Sunday, September 18

Week -11 Summary - Punters and Bolters (we’re neither)

Situation: There are many styles of investing, and “buy and hold” is currently out of style. Here at ITR, we propose that the modest but relatively stable returns from buy-and-hold investing can be optimized by a) limiting our stock investments to those that are of high quality and have provided a total return that beats the S&P 500 Index over two market cycles, b) emphasizing the centrality of bonds, c) cutting transaction costs, and d) buying stocks and bonds when they’re cheap. These goals can be met with dollar cost averaging by using online dividend re-investment plans (DRIPs) and no-load mutual funds.
Goal: Summarize ITR’s investment philosophy.
We focused on Risk in the Week 7 blog, and the conclusion was pretty straightforward: risk comes from borrowing money to buy things. The government helps homeowners and corporations borrow money by making interest payments non-taxable. Both homeowners and corporations enjoy a greater return on investment by borrowing part of the capital needed to buy homes and expand facilities. These policies act to lower interest rates and accelerate economic growth but all debts eventually have to be repaid. Let’s start with your present situation (if not yours, then your neighbor’s).
What happened to your retirement savings? For many of us, our savings consisted mainly of our home equity - the same equity that we refinanced to pay the college tuition of our kids, or pay off credit cards, etc. Likely as not, your home equity is now a negative number since home equity equals market value minus the mortgage balance.
What caused your home equity to collapse? Owning real estate has historically been the riskiest sector in any economy. Values can change dramatically in both directions, and will follow the boom and bust cycle of the construction industry which, in turn, follows the boom and bust cycle of interest rates - often set unrealistically low by the Federal Open Market Committee. Twenty years ago, our government (aided and abetted by bankers and financiers) began to encourage home ownership by whatever means necessary. This compounded the risk inherent in home ownership by allowing mortgages to be obtained without evidence the loan could be repaid (Gretchen Morgenson and Joshua Rosner: Reckless Endangerment, Times Books, New York, 2011). Other governments, such as Canada’s, continued to restrict home ownership to those with adequate finances to make a down payment and an earnings horizon that is likely to fund repayment of the loan. The Canadian government did not have to bail out it’s banks during The Great Credit Bust of 2008. Canada did not have a credit bust, nor did Canadian homeowners default on their mortgages at an increased rate.
How is my home going to recover it’s value? That will happen when enough babies are born, enough vacant and run-down homes are bulldozed, and enough foreclosed homes are sold. Then, a growing demand for housing will encounter a dwindling supply of suitable houses or apartments, and prices will rise accordingly.
Our view at ITR is that the decision of where to live is a personal choice based on utility, and that it is better to take a less personal and risky approach to saving for retirement. We recommend sticking to stocks & bonds, where a great deal of historical data illuminates the choices you’ll make. Unfortunately, some people try to find the same kind of personal gratification from owning stocks & bonds that they seek in owning a home. Personal gratification of the short-term kind is also known as an adrenaline rush. This rush is addicting and leads to “short-termism”. When dealing with stocks & bonds, a short term mentality leads to a high turnover rate: Half or more of the positions in a stock portfolio are different at the end of each year than at the beginning. With respect to managed mutual funds, where turnover rates often exceed 30%, portfolio managers try to predict a company’s future prospects but then change their mind and sell a holding they label “dead money” to pursue something more promising. In Great Britain, the term that is applied to such speculators is “punter”. A related term is “bolter”, denoting one who engages in poorly considered asset sales. Either action may be based on rumors, since insider information is one way to beat the market. The point is that either behavior may exist to provide the next adrenaline rush, which can become habit forming and spread to things (“starter home”) and people (“starter wife”).
With stocks, the ITR goal is to offer a long-term path to improve on the performance of the S&P 500 Stock Index while incurring less volatility. Bonds (including international bonds) are used as a hedge against stock market over-valuations and currency risk. Our recommendation is to make careful but small purchases of each stock regularly in a DRIP, and to continue this for at least 10 years. It is a good idea to pick at least 5 DRIPs. (For example, this writer dollar-averages into IBM, KO, XOM, NEE, and JNJ.) Over time, you will expend the same amount of money when stocks are over-priced as under-priced. The key point is that such a program forces you to buy stocks when almost no one else is buying. Many studies have shown that the greatest risk faced by the individual investor is that she will stop buying stocks during a recession, and stop buying bonds when the economy is booming and stocks are soaring. Even worse, she may decide to sell stocks during a recession in order to buy into bonds (which are overpriced at that point), i.e., unless she is firmly committed to dollar-cost-averaging she will “buy high and sell low”.
Investors today have an added advantage in being able to use a computer-based “point-and-click” method of acquiring stocks and bonds. This approach takes on the importance of being a “best kept secret” in investment strategy because it allows small investors to keep their buying and selling fees to a minimum. Witness the myriad ways that mutual fund managers are using to deplete earnings from pension funds by levying mysterious and ill-explained fees or paying commissions for a high turnover rate! Being your own fund manager allows those expenses to be recouped and added back in to your investment. You’re only going to sell a stock if a) you retire, or b) the reasons you bought it no longer apply (i.e., it falls off the Master List).
Bottom Line: A 50:50 stock:bond portfolio is a safe and effective way to save for retirement, particularly when a) the internet is employed to lower costs, and b) purchases are made regularly through automatic electronic withdrawals from your checking account so as to be certain of catching financial assets when they’re “on sale”. Variance and risk are further reduced if your stock selections are confined to high-quality companies with a history of a) carrying less debt than equity, and b) increasing dividends annually.    
The stock market has been particularly volatile for the past several weeks, providing a test of sorts for our quality-based stock-picking thesis. As of 9/10/11, 8 of the 34 companies on our Master List have out-performed the S&P 500 Index (in terms of price) over the past month, 3 months, 6 months, yr-to-date, two yrs, and 5 yrs: CVX, KO, CL, MCD, PG, MKC, VFC, and GWW. We know of only one mutual fund that has managed the same feat, VWINX (the bond-heavy Vanguard Wellesley Income Fund).

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