The Bouncing Ball Principle

There is a huge difference between stocks and fixed income investments. Stock prices will move up and down while T-Bills and bonds won't. The problem with having a desire for higher returns is that we will have to endure the ups and downs of stock prices to get them. In other words there is a price to be paid in order to move up to the potential of high returns offered by investing in the market. The big question each investor must answer is whether or not they are truly ready to put their hard earned dollars into an investment that can lose its entire principal. A lot of people will say that they are ready but it isn't enough to just say that we are ready. We must embrace the plan that we choose to follow for investing our hard earned dollars. The problem is that if we aren't convinced in our hearts that we are dong the right thing then we will run at the first sign of dropping prices. There is a saying that I have heard throughout my life which says that everyone wants to get to heaven but yet no wants to die. We all want to reach a goal. For me that is to be able to retire and for you it may be something entirely different but the key is that each one of us has at least one financial goal that we are reaching for. If it is a long term goal that there is no better place to park our dollars than in the stock market. The bouncing ball of rising and falling prices which follows is simply part of being in the market. Put simply - they are a part of the stairway to our investment heaven which is the place where we reach our goals.

Quotes

Today I have two quotes that I want to share with you. The first is from Albert Einstein. It may even surprise you to find out that a lot of the things that I am doing in my own investment program today are based upon his theory of economics. We all know about his E = MC squared but very few people have heard a lesser known statement that he also is said to have made.

"Compound interest is the greatest mathematical discovery of all time."

As I continue to talk about various investment vehicles that can put our money into it will become clear to you that I am soured on certain ones. When I was younger and working as a financial planner my whole theory was based on the beauty of diversification offered by mutual funds. In every professional magazine that I read reference after reference was made about the wonders of mutual fund investing. We can put in as little as $50 a month and be invested across more than 100 companies. How can anyone go wrong with an investment like this? There is an evil side of mutual funds that few people talk about. Unfortunately I led people into these things like cattle to slaughter. What is this evil lurking in the mutual fund shadow world? It is the evil of management fees. I call them evil because they can single handily destroy our ability to create wealth! You may be wondering at this point what is so bad about the fees charged by mutual fund families. The industry average at this point is said to be about 1% which doesn't seem to be that high of a price to pay for the opportunity to have a true expert manage our money, right? Wrong! Over a twenty year time frame just a 1% management fee will reduce our total return by 17%. I don't know about you but I want to maximize my return as much as possible and 17% is kind of a hefty fee to pay. People think that if they can just get past the loads some fund families charge by going with no load mutual funds then they will be home free but this isn't true because there is no fund out there which does not come without management fees. I have already said that 1% is said to be the average but quite a few have fees of 3% or higher and most investors never take the time to see what they will really be paying. None of the above will apply to our portfolio if we find a manager who will guarantee that they can get us a return that is at least 3% greater than what we can do on our own but I wish you luck in finding a manager who will do so. The reason that they would never make such a guarantee is that they could never do such a thing. The second evil of mutual funds is found in the second quote that I would like to share with you:

"The surest way to accumulate wealth is to make sure that you never pay taxes on income your don't use."

John D. Rockefeller said this and it is something we all need to keep in mind as we select investments to put our money into. Most of us don't have a whole lot of money to put into our investment programs and to have what little we have eaten up by taxes and fees is ludicrous! I don't know if you realize it or not but every time a fund manager buys or sells a stock the capital gains are passed on to us and we get to pay taxes. If dividends are paid in our mutual fund we get a tax statement for Christmas. I have discovered a way to invest in stocks that takes advantage of both compounding and also minimizes both taxes and fees - a win win on every side.

The Problem We Face Today

In the past retirement was something people didn't have to think about. Companies had pensions available and for the most part all a person had to do was put in their time and they would have a retirement pension from their company. When I was in the financial planning business it always amazed to have people come in who were in their 70's. They would show me thier investment portfolio and then show me their pensions. These people had come up in much simpler times then you and I are living in today. They could have actually gotten 5% from a local bank's passbook saving account. I dare you to find a bank paying this type of interest today in a simple savings account! What a wonderful time that must have been. The boss took care of retirement and social security would have taken care of any gaps which left any savings to be used for whatever a person wanted. Today things are different. Defined benefit plans (the things that used to provide retirement) have for the most part dissapeared as far as the average working stiff is concerned. The muckety mucks up at the top still have them but how long that will last with the economic situation we have gone through is questionable. This is the problem we are facing today. When we retire the vast majority of us will have our social security (if that lasts) and whatever we have put aside in savings to support ourselves through our retirement years. My father retired last year with approximately $250,000 in investments. This sounds like a lot of money but now he is faced with how to take an income out of that portfolio and not using it up. This isn't as easy as it sounds. This is the problem we all face. This is why I have seriously dropped the ball in waiting till forty to start. The companies I have worked for have never provided a 401(k) plan and retirement seemed sooo far away. I believe though I have found an answer that any of us working stiffs can take advantage of that will enable us to still have a comfortable retirement and that is why I have chosen to start this blog.

The Problem We Face Today

The Dangers of Fixed Income Investments

In the past it was entirely possible to earn a much higher rate of return in T-bills than the inflation rate. This was a long long time ago though. Today things have changed and we must consider the effects of inflation of our 'purchasing power.' Wikipedia defines 'purchasing power' as:'Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold or silver, or fiat currency like US dollars which are the world reserve currency[citation needed]. As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency.'I like to think of the concept as being what I am able to buy after inflation takes a silent bite out of my earnings. As an example let's think about the number of things we could have done in 1945 with $10,000. The mind could go wild with the possibilities as a person could have even bought a modest home with that amount. Today we cannot even fathom the concept of buying a home for $10,000! One thing I have discovered in my studies is that at an average rate of 4% the value of my hard earned dollars is reduced by at least half each decade that I live. This would be an average rate because a lot of things have prices which rise faster (exg. health care) and will cut the value of my dollars even greater that 50%. What does this do with our building an investment portfolio to prepare for retirement or some other long term goal? Well if we are planning to live for more than ten years (and you can bet that I am) that the vehicles that we choose to plant our hard earned dollars into better have a rate of return that grows fast enough to overcome the effects of inflation. The title of this blog is 'The Dangers of Fixed Income Investments.' A lot of people who read this might wonder how any 'fixed income' investment could ever be dangerous. In my mind they are dangerous simply because of the fact that they do not rise with inflation. With this in mind I would even dare to say that a bond is actually an even riskier investment than a stock if we are investing for the long term because it cannot increase in value. In fact I would even go so far as to say that the only useful means I have actually found for fixed income investments is in using them as a parking lot. If we have money that will be needed in less than five years then we need to be thinking about preserving the money that we have worked hard to get into our hands. Other than serving as a parking lot for short term needs they are something we will need to steer clear of if we are investing for the long term. I will talk about these things more in future blogs but let me finish with a few last thoughts. History teaches us that for any long term investor stocks will be the best bet. Stocks are investments which will grow over a period of time. Fixed income investments are parking spots where our principle is safe and where our return is fixed.

Inflation

I began to talk yesterday about asset allocation and used an illustration of a gambler betting on every horse in the race. The key to understanding my thoughts in this matter is to understand the environment that investors live in. A lot of people miss this key part of investing in their search for the 'hot' investment that will make them rich. It is important though for us to take a step back because the environment is a major part of any successful investment program. There are several key forces that will affect our investment program just as gravity affects everything and everyone on the earth. Just as it is impossible to ignore gravity so also is it impossible to ignore the environmental factors affecting any investment that we decide to put our hard earned dollars into. The first of these factors is inflation. As I have been reading and interviewing various people about investments I have been surprised to find very little people acknowledge this as a factor affecting the return we experience from our portfolios. It is important for us to take this into consideration because studies tell us that there have actually been only two years since World War II that have seen a decline in inflation. The average I have found is 4.10%. This means that if we obtain a 3% return then our investment has still lost because it is below the inflation rate. Do you see the problem with this? One problem with inflation that a lot of people miss is the fact that it will compound over time. In other words the price that we pay for our 'stuff' will increase each year and this will cause the value of our original investment dollar to decline. To simplify this concept - if the price of a pack of gum doubles over the lifetime doubles over the life of an investment and the amount you invested had been enough to buy a pack then that investment would have to double over its lifetime in order for us to buy a pack when we cash in. Inflation affects the price on everything we purchase. I remember buying gasoline for 62 cents when I first got my drivers license and now it is hard to find it for less than 2 dollars a gallon! The reason for the increase is inflation. Statistically a 4% inflation rate will cause the price of goods to double on an average of 18.1 years. This means that an investment with the goal of enabling us to retire at a decent age will have to gain more that 4% annually in order to keep us ahead of inflation. So as we seen then inflation is the first hurdle we are going to have to overcome in order to be successful in our investment program.

Discoveries

So I have now determined the need to catch up and have investigated a number of options and have discussed my problems with a number of people I know who work in the investment business. Some have recommended 'balanced' portfolios, some say to invest in mutual funds, and others have other ideas. Do you get as confused as I do by all of these options? The most common of all buzzwords that I keep finding is asset allocation (which is actually two separate words). I have discovered that there is a theory floating around the investment community which states that 'risk' goes down the more a portfolio is diversified. After reading more than thirty investment books over the last two months I have determined that risk can refer to both volatility (the up and down fluctuations of value in the investment price) and to the 'risk' of not being invested in a the best performing investment on earth. As none of us has a crystal ball the theory goes that we have to spread our investment dollars across a number of different investments in order to maximize our chances of getting that great investment. In a way it reminds me of a gambler at a horse race that wants to guarantee his being able to win by betting on every horse in the race. By betting on each horse he will guarantee his ability to bet on a winner even though the majority of his bets will end up being losers. A friend who works as a stockbroker told me this was a bit extreme but I am just a novice trying to come up with a way to understand what is going in the investment arena. This journey is in some ways like trying to learn a new language! Extreme examples aside I can truly say that I truly believe from my research that if done right it is almost impossible to lose all of your money in an investment unlike a horse race even though I am thinking that the asset-allocation mentality I am seeing seems to be very much aligned with the gambler who bets on every horse. This isn't an entirely positive thing because it seems entirely possible for an intelligent person to be able to create a portfolio without spreading what little dollars are available to invest among an untold number of different asset classes. I don't know about you but I have gotten entirely excited just seeing my little portfolio grow to $1,000 over the past four months. This has taken sacrifice and serious budgeting but I am sure it will be worth it in twenty years when I am ready to retire!