses are already exceeding FICA tax revenues.  This situation is clearly not financial checkers, it’s chess.

In order to prosper with the financial world becoming more complex and less predictable, it requires more sophisticated strategies.  The promises of social security and pensions were made by past generations of politicians without the slightest thought or care how they were going to be financed in the long run.  The long run has arrived, and the party is about to end.  It is likely that the government will result to monetary expansion (known to regular people as “inflation”) to satisfy their nominal obligations.  This will carry the unfortunate result of de-valuing the social security and pension payments they are making, de-valuing the savings of people who acted responsibly, de-valuing the equity of people who paid off their homes, and de-valuing the income paid to people who purchased bonds because of their “safety” relative to other investments.  In this situation, all of the people who have been trained to play financial checkers will be slaughtered by the financial buzz saw of runaway government and inflation.

What will happen to the equity in that home that everybody told you to pay off?  What will happen to the value of your investment portfolio that everybody told you to judiciously save, and then invest in bonds to protect against market cycles?  What will happen to the value of your employers pension payments?  What will happen to the value of your Social Security payments, if you even receive them?  The answer to each of these questions is that your hard work and sacrifice will be rewarded by inflation that decimates the purchasing power of all your assets.

So how do we play financial chess?  How do we beat this game where responsible savers are punished so that politicians can spend money to purchase votes?  The answer is to own assets that increase in value with inflation and owe liabilities that are destroyed by inflation.

Assets that Increase in Value with Inflation

The first thing that most people think of when talking about inflation-favored assets is gold.  However, gold represents a fundamental enigma, since its value is purely speculative.  The only thing that gives it value is a willingness by somebody else to pay you for it.  It is not used for many industrious purposes outside of jewelry.  Some people have certainly profited from increases in gold prices, but the fundamentals do not justify making gold the basis of your financial future.

Another thing that many people think of is stocks.  It is certainly true that the stock market is a much greater hedge against inflation than bonds, but there is a deeper understanding that many stock market investors miss.  Aggregate stock market values move up and down based on the total amount of capital in the market.  Presumably, more money in circulation will result in more stock market investment.  However, there is a danger that higher prices will mean less capital available to inflate market values.  The flip-side of this danger is that many of the companies who will have their prices most impacted by inflation are the same ones who pay dividends.  Thus, it is most likely that a higher percentage of stock market returns in an inflationary environment will come from dividends instead of capital gains.

Another very important asset that increases with inflation is rents.  Not necessarily home prices, but rents.  The important difference is that home prices are based on credit availability.  During inflationary times, it is likely that high interest rates will decrease housing affordability.  However, that same decrease in affordability will increase rents by pushing more people into the renter pool.  Thus, people who invest in income properties are likely to have some very prosperous times ahead as their rents increase from the influx of people who need to find new housing.

Liabilities that Decrease in Value with Inflation

The key liability that decreases in value with inflation is fixed-rate debt.  The reason for this is because inflation frequently rolls through to wage incomes, dividends, and rent incomes.  Inflation also frequently pushes-up interest rates.  However, if you own a long-term loan at a low rate of interest, it means that you can pay back that capital at a low rate.  If your other forms of income flow from areas that increase with inflation, it will result in your loan becoming cheaper over time.  In the Creating Wealth Show, Jason Hartman refers to this as “Inflation Induced Debt Destruction.”

In this scenario, a paid-off loan can actually become problematic.  If tight credit suppresses the value of your house, and inflation destroys the value of your equity, it can place you in a tight financial situation.  People who use the power of the home mortgage to borrow at low rates of interest for a long time can frequently invest in assets such as income property that produce much higher rates of return than their interest payment and realize a significant profit.

The key to winning at financial chess and thriving in an iflationary environment is to create income streams that are pushed up by inflation, and finance those income streams with fixed-rate liabilities that are eroded by inflation.  The incentives of the financial world have been rigged against people who took what was once good advice and turned them into people who are waiting to be fleeced by a government that is hungry for money to feed its unmet promises.  It is a matter of mathematical certainty that the current trajectory of government entitlements and spending cannot continue.  The result will be large budget cuts, large amounts of inflation, or some combination of the two.  When these events finally unfold, it will be the people who have educated themselves and played financial chess that will come out ahead when the world of checkers finally implodes.

 

How would you like to triple the yield on your bonds?

Most of us can only dream. But look at the eye-popping variation in yields among funds that focus on Treasury inflation-protected securities, or TIPS, the U.S. obligations that rise in value as the consumer-price index goes up.

Christophe Vorlet

Among the 173 TIPS mutual funds tracked by Morningstar, the reported “SEC yields” as of March 31 ranged from minus-0.77% to 5.58%, with 12 funds yielding at least 5%. Four of the seven exchange-traded funds that specialize in TIPS displayed yields greater than 5%, with Pimco 15+ Year U.S. TIPS Index leading the pack at 6.07%.

Yet no TIPS yield more than 1.75%. How could anyone but an alchemist generate 5% or more out of 1.75% or less?

The answer lies hidden in the term “SEC yield.” In 1988, the Securities and Exchange Commission forced funds to include only dividends and interest income in the yield that they must show investors.

The return on TIPS, however, comes not just from interest income but also from any adjustment in value as inflation rises.

The SEC hasn’t issued any guidance to fund companies on how to handle this peculiarity when they show standardized yields, says Gene Gohlke, associate director for examinations at the agency. As a result, firms are free to do more or less as they please, without running afoul of the rules.

Given the way many TIPS funds interpret the SEC yield formula, the change in inflation over the latest reported month gets added to interest income to produce an annualized figure. Thus, in months that capture a small inflation change, SEC yields on TIPS funds will be low. In months like April, when the rise in the Treasury’s inflation value was about 0.5%, SEC yields can brush 6%.

The inflation change upon which TIPS funds will be basing their SEC yields in May will be nearly 1%, notes Dan Dektar, chief investment officer at Smith Breeden Associates in Durham, N.C. That suggests some funds might soon sport much higher yields.

A few brave TIPS funds back the inflation adjustment out of the SEC yield, producing a much smaller number often called “real yield.”

“It hurts us in a sense,” says Ken Volpert, head of taxable bonds at Vanguard Group. “But at least we’re not getting people making misjudgments based on unsustainable yields.” At iShares, the website displays four additional types of yield calculations on its TIPS portfolios—most of them considerably lower than the SEC number. “Investors need to understand what yield they’re getting,” says Matt Tucker, a managing director at iShares.

Inflation-protected mutual funds and ETFs command $110 billion in assets and have taken in $35 billion in new investment over the past two years, according to Morningstar.

“I’m absolutely confident that a lot of these investors didn’t have a clear understanding,” says Todd Petzel, chief investment officer at Offit Capital Advisors in New York. “They saw high past performance, then they saw an SEC yield that was much more attractive than in a conventional bond fund and thought the higher yield will protect them. But the assumptions behind the SEC yield are not clear.”

“It would seem to be a risk area, because these funds are fairly popular at this moment,” says Mr. Gohlke of the SEC. “Investors ought to be getting appropriate information on what the return is likely to be. Maybe [the SEC] ought to dig down deeper and take a look at how funds are handling this,” adds Mr. Gohlke, who is about to retire from the agency.

This week, the Schwab U.S. TIPS ETF reported a 5.64% SEC yield. “We feel that including the inflation adjustment in our yield gives a better representation of the fund,” says Sam Grenning, a managing director at Charles Schwab. “But if the SEC required us to [strip it out], of course we would go along with that.”

American Century Inflation-Adjusted Bond Fund has a 4.99% SEC yield%. “I was surprised to hear that our methodology is not consistent [with all other funds],” says Jean Wade, vice president of investment operations. “We based it off published industry guidance. I hope that shareholders wouldn’t be using these funds for a steady income flow. They’re not going to get that.”

Pimco declined to comment on how it calculates the yields on its TIPS funds and whether investors could be confused by the high reported numbers.

The bottom line: While the SEC yield is a decent guide in other bond funds, it can steer you wrong in an inflation-protected bond fund. Before buying a TIPS fund, ask instead what its real yield is.

SEC yields “are like the square root of negative-1 in algebra,” says bond expert Frank Fabozzi, a finance professor at Yale University. “They give you an imaginary number.

Article source: Wall Street Journal

 

Most people who have spent any amount of time around college towns or night clubs are familiar with the phrase “beer goggles.”  Simply put, this phrase refers to a general tendency for people who have been drinking alcohol excessively to develop highly distorted perceptions of other people’s attractiveness.  In these situations, many people find themselves making romantic advances toward people whom they would not be interested in if they were sober.

Fortunately, most people mature with age and grow out of the propensity to don “Beer Goggles” when finding their spouse.  As we gain more experience, the importance of intelligent decisions becomes increasingly apparent.  The decisions that we make in regards to our education, career, and spouse all have long-lasting impacts on our life.  Thus, it is not difficult to see why making these decisions with a sober mind is of paramount importance.

Unfortunately, there is a distinctive sector of life where many people bring back the “Beer Goggles” in full force.  This part of life is investing, and many people allow themselves to become inebriated by promises of high returns that lure them into deals that are much less attractive when viewed with sober eyes.

Consider all of the late-night infomercials that you have seen, soliciting you to purchase a system that will teach you to “Buy Real Estate with No Money Down” or “Grow Wealthy with FOREX Currency Trading” or simple exhortations to abandon the dollar and “Buy Gold.”  The interesting thing to consider is that the people selling each of these products earn substantial fees and commissions when you choose to buy.  What these “systems” are banking on is that their promises of fast, easy profits will lure you to send in your money.

This is not limited to inf0-mercials either.  How many people concentrated their 401k portfolios in Technology stocks during the 1990′s, in Energy and Financial stocks during the Real Estate boom, and in Gold now that the spot price has rapid escalated in response to continued government budget deficits.  Each of these represents a “fad” that is generated by investor enthusiasm for quick profits … not for fundamentals, not for cash flow, but for the simple fact that they expect prices to continue rocketing up, just like they have rocketed up in the past.

A common phrase among financial planners is that “Trees don’t grow to the sky,” meaning that abnormally high rates of growth cannot continue indefinitely.  It would be well for many people to remember this wisdom, since the allure of easy profits results in “Beer Goggles” for investors that come on in full force.  When seeking to earn returns from investing, it is critical to understand that there is no such thing as a free lunch.  All investments carry some form of risk:

Default Risk

Some product such as bonds carry a risk of default, where the issuer is no longer able to pay.  Typically, when the default risk is higher, the interest yield also tends to be higher.  This means that bond investors who are earning high yields are running a greater risk of losing their principal.  Most government bond investors are primarily worried about guarding against default with the guaranteed principal value of treasuries.

Market Risk

Products like stocks, mutual funds, and commodities carry a risk that the market value will be lower when they are sold than whey they were purchased.  This risk is even more pronounced when the security does not pay any dividends, because the returns are totally concentrated in capital appreciation.  Volatility of market prices represents one of the main risks for equity or commodity investors.

Inflation Risk

A large risk associated with many investment products is that their performance will either not keep pace with inflation or will have their returns significantly eroded by inflation.  This risk factor is especially dangerous for bond investors, since the interest payments from bonds are fixed.  Because of this, investors who anticipate that inflation will result from current government policy should seek investment vehicles that are more robust in defending against inflation than bonds.

Liquidity Risk

Some investments such as Real Estate produce favorable rates of return from cash flow and leveraged appreciation, but are very difficult to sell quickly without significantly discounting the price.  This means that people investing in these types of assets should only do so with capital that will not be needed for a long period of time. Problems can arise very quickly if your are forced to sell a property and must discount the price lower than your loan balance in order to attract buyers.  In this situation, leveraged gains can turn into leveraged losses very quickly.

In the end, it is critically important for each person to remove the “Beer Goggles” when they are choosing their investment strategy.  Sticking to fundamentals and avoiding the urge to chase after investment fads or pursue quick profits with packaged systems.  By ensuring that your investing activity revolves around creating fundamental value for paying customers with your capital, it will help to avoid chasing the elusive quick buck and keep you on the track to building long-term wealth.

 

The subject of taxes is typically highly charged with political animosity.  During every election cycle, there tends to be quite a bit of discussion how what the ‘right’ amount and structure of taxation should be.  However, there are actually two types of taxes that people pay.  The first is the taxes that the IRS or state revenue agency assesses on your earned income during the year.  (This is what most people think of when you say the word taxes)  The second and much stealthier tax is inflation.

At this point, I’m sure that many of you are wondering what inflation has to do with taxes.  Most people think of inflation as being the result of increases in the price of commodities such as oil or concrete.  However, let’s step back from the details for a moment and think about the big picture.  If the total amount of products & services in the economy stays the same, and the total amount of money in circulation (both hard currency & electronic records) stays the same, any time one product goes up in price something else would have to go down in price.  The only way that you can possibly experience an across-the-board increase in prices is for economic output to go down or for the amount of money in circulation to increase.  (Please note that this isn’t an original observation.  Milton Friedman won the Nobel Prize in 1976 for his work on the relation between monetary policy and inflation)

So how does this relate to taxes?  Since the government has the power to increase or decrease the money supply, they have the ability to spend money without increasing taxes by increasing the money supply.  Because of this fact, the primary danger of the national debt is not that the government will not be able to pay its obligations.  (The federal reserve could literally ‘wipe-out’ the national debt by purchasing all of the outstanding government bonds with treasury notes and tremendously increase the money supply, thus causing widespread inflation)  The primary danger of the national debt and unfunded social security / medicare obligations is that the government will have to massively inflate the currency to meet its previously committed obligations.  Ultimately, this amounts to a tax that is never passed by congress.

 

One of the peculiar things about the human condition is that we tend to look backward while we are attempting to move forward.  When the problem shifts from individuals to organizations and government, the problem becomes much greater in severity and much larger in scale.  The fundamental reason why human beings look backward so often when seeking wisdom, is that past experience is something that feels concrete while the future is always murky and unknown.

The inherent danger in this tendency to grasp what we know and scorn what unknowable is that we constantly endeavor to solve yesterday’s problems.  This phenomenon plays itself out with government entities that attempt to solve the problems of their last generation while a new crisis begins brewing for the next.  It manifests itself in companies that cling to antiquated business models, small businesses run by owners that insist on the ‘old way’ of doing things, and individuals who invest based on what prospered during the last economic expansion while avoiding the assets that were most troubled.

In an era of burgeoning unfunded government entitlement liabilities and looming inflation, the national authorities are currently attempting to generate a health care entitlement while the systematic destruction of the dollar’s purchasing power from monetary expansion and price inflation looms over the national economy like a snowdrift perched in position to unleash a devastating avalanche.

In a market environment where real estate values have collapsed, many people are seeking the security of treasury notes for fear of volatility in values that were experienced in both the stock market and real estate during the last few years.  This fear has left many people blind to the risk of severe inflation from monetary expansion by the government.  In this attempt to preserve what assets they still have, many people are placing themselves in severe danger of losing the purchasing power of their assets to inflation.

True vision requires that people see the problems and challenges of tomorrow so that they can be solved today.  We cannot expect our elected officials to exhibit this level of foresight in the midst of their terminal pandering for electoral support from people who are focused on the problems of yesterday.  While we can draw inspiration from the rare person who exhibits this insight in the public arena, it is our responsibility to find our personal path.  Each person must develop their own vision and find their own solutions.