Q: My son and I bought a house to remodel and resell. We had it for two years, during which time no one lived in it. We sold it at a loss. Is the loss deductible?

—K.B., Ridgecrest, Calif.

A: The general rule is that you can’t deduct a loss on the sale of your personal residence. But the answer is different in cases such as the one you mentioned.

If the house is “an asset that was purchased for investment purposes only, with the intention of incurring a profit and not used for personal purposes, then the loss would be deductible as a capital loss,” says Brittney Saks, who heads the U.S. Personal Financial Services Practice at PricewaterhouseCoopers.

Based on what our California reader has told us “it would seem that the house was bought purely for investment purposes,” Ms. Saks says.

Mark Luscombe, principal federal tax analyst at CCH, a Wolters Kluwer business, agrees. “Yes, it appears that the home was investment property and not a residence, so it would qualify for capital-loss treatment on sale,” he says.

Here is how those capital-loss rules typically work:

You can use your capital losses to offset your capital gains on a dollar-for-dollar basis.

If your losses exceed your gains, or if you don’t have any gains at all, then you can use your net loss to soak up as much as $3,000 a year ($1,500 if you’re married and filing separately from your spouse) of your wages and other ordinary income. Additional losses are carried over into future years.

For more details, see the Internal Revenue Service website, and type “capital gains and losses” in the search box.

However, Ms. Saks points out that the taxpayer has the burden of proof to show the intention and correct classification of the property.

Q: Has Congress extended the tax break for IRA distributions that are donated directly to a charity?

—E.D., Providence, R.I.

A: Not yet. That law expired at the end of last year.

Most tax advisers I have spoken with predict lawmakers will approve another extension this year of the provision, which lets many people who are 70½ or older transfer as much as $100,000 a year directly from an individual retirement account to one or more qualified charities without having to report any of that money as taxable income.

—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

 

Chances are you have a 401(k) plan at work. And the chances are you’re not making nearly enough of it. A new year means a new leaf: This is as good a time as any to start turning that around.

If you’re letting your 401(k) languish, a report released over the holiday season shows that you’re not alone. According to the latest study by the Employee Benefits Research Institute, a think tank in Washington, most of us continue to neglect our 401(k) plan. The median account contains a balance of just $18,000, says EBRI.

Good luck with that.

Here’s a five-step plan to fix your 401(k).

1 Take control.

Take a look at the full range of investment choices available to you. That should include, at a minimum, a handful of low-cost domestic and international stock and bond funds. If your plan doesn’t even offer those you should talk to the people in charge at your employer and insist that they move to a better plan.

Many people are too intimidated, or busy, to choose their portfolio. If you’re in that camp, your plan will have dumped your money into a default portfolio—such as a low-yielding but “stable” fund, or a target-date fund ostensibly designed for someone of your age.

There is nothing inherently wrong with these funds. But that doesn’t mean you can rely on them, either.

These default options aren’t designed for your best interests, but for the best interests of your plan provider. Instead of maximizing your likely returns, they are designed to minimize the provider’s risk of a nasty lawsuit.

As a result, your money may well be sitting in a poorly designed portfolio that guarantees mediocre performance. Target-date funds, for example, are a great idea in theory. In practice, most are far too heavily weighted toward U.S. stocks, and they use a cookie-cutter approach to investing.

Consider the alternatives available to you.

You also should understand if your company makes matching contributions, and, if so, how much it will match. There’s no good reason for missing out on a company match. It’s also a good idea to find out if your plan allows such things as personal loans: This may offer you access to cheaper capital than a bank, although there are risks in borrowing from your plan.

2 Cut your costs.

Many 401(k) plan providers stock their plans with high-fee mutual funds. That’s great for them, and bad for you. Most mutual funds are far too mediocre to justify hefty fees, which just soak up a lot of your investment returns. A fund that charges you an extra 1% a year may end up costing you most of the tax benefits of your plan.

There are managed investment funds out there that are worth the money, but few of them—if any—are likely to find their way into a 401(k) plan. If you’re stuck with plain-vanilla funds, you are going to be better off going for the ones with the lowest costs. Nearly all the time your best options will be the low-cost index funds.

3 Lighten up on U.S. stocks.

Most people keep most of their stock-market investments in the U.S. It’s safer, right? I mean, it’s the home market so it’s less risky than foreign stocks, yes?

That’s what conventional wisdom says, but it’s hooey. Investors sell themselves short by investing too much in the U.S.A. You’re already overinvested here anyway—you have your life and career here.

And U.S. equities start 2012 looking relatively expensive. U.S. stocks today are somewhere between modestly and heavily overpriced when compared to such metrics as average earnings or the value of corporate assets, according to data from the Federal Reserve and data tracked by Yale University economics professor Robert Shiller.

The dividend yield on the Standard Poor’s 500-stock index, at just 2.1%, is very low by historical standards.

Predicting future stock-market returns is notoriously difficult. But based on current valuations, the U.S. stock market seems to offer a mediocre bet.

4 Look internationally.

Many 401(k) plans go light on international investment options. The real reason is simply the incompetence and complacency of plan sponsors.

But if your plan offers international options, take advantage. The turmoil of 2011 has left many overseas stock markets looking like a good value.

Western European markets fell nearly 30% from last year’s peak. Japan’s Nikkei 225 index is now lower than it was during the tsunami panic nearly a year ago. Emerging markets from Brazil to India, the investment hotshots of 2010, have dropped dramatically out of fashion again. Their stock markets crashed last year.

These offer some excellent buying opportunities.

Emerging markets account for about a third of the world economy, and their share is growing. Developed overseas markets, meaning Europe, Japan and Australasia, account for about two-fifths. They are on sale, and most people are underinvested there.

5 Review your bond funds.

As a general rule, your 401(k) and other tax shelters are where to hold the bond portion of your portfolio. That’s because bonds are much more vulnerable to taxes than stocks.

Bonds generate most of their returns through coupons, and those are usually taxed at ordinary-income tax rates. By contrast, stock dividends and capital gains generally get taxed more lightly.

Right now is, admittedly, a risky time to invest in U.S. bonds. Yields on U.S. Treasurys have slumped to historic lows. Any pickup in the economy, and inflation, could send bond funds tumbling.

While Treasury bonds offer meager yields here, look at any corporate bond funds. That includes investment-grade bonds and more volatile high-yield bonds.Both offer somewhat better yields. Emerging-markets bonds offer particularly good opportunities, argues investment guru Rob Arnott, chairman of Research Affiliates. They pay higher interest rates than those in the U.S., while their governments’ finances are actually in better shape.

It’s crazy that most 401(k) plans offer such a limited range of investment options. Paradoxically you don’t get full control of your money unless you leave your employer, when you can roll the plan over into a self-directed individual retirement account. But your 401(k) still represents a great investment asset, and this is a good time to get it into shape.

Write to Brett Arends at brett.arends@wsj.com

Article source: Wall Street Journal

 

By 2030, around 20 percent of the U.S. population will be 65 and older, up from 13 percent today, reckons the Census Bureau. There’s a gloomy theory on how that will affect stocks. As boomers earned and saved in the 1980s and 1990s, the market soared, the thinking goes. As they retire and draw down their savings, share prices could deflate.

Nonsense, concluded the Government Accountability Office in a 2006 study. Baby boomers own less than a quarter of the U.S. stocks and bonds held by U.S. savers, so their influence on prices is overstated, according to the authors. Anyhow, many old folks spend down their assets slowly and continue to save.

But if there’s one thing economists can be counted on for it’s to publish perfectly contradictory, equally convincing findings. Researchers for the Federal Reserve Bank of San Francisco recently wrote that the historical link between age distribution and stock returns suggests the boomer retirement “could be a factor holding down equity valuations over the next two decades.”

These two divergent views would seem to prescribe radically different investment approaches, with a steep penalty for guessing wrong. But maybe not. What boomers will really want in retirement is more investment income, says Savita Subramanian, a strategist for Bank of America Merrill Lynch. “If you think about it, yield is scarce at the moment, and competition for it is only going to increase.”

To her first point, on average over the past 50 years, investors who spent $1 million on 10-year Treasury bonds could have looked forward to a yearly income of $67,000. At recent rates, the same investment would provide just $21,000. And the percentage of dividend-paying firms in the SP 500 index fell to 75 percent in 2010, from 94 percent in 1980.

The dividend decline is beginning to reverse, however. The percentage of payers hit 78 percent in 2011. Still, some companies can afford to pay much more: SP 500 companies distribute barely one-third of their operating profits as dividends their stingiest amount ever. Nonfinancial companies in the index hold more than $1 trillion in cash.

Companies in the best position to supply boomers with steadily rising dividends in coming decades will be rewarded with plenty of demand for their shares, says Subramanian. She recommends a could-would-should strategy for investors looking for such firms. Companies that could raise payments include those with plenty of cash and modest debt. Firms that should are those with high returns on equity and stable earnings despite slow growth. And companies that would are those that most likely already are. A recent screen for all these attributes produced the firms below.

• Baxter (BAX)
• Coca-Cola (KO)
• Deere (DE)
• 3M (MMM)

Article source: Wall Street Journal

 

In the game of blackjack, you can ‘double down’ on a hand by doubling your bet for one more card from the dealer.  (When playing blackjack, your goal is to create a hand that is as close as possible to 21 without going over)  This action allows you to take additional risk for an immediate payoff.  Within the community of people who enjoy the game of blackjack, most will tell you that it is advantageous to double down on an eleven, or possibly a ten.  The principal reason for this is because cards with a value of ten have a higher concentration than other cards.  Because of this, it is advantageous for players to increase their risk in certain situations because of an increased probability for a higher payoff.

In the world of investing, there are both times to increase your exposure to risk for a higher payoff, and appropriate situations.  The problem which arises is that many people end up taking excessive risk to chase returns.  In this situation, it is rarely the optimal time to take more risk in the hopes of earning a higher return.

Currently, there are many people from the baby boom generation who are currently ‘doubling down’ with their retirement accounts by over-weighting their portfolios in high-risk ventures such as emerging market stocks and speculative real-estate in an attempt to pump-up the value of their nest egg before retirement.  The risk of this strategy is that your nest egg could crack just before it hatches.

The hidden danger of highly volatile investments is that the risk of loss generally stays hidden until market disruptions push the value of multiple asset classes down simultaneously.  In this case, there is not enough time to adjust your portfolio before it has been significantly burned.  These types of situations are especially dangerous, because the market tends to change very abruptly as relevant news and information develop.  For people who are approaching retirement, volatility can be especially dangerous.

This is not to say that investors shouldn’t take risks . . . it is very difficult to generate returns in excess of bond or money market yields without taking risks.  The caution is that you should be aware of the risks that you are taking, and not allow yourself to fall into a false sense of security because the market hasn’t had a significant downward movement lately.  Large returns generally require that you take large risks.  If you are currently earning large returns, chances are that you are at risk for a large adjustment.  It is very important to make sure that a significant downward adjustment in value of your risky investments will not place you in a situation that you can’t recover from.

Thus, when deciding whether to ‘double down’ on your investment strategy, it is critically important to understand whether you are in a situation where such a decision is optimal.  Are your personal emotions constructed in such a way that a dramatic shift in market valuation will cause excessive nervous tension?  In most cases, investors are their own worst enemy … we allow our emotions over the movements of our portfolio value to influence our actions in a way that frequently moves contrary to our rational thoughts.

Thus, investing becomes a battle of reason vs. emotion.  Our reason frequently tells us to make decisions that would appear to be quite smart by most objective standards.  Reason typically evaluates decisions based on their inherent merits.  However, not all of our decisions are made rationally.  Instead of making our investing decisions based simply on the merits of a particular investment, we allow ourselves to be influenced by the other people we have seen being successful in making money.  When the market is going up, our emotions want to double-down on what we have seen as being successful.  When the market is going down, our emotions want to run for the hills and retreat from the perceived danger of the investing world.

As it turns out, the movement in market perception of a particular investment does not necessarily change the underlying fundamentals.  Many investments that are fundamentally sound experience negative market news, and other investments that lack solid fundamentals will experience upward escalations in market valuation that defy reason.  In the former case, it is important to avoid the emotional pull to bail-out on an otherwise solid investment strategy.  In the latter example, it is important to avoid the temptation to increase our investment, simply because the price has gone up and we hope that it will go up some more.

In the end, it is important for each of us to understand the extent to which our emotions compel us to ‘double down’ on what may turn out to be a highly risky strategy.  All of our decision should be made because of what we judge to be best for our well-being.  Achieving our desires will require that we take risks of some manner along the way.  However, it is important to ensure that all of our decisions are being made consciously instead of re-actively … rationally instead of emotionally.  This will help us to make sure that we don’t double-down on risky situations that we are not emotionally prepared to deal with.

 

Taking a loss is hard to take. But avoiding a loss can be much worse.

U.S. stocks have lost some $4 trillion since their peak in October 2007, but investors aren’t fleeing the market en masse. So far this year, according to investment-research firm Morningstar, investors have taken $14 billion more out of U.S. stock mutual funds and exchange-traded funds than they have added. That is less than 0.4% of the total assets of U.S. stock funds.

Can losing money feel good? Recent experiments show that reward circuits in the brains of investors who have losses will fire intensely whenever money-losing holdings have an uptick in price. Jason Zweig has details on The News Hub.

In other words, while some investors have taken their losses, most are grimly sitting on them.

That could be a mistake. Research published in 1998 by behavioral-finance professor Terrance Odean of the University of California, Berkeley, showed that individual investors are 50% more likely to sell a winning stock than a loser—even though, on average, the stocks these investors sell go on to outperform while those they hold onto underperform.

Why the reluctance to bail? Selling an underwater asset, says Mr. Odean, “isn’t primarily about economic loss, it’s about emotional loss.” Once you sell below your purchase price, he believes, you can no longer tell yourself, “I still made a good choice, and it’ll come back.”

Individual investors aren’t the only ones who can’t make peace with their losses, according to numerous academic studies. Mutual-fund managers who cling to losing stocks underperform, by roughly four percentage points annually, the managers who cut their losses.

Christophe Vorlet

While some investors have taken their losses, most are grimly sitting on them.

On average, professional futures traders and stock traders hurt their returns by clinging to their losers. Real-estate investment trusts hang onto properties that are losing money longer than they keep those that are in the black.

Unpublished research presented at the annual meeting of the Society for Neuroeconomics earlier this month sheds new light on this old problem. Neuroeconomics is an emerging field that combines the techniques of neuroscience with theories from psychology and economics to study financial behavior.

In one study, led by Gregory Berns of Emory University, people lay inside a brain scanner while deciding to hold or sell an investment; the price of the asset changed randomly up or down. The researchers focused on the ventral striatum, a region of the brain that has been shown to respond to rewards, particularly when they are unexpected.

When an asset was underwater and its price rose, activity in the ventral striatum of the typical person in the experiment was “blunted,” or insignificant, rather than robust. “Many of the participants told us they had hope for a rise,” says Andrew Brooks, a co-author of the study. Perhaps because these people got what they expected, an uptick in price “wasn’t surprising,” Mr. Brooks says, and therefore didn’t excite this part of the brain’s reward center.

That suggests that many investors who are losing money may automatically assume—rightly or wrongly—that their position is bound to recover.

Other research at the meeting pointed to a second flaw in how investors might think about losses. A study led by Camelia Kuhnen of Northwestern University found that people are much worse at estimating whether a bad investment will produce mild or severe losses than they are at predicting whether a winning investment will generate small or large gains. “Learning [about probabilities] is particularly faulty,” Prof. Kuhnen says, “when people are in a bad environment with losses left and right and they have their own money at stake.”

There are several steps that can help you dump your losers.

First, get a second opinion, from a financial adviser or an investor you respect, on your money-losing positions. Ask not whether you should sell the investments, but rather if they are worth buying at today’s price. If the answer is no, consider selling.

Measure how long you hold your losers and your winners. If you hang onto your money-losing positions much longer than your winners, then put yourself on a regular schedule of looking for losses to harvest. (You don’t have to wait until December.)

Taking a loss is easier when you think of it as a swap—in which you replace a loser with a new investment in a similar (but not identical) asset—rather than a sale. That makes taking action easier, since you aren’t forced to admit that your original judgment was a complete failure.

Finally, realize that a loser can change from a liability to an asset when you close it out at a loss, since you can use losses to offset up to $3,000 of ordinary income on your tax return.

“Think about the term ‘harvesting your losses,’” suggests Meir Statman, a finance professor at Santa Clara University. “That should put you in mind of strolling in an orchard picking ripe peaches rather than rotten losses.” Just be sure to check with your accountant to make sure the loss is worth taking.

Article source: Wall Street Journal

 

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.

 

One of the trends that many people experience in the world of investing is a noted tendency to become ‘gun shy’ when they experience volatility in their investments.  The reason for this is because our psychological makeup is much more afraid of loss than joyful over gains.  This leads many people to either become irrationally risk averse, or to take risks that they are not aware of in a desire to achieve safety.  The problem this creates is that fear of loss can make people blind to the opportunity for gain.

Volatile stock markets are hard to weather out.  Watching your house lose value triggers an impulse to run for safety.  However, safety is an illusion.  Just because the value of something doesn’t fluctuate very much doesn’t mean that it’s safe.  The price that is typically paid for value stability is low rates of return.  These low rates of return can significantly impede your ability to grow long-term wealth.  Acting to avoid losses frequently involves the same actions that avoid gains.  Thus, in attempting to protect your financial future, you may be inadvertently handicapping your financial futures.

You Lose What You Do Not Make

One of the consistent ideas in finance and economics is the notion that you gain what you do not lose, and you lose what you do not make.  Most people are very familiar with the notion of avoided losses, but blind to the idea of lost gains.  The reason for this is because the lost gains are largely invisible.  We are unaware of them because we did not see them.  In this way, many people have allowed themselves to take risks that they didn’t even know are present.  The most insidious of these is the risk of inflation.  Future price increases will erode the purchasing power of dollars that you own.  If your investment capital does not grow at a sufficient rate, it may be worth less (in real terms) when you retire than it is now.

This can be particularly damaging since it is unlikely that the government will be able to finance its entitlement obligations without significantly inflating the currency and eroding the purchasing power of people’s savings, investments, interest income, and annuity payments.  It is likely that most people will need a substantial amount of investment income in addition to whatever is provided by the government in order to avoid a significant decrease in their standard of living during retirement.  In most cases, this can only be accomplished by taking on the risk of losses that accompany exceptional investment opportunities.

Over-Reaction to Recent Trends

In general, people tend to over-emphasize events that have happened recently.  In the current environment, this has led to excessive pessimism about investing.  One example of this phenomenon in practice is a general tendency for people to view the recent real estate collapse in multiple markets across the country as a harbinger of risk with real estate investment.  While this risk looms large in the minds of potential investors, it is accompanied by the opportunity for tremendous gains if investors possess the insight and intelligence to act.  Prices have been significantly depressed in some areas (pushed below the cost of construction in a number of cases), and can present the potential for amazing rates of return.

The opposite side of this phenomenon was the stock market bubble of the late 1990′s and the real estate bubble of the mid 2000′s.  In both cases, people grew to believe that values would constantly go up, and that they could never come down.  A similar sentiment is now being expressed about the price of gold.  In all of these cases, the values do not go up indefinitely.  The same frenzy behavior that drives them up subsequently drives them back down when new buyers disappear, and people rush to cash out before the price crashes.

Fundamentals are Key

The bottom-line for any era of investing is to focus on fundamentals.  The long-term success of any investment strategy is solely dependent on its underlying fundamental value.  Speculation can drive the price above or below its fundamental value for a while, but it cannot keep it there permanently.  All values eventually regress toward their equilibrium value.  Astute investors target investments with an equilibrium value that is likely to grow so that they are not captive to market cycles.  Buying at the “bottom” of a market correction is much harder to do in real life than in hindsight.  It is much better to target exceptional fundamental value and invest for long-term gains.

It can be very difficult to overcome the fear of incurring losses and undertake compelling investment opportunities.  Doing so requires that one muster the courage to act against the grain of popular sentiment.  It can be surprisingly difficult to do, since there is comfort in following the crowd.  However, comfort and profit rarely come at the same time.  If you are seeking profits, it will probably require a departure from your comfort zone, and if you ware seeking comfort, it will probably mean the forfeiture of profitable opportunities.

In the end, each person must find the investment strategy that suits them best.  Some are more comfortable with risk than others, and some are more comfortable with active investment than others.  Regardless of your comfort level, it is important to understand that some risks will always be inherent in capturing gains.  Similarly, risk is inherent in avoiding losses.  All decisions that we make involve some kind of risk.  It is our responsibility to make sure that we are aware of the risks we are taking in the pursuit of gains.  It may well be that these risks are much less dire than the consequences of playing it safe.

 

The financial planning profession has a long history of demonstrating the power of compounded growth to clients who are looking to invest for the future.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically produced a high rate of return so that you will be able to enjoy a happy and comfortable retirement from your compounded returns.

Unfortunately, there is one question that never seems to enter into the conversation.  This question is whether the historic rates of compounded growth for the stock market will continue into the future?  If the returns produced by the stock market in the past do not extend out into the future, there will be many hundreds of millions of people who have their entire financial lives decimated.  And the shock will be even more severe, as many people have not even considered that it could happen.  For many years, it has been assumed that the stock market can continue to grow faster than Gross Domestic Product (GDP) indefinitely.  However, that assumption may be faulty.

Currently, the ratio of total US Stock Market Capitalization compared against GDP stands at approximately 95%.  This means that the total value of all US stocks adds up to 95% of total US economic output for one year.  This ratio is consistent with the 10-year average from 2000 through 2010, but is higher than the 20-year or 30-year average for the stock market to GDP ratio.  This disconnect raises an interesting question.  How much longer can the stock market continue to grow faster than the economy?

It is important to consider that the overall stock market can only grow if new capital is invested.  Individual stocks will go up or down in value as people switch from holding one company to holding another, but there is only one thing that can propel the entire market upward, and that factor is additional investment.  However, that additional investment must come from economic activity.  What happens if the level of investment required to continue driving the stock market upward at historic rates is larger than the amount of economic growth?  The answer should not come as a surprise … if the money to invest isn’t being generated by the economy, it won’t be invested, and the stock market won’t grow at it’s historic rate of appreciation.

To illustrate this point, both total stock market capitalization and GDP have been projected out at historic growth rates over the next 15 years, starting with actual data from 2010.  Over the last 30 years, the total stock market capitalization has grown at approximately 9% per year, while GDP has grown at approximately 5% per year.  When these assumptions are extended out to 2025, the infinite compounding fallacy becomes quite clear.  in order to maintain the historical rates of appreciation that are used in almost every financial planning model, the stock market will need to be $17.4 Trillion dollars larger than US Gross Domestic Product by the year 2025.

When one considers that this gap represents approximately 57% of Gross Domestic Product, it becomes increasingly evident that the total stock market capitalization simply cannot continue to grow at its past rates because there is not enough additional output being generated to fund the incremental investments that would be necessary to continue driving market values upward.  Thus, the answer to the question of what will happen to stock market capitalization is very apparent.  Unless the economy grows dramatically faster than it has in the past, there will be insufficient capital to propel the stock market values upward at previously experienced rates of appreciation.

Upon further analysis, the problem grows even more complicated.  Since the ratio of total stock market capitalization to GDP is currently equal to the 10-year average from 2000 through 2010, and is higher than both the 20 and 30 year averages.  This means that if the ratio between stock market capitalization and GDP regresses back to historical levels, the growth in stock market valuation will not only be constrained by GDP, but may actually grow slower than overall economic output.

Over time, it is not possible for the stock market to grow nearly twice as fast as the economy.  Eventually the capital required to drive further value growth equal to past rates of appreciation will not be available.  In this way, the fallacy of infinite compounding becomes strikingly apparent.  Financial planning models have been built on the assumption that one can passively generate a rate of return significantly higher than the growth rate of the overall economy.  Over time, this assumption will prove to be faulty, and spell ruin for the traditional models of investment planning.

So what can a person do?  It’s one thing to point out the problems with compounded appreciation assumptions built into financial planning models, but it’s another thing entirely to plot out a new course that overcomes these challenges.  The truth is that this course will be different for every person.  However, there are a few guiding principals that will make finding this course much easier.  These considerations are that cash is king, and leverage amplifies results.

Cash is King

This is the oldest and most hallowed of financial axioms.  Cash stands and the fundamental basis of investment value.  The ‘real’ value of an investment is the cumulative discounted value of all future cash flows it produces.  This can come in the form of dividends from a stock or rent revenue from an income property.  When evaluating an investment based on the cash it produces, the value is easy to see.  However, if the value of an investment depends solely on selling it to somebody else for a higher price in the future, it can result in tremendous volatility and risk … especially if the investment does not produce any cash flow.  Thus, the paradigm of the future for investors should be to seek cash flows.

Leverage Amplifies Results

Another fundamental consideration for astute investors is the power of leverage.  This can take the form of both financial leverage and organizational leverage.  In either case, the leverage will allow you to amplify the results produced by your efforts.  In the case of financial investments, borrowing at a low rate of interest and investing at a higher rate of return will allow you to amplify your returns much higher than could be earned with cash alone.  Similarly, leverage will amplify any losses that are incurred from your investments.  This is equally true with organizational leverage for business owners.  Amplifying your time through the efforts of others will allow you to generate better results if you are highly effective, or will create chaos if you are disorganized.

In the end, future investors will need to rely on their ability to create value.  The days of infinite compounding from perpetually escalating market values are reaching an end.  The people who survive and thrive in this environment will be the ones who focus on fundamentals and create value.  It is important to understand that every difficulty carries an opportunity, and that each person is responsible for capturing that opportunity to create the best future that they can.

 

One of the most famous institutions in American cultural history during the 20th century is the Circus.  During the early portion of the 20th century, many Circuses moved from one small town to another, setting up a “Big Top” for their main show, and sponsoring side-shows, performance, and greasy food alongside carnival games in an area called the midway.  Traditionally, these carnival games were “difficult” (meaning that they were constructed so that you had an extremely low chance of winning) and required many attempts before the desired prizes were won.

When the Circus pulled into a new town, the local residents were frequently referred to as Rubes, which is a euphemism for an unsophisticated country bumpkin.  When these Rubes came to the midway, they frequently spent substantial sums of money buying food, playing rigged games, and paying to see side-shows or freaks of nature.  Another mainstay of the Circus midway was the announcer who would talk-up all of the shows and events to draw large crowds of people into the shows and attractions to spend their money.

There were some Circuses of a less than savory nature who would employ con-men that would cheat people at the midway games and pickpockets who would steal their wallet in the crowd.  Over time, these sketchy operations eventually collapsed, but the spirit of attracting people to the midway for the express purpose of separating them from their money remains.  Even among the carnival operations that remain today, the midway games are still extremely tilted against the player, and the prizes can be purchased at the store for much less than the cost of playing multiple games in an attempt to win.  Regardless, it is the excitement, lights, sounds, and smells of the midway that attract people to the games of chance that most people inwardly know are tilted against them.

An interesting parallel to the world of the circus is the realm of investments.  Many investment funds invest great amounts of fanfare and marketing behind their manager or fund family.  High budget advertising campaigns are created for the purpose of convincing you that the manager in charge of a particular investment fund or that the characteristics of a particular insurance product are going to provide everything you could every want.  In this environment, people who have not yet learned a tremendous amount about about investing are attracted like Rubes at the midway.  The excitement of a high-profile investment fund, the advertising campaigns and the colorful brochures all serve to attract new investors (Rubes).

Unfortunately, what the investors ultimately find out is that this game has been tilted in favor of the house as well.  The high-profile fund manager takes 2% of the asset base as a fee, but can’t consistently beat the market indexes.  Maybe he’ll do better than the market for a year or two, but then he does worse for a year or two.  When all of the fees are subtracted out, most of the investors would have been better off buying an index fund with low costs and no commissions.  The investors just got fleeced like Rubes at the midway.

This same phenomenon repeats itself over and over again with each new financial product that is rolled out for the investment Rubes.  The insurance product with an investment account may have some tax advantages vs. a regular brokerage account, but your cash is subject to fees and charges for the insurance part of your policy, and the associated expenses for each of the sub-accounts.  Some products even have a “guaranteed” rate of return from the insurance company that make the Rubes feel warm and cozy since they have a guarantee to fall back on.  However, that guarantee only holds water if the insurance company makes enough on its other investments to meet it’s capital reserve requirements.  Many people make the mistake of assuming that a guarantee from another party is guaranteed … it is nothing of the sort.  The guarantee of another person or company is only good if that company can make good on the promise when it becomes necessary.  What happens if the insurance company goes bankrupt before they can make good on your guarantee?

Another things that people frequently overlook is the fact that every time somebody touches your money in a financial product, they take a cut, a percentage, a taste.  By the time your money has passed through multiple sets of hands, it will be exceedingly difficult for you to realize a rate of return that exceeds the market by a large enough margin to dissipate the costs.  The way that financial companies make their profits is by attracting money to “manage” for a percentage of the asset base.  The way that they attract capital to “manage” is by making loud, outlandish claims about their great skill and amazing ability.  Strangely, this is remarkably similar to the barker at the midway trying to fleece the Rubes.

One of the things that are very important for people to understand is the difference between financial products and direct investments.

Financial Products:

• Financial products are packaged together by a bank, brokerage, or other financial institution.  Typically, they involve multiple riders, proviso’s, or conditions that are all packaged into a single product.
• Each level of intermediary or “middleman” between you and the actual investments will take a percentage.
• The incentives are set such that manager succeed by attracting large amounts of capital.  This means that they will either produce average rates of return or must take very high risks to beat the market.
• If the returns end up being average, the high costs will push you behind simply purchasing the market portfolio.
• If high risks are taken to produce large returns, you will be unknowingly bearing a risk of substantial loss.
• Products frequently involve “guarantees” that are subject to change in the future … especially if there are financial problems.
• The financial companies who sell products to you will take your money and make direct investments into assets like bonds and real estate.

Direct Investments:

• As the name indicates, direct investments involve directly purchasing ownership in a company, property, or debt instrument.  There are no additional intermediaries between you and the investment.
• You must become educated about the investments available, the process of purchasing, and the management of these investments.
• As the owner of the investment, there will be nobody to take a cut from your returns.
• As the owner of the investment, there will be nobody to shield you from risk if problems arise.
• Direct investments can have rates of return that are much higher than market indexes, due to small fragmented opportunities that cannot be efficiently collateralized by a financial institution.

Ultimately, the question of direct investing or purchasing financial products comes down to one of personal comfort, preference, and willingness to do one’s own research and analysis.  There are some financial products such as Term Life Insurance or indexed mutual funds that offer minimal costs, and no additional layers of middlemen between you and the underlying investments.  There are also some financial products with exceedingly high fees, high levels of complexity, and a very confusing value proposition.  In the end, each person must make their own choices when it comes to investments.  However, in most circumstances it is quite safe to say that if you do not fully understand how a financial product or direct investment works, then it is probably not a good idea to place your money there.  It is almost always best to start with the products and investments that you understand, and then seek to expand that universe of understanding.

This is how you avoid being fleeced like a Rube at the midway.

 

In the world of business, life, and investing there are many risks present.  The traditional view of risk is the probability of suffering a loss of value on your investment.  This is a very significant form of risk, but there are other equally important factors that must be considered for a full picture of risk to be formed.

Another kind of risk to be considered is the risk that your ‘safe’ investment will produce low returns that do not keep pace with inflation or do not make you any wealthier.  Preservation of capital is a viable short term strategy, but it will produce very unremarkable results if it is allowed to dominate you consciousness.

Let us also consider the risk that you will not be able to sell your investment asset when you need to.  This risk is particularly appropriate for the people that were engaged in buying and ‘flipping’ real estate properties.  When values contracted and credit standards tightened, there were many people who owned a property that was producing zero cash flow, and couldn’t be sold without incurring a significant loss.

In addition to this, it is important to consider the risk of allowing another person to manage your investments.  The highly publicized Madoff scandal provides a testament to the implicit dangers of allowing an intermediary to do your investment thinking for you.  Also consider that this risk is not limited to theft.  Investment managers tend to charge very hefty fees for their services.  These fees usually have a detrimental impact on your long-term wealth building prospects.

Finally, there is the greatest risk of all . . . the risk of lost opportunity.  People who are afraid to act because of risking failure are passed over by countless opportunities for gain.  As human beings, our perspectives are more heavily influenced by what we can see and touch.  Conversely, we tend to ignore or disregard that which we cannot directly see or feel.  Lost opportunities are unknown to the person whom they pass over, and as such are not considered.  However, opportunity is where the big gains of business, life, and investing are found.  It is critically important that the light of each person’s consciousness be allowed to shine on opportunity before it disappears into the darkness, never to be seen or heard from again.