Monday, July 23, 2012

Why Not Just Go To Cash?

There was an article in the WSJ today on how investors are bidding up shares of dividend paying stocks because investors look at them as defensive.  Here is the link if you are a subscriber:

I have written about dividend stocks before and probably will again.  The bottom line is this, if you want to be defensive you move to cash, that is the only thing where you have a "guarantee" that you will not lose any money.  Why don't investors do this?  Two main reasons:

1. Sales sizzle-----Wall Street gets compensated on getting people to act and to do that you need some sales sizzle.  Dividend stocks have that now, most yield more than Treasury Bonds.   This ignores the fact that if the market drops 10-20% you will probably make money in Treasuries and get crushed in dividend stocks.

2. Wall Street clings to the theory that you always need to do something------Instead of moving to cash during times when the risk outweighs the reward, Wall Street feels that it needs to do something to justify fees (I would argue that moving to cash and protecting money during times of distress is the ultimate way to justify fees).  Therefore, they hold their nose and try to find things that are less bad than others.  If the market goes down 30% and they only lose 20% that is a success.

Bottom line is this, don't fall for the idea that you have to do something and don't fall for sales sizzle.  Sometimes the best course of action is to just hold cash.  It is boring, but the key to making money in the market is to avoid large losses and cash is one of the only things that can promise this.

Monday, July 16, 2012

Matthew Tuttle Interviewed by Donald Giannattasio

Matthew Tuttle Interview About Tactical Asset Allocation

I Want Tax Free Income

I often get questions from people who either "want" tax free income or wonder if Municipal Bonds will help them save on taxes.  What I often find is that when an individual investor "wants" something it is because somebody convinced them that they need it.  Usually, that somebody is trying to sell the exact thing.  Municipal Bonds are an easy sell, they provide:

1. Income that is free from Federal taxes and free from state taxes if you buy Munis in your state.
2. They are not as volatile as stocks

In this environment who wouldn't want an investment that is tax free and doesn't fluctuate like stocks?

However, if you look at these issues in more detail Municipal Bonds end up not looking that good.

First, lets look at tax free income.  If I gave you the choice between a bond that would pay interest of $100k that was taxable or a bond that would pay interest of $100k that was tax free which would you want?  Easy answer, all things being equal you choose tax free.  Now I know what you are thinking, Muni's typically yield less than other types of bonds so you have to look at tax equivalent yield (TEY).  So in my example above, lets say I gave you the choice between $100k taxable or $70k tax free.  To get the TEY you divide the $70k by 1-your tax rate, if you are in a 35% tax bracket then the $70k is really work $107k, so the Muni bond is better right?  That's what the salesman wants you to believe but we are still missing the most important issue----how much money do you have in your pocket at the end of the day.

The return from a bond is more than just interest payments, it is also capital appreciation or depreciation.  If I earn $100k of interest but lose $500k of principal then I have a net loss of $400k.  When looking at any investment their are three key questions you need to ask yourself:

1. Can I lose money?
2. If so, how much?
3. Am I being paid enough to take that risk?

As of 7/16/12 the yield on the Merrill Lynch 7-12 yr tax exempt index is 1.78%.  Forget about TEY for a minute and think about this, I am being paid 1.78% tax free to take the following risks:

1. My bond(s) might go bankrupt.  Look at all the states declaring bankruptcy and the problems that states are having with their budgets.
2. Interest rates will increase making my principal go down.

These risks are very real possibilities.  Is 1.78% tax free worth it to take these risks?  No.

Monday, July 9, 2012

Target Date Funds---Hazardous to Your Wealth

Another article in the WSJ this morning on target date funds, here is the link if you are a subscriber:

Here are some of the key points:

Despite that uncertainty, money is flowing into target-date funds at a brisk pace. Their assets now total around $400 billion, more than five times the amount at the end of 2005, according to Morningstar.

 In 10 years, target-date funds could represent half of all the assets in U.S. 401(k) plans and other defined-contribution plans, says David Bauer, a partner at asset-management consultant Casey, Quirk & Associates, Darien, Conn.

The idea makes sense on the surface-----older investors who may be closer to needing to withdraw money can't afford to sustain large losses so target date funds naturally get more "conservative".  However, in practice this doesn't work for a number of reasons:

1. Life expectancy is too long-----If I retire at 65 and have all my money invested "conservatively" I could still live another 30-40+ years.  Add inflation into the mix and this is a recipe to run out of money.

2. What is conservative?  Is investing a bunch of money into bonds at these yields conservative?  I don't think so.  Long term interest rates can't go much lower but they can go a lot higher.

3. Nobody should subject their portfolio to large losses, at age 65 or 20, that is why for the average investor nothing significant ever happens with their money---they get good returns in the up years and then give it all back in then some in the down years.

4. The market doesn't care how old you are----moving money based on your age makes no sense, move it based on market dynamics.  During a period like 1995-1999 when making money in the market was easy a 65 year old has just as much a right to earn 30% a year as a 30 year old did.  During 2000-2002 and 2008  a 30 year old has just as much right to be protective as a 65 year old does.