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FACTS OF INVESTMENT
LIFE TO PONDER FROM A NON PROFESSIONAL
THOUGHTS OF SOMEONE WHO
HAS SAT THROUGH HUNDREDS OF INVESTMENT SEMINARS, EXPLANATIONS, SALES
PITCHES AND ANALYSIS BY INVESTMENT EXPERTS AND IS TRUSTEE AND FIDUCIARY
ON DOZENS OF ACCOUNTS…BUT THINKS IT ALL COMES DOWN TO SOME COMMON SENSE…
Attorneys are expert
in law and litigation and not necessarily in investments. Nevertheless,
one does not practice law, particularly business and trust law, for
decades without learning some basic truths about investments in general.
This article is to share some common sense truths learned by a lawyer
who has sat through and been involved in thousands of investment
planning sessions…and seen the successes and failures over the decades.
It is common sense, not deep study…but it seems to work for most of the
estates, trusts, and equivalent accounts we work with.
Often our clients
ask our opinions about particular investments or about advisors.
Occasionally, we are asked about criteria to utilize in pondering how to
invest in stocks and bonds, real estates, limited partnerships, etc.
and about appropriate rates of return. Since we are often trustees and
executors, or advising same, the ability to evaluate investment
performance is at times required.
Of course, the
Prudent Investor Rule
and the
Unitrust
rules impose upon fiduciaries a specified type of return on investments
and a person considering what to expect on returns would do well to read
those articles since they express what the experts think a reasonable
return on investments would be in this day and age.
Another good place
for an investor to learn some truths about appropriate investment is how
the Courts and juries have traditionally treated those charged with
obtaining a conservative but appropriate return on investments-the
executors and trustees who handle the monies left in Trust. For the last
hundred years both the Courts and legislatures have laid down minimal
requirements for performance that a “reasonable fiduciary” should obtain
while handling investments. Since the decisions have been rendered over
decades, their instructions and lessons are not limited to a particular
market or boom or bust period. The lessons are universal.
Their lessons are
useful to keep in mind since they derive from the objective
consideration of Triers of fact who, inevitably, have heard both sides
of the argument in the trial or hearing. And their lessons are at times
surprising. Roughly, the following truths seem appropriate in most
circumstances.
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STAYING IN CASH IN NOT SAFE IN THE LONG TERM:
Note that simply sitting in cash or even low interest money market
funds has been held by the Courts to be a breach of a fiduciary’s
duties in wisely investing. With inflation historically at two to
four percent in typical times (and up to 18% or down to .00% at
other times) one must expect erosion of investments if one does not
seek to earn at least four to five percent. Inflation erodes any
asset that earns less. And the loss is significant. Assuming 3%
inflation, if you are in cash now that earns .05% in savings, you
lose 2.5% a year. A hundred thousand dollars, after ten years, would
be worth $75,000 at that rate. Further, since you pay taxes on your
earnings, you actually would be down to less than sixty five
thousand dollars in real money by choosing that investment. Thinking
you are being safe, you have actually nearly guaranteed a loss of
over one quarter of the value of the asset. The courts have held
that a breach of fiduciary duty. For short periods of extreme
turbulence, cash or near cash investments may make sense. In the
long term, they are inevitably a bad choice.
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TIME MATTERS IN RISK:
The studies clearly show that a diversified portfolio in the stock
market has a ninety percent or greater chance of earning a profit
for you if invested for ten years or more and that the annual
appreciation if reinvested will exceed six percent on the average.
However, if the window for investment is five years or less, the
chances of success drop from 90% to about 60%. If you are going to
need the money in less than ten years, the stock market is a real
risk. If you will not need it for more than ten years, it is a very
safe and profitable investment.
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DIVERSIFICATION MATTERS:
Again, the studies are clear: no class of investment is always
beneficial. All go up or down at one time or another. There is no
“safe bet.” Even cash, as seen above, is a bad investment in times
of inflation or if the return is not significant.
The need for diversification of types of investments seems a lesson
that is apparently forgotten every ten years by the bulk of
Americans. We just finished a period in which laypersons were
convinced real property could not decline and borrowed heavily to
buy it. Ten years before then, stocks “could not lose” and people
borrowed heavily to buy them. The collapse in real estate of 2006
was astonishing to these people. When the stock market plunged in
2001, the surprise was widespread. The only surprise should
be---that anyone thinks any investment will continue to appreciate
forever.
All investment classes sooner or later go up. All investments sooner
or later go down. To maximize return, you need a mix of
investments ranging from stocks to bonds, from real property to
cash equivalents, from domestic stocks to emerging market stocks.
The more you diversify, the less risk you run. The moment someone
advises you that a particular class of investments is a sure thing
and bound to appreciate no matter what…find another investment.
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MARGIN BUYING IS RISKY.
Again this is a lesson that seems to be forgotten by the bulk of
people much of the time. While all investments have some risk, if
one borrows money to maximize return, the risk is greatly increased.
In the first part of this century, it was those who borrowed to buy
stocks that faced catastrophe. In 2006-8, those who borrowed heavily
to purchase real estate or used equity lines to obtain cash faced
catastrophe. If you own an asset and the market goes down, you can
“tough it out” and merely retain the asset until the market turns
around, as it always does. But if you have borrowed money to buy the
asset, you face nervous creditors who may call the margin or face
payments that are significant at the very moment that your assets
are depleted.
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HIGH RETURNS ARE SUSPICIOUS.
“If it’s too good to be true…it isn’t true.” That axiom is, itself,
not always true. All of us know people who have doubled their money
with some remarkable investment. Real estate made many millionaires
in the last decade. What is probably more appropriate to conclude
is that what is too good to be true will soon not be true. Nothing
goes up forever and if you are making very good, indeed,
surprisingly good money in any investment, recognize that it will
soon end, take your profit and exit.
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THERE ARE NO EXPERTS.
It was perhaps fifteen years ago that, more as a stunt than as a
scientific inquiry, a famous newspaper tried throwing darts at a
board with stocks on it and purchasing the stocks based on what the
darts hit...then compared it to following the advice of ten of the
best gurus in the field. They did it for a year. The dart board did
not win…it was simply just as good as the best of the advice
received. Anyone brilliant enough to invariably chose right…already
chose right and left the market and does not have to waste time
telling you how to invest. Anyone with a sure fire scheme to beat
the market would not be selling it to you if it worked. He/she would
be beating the market.
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PAYING BY THE HOUR IS THE CHEAPEST ADVICE THERE IS.
If you want investment advice that is truly objective, do not ask
advice of someone who is paid money only if you buy the investment.
This is so obvious that one would not think it was necessary to
advance, but the number of people who rely on investment brokers
paid a commission or investment advisors who are directly or
indirectly paid predicated on the number of trades (either as
kickbacks or by you) is remarkable. Investment advisors can be found
who charge by the hour or by the total increase in your portfolio.
They are the only ones whose advice is not subject to the powerful
influence of conflict of interest.
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THERE ARE NO NEW MIRACLES THAT HAVE ALTERED THE PLAYING FIELD.
The first new product that was going to revolutionize the stock
market and could never go down was…tulips. In Holland. The “bust”
destroyed most of the middle class of Holland and much of the upper
middle class of England. That was four hundred years ago. We just
finished two recent pyramids (real estate and, before that, the high
tech boom) and in both cases “experts” carefully explained that the
vagaries of the new technology and market no longer created a
situation in which investors need fear a decline in the market. The
Dow was supposed to hit thirty thousand by 2003, the pundits claimed
in 1999 and real estate would appreciate at ten percent or more a
year for at least a decade a real estate expert advised this writer
in 2004.Historically,
diversified investments will appreciate at six to eight percent if
kept in a diversified portfolio over time. If your asset appreciates
faster than that, it will eventually stop or decline. If slower than
that, it will eventually accelerate. What has occurred for four
hundred years is not going to stop because of a particular new
technology or popularity of a type of asset. Sooner or later the
medium return will occur.
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DEBT IS DANGEROUS. CREDIT CARD DEBT IS RUINOUS.
Your best investment is not to owe money. It not only allows you to
save interest payments but gives you freedom to determine if you
wish not to sell due to tight money, and allows you, if you have
developed a cash reserve, to buy from those who do not apply this
maxim. The more you owe, the less freedom of action you have. Margin
appreciation is nice, yes. To enjoy appreciation on a million
dollars of assets that only cost you one hundred thousand out of
pocket as a down payment is fine so long as nothing wrong happens.
But if that asset drops or you lose your income stream, that margin
appreciation not only disappears but you are facing a very dangerous
situation in which you may have to sell at a loss. Credit cards
usually have terms that indicate that even a day late in payment
allows permanent increase of interest to sums appropriate to
organized crime. It is typical to pay 22% interest or more. Thus,
the moment things are tight, you face an increase in interest that
is disastrous to your budget. The best recipe for investment? Stay
out of debt.
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401KS ARE THE BEST INVESTMENT AROUND.
Given the tax benefits, the 401K should be the very first investment
you seek to maximize. You use before tax dollars to invest and
do not pay tax on the income you earn until you retire. That, alone,
is a thirty percent bonus from the government on the investment.
Same with IRAS.
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THE FAMILY HOME IS A GOOD INVESTMENT. IT IS NOT A BANK.
Given the tax benefits of interest deduction, property tax
deduction and capital gains protection inherent in the family home,
it can be a very good investment…but only if one buys what one can
afford and does not utilize equity lines to eliminate equity. The
home will appreciate about six percent a year over a period ten
years or longer. Not every year, but on the average. If it goes up
faster than that, it will eventually stop or go down long enough to
equal out. It is where you live, not your primary investment in
life.
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TAXES MATTER. A GOOD CPA IS MORE VITAL THAN GOOD INVESTMENT ADVICE.
TAXES CHANGE.
Your investment horizon is twenty to thirty years if you are smart.
In that period of time, the tax laws will radically alter once, and
substantially alter two or three times. In the last thirty years,
credit card interest was deductible…then not. Income tax and capital
gain rates have gone up…then down…then up. Estate taxes
plummeted…and now may go up again. Etc. etc. In California, combined
with the Federal tax rate, your operative rate if you are making
good money will be 43% today. Absent tax planning, a return of six
percent becomes a return of less than four percent. It will barely
keep ahead of inflation. Your only chance to make real progress…is
good tax planning. Find a good CPA and get his or her advice. Plan
ahead. But never chose an investment that will only have tax
benefit. That was the mistake of those who invested heavily in
limited partnerships before the collapse of the Savings and Loan
system fifteen years ago. Seek tax benefits, yes…but if that is the
only benefit of the investment, find a different investment. Taxes
are never one hundred percent…thus a loss is always greater than the
tax benefit. You need investments that will appreciate or generate a
profit.
13. THE GOVERNMENT WILL NOT SAVE YOU.
There is only one entity worse at saving and investing than
you are. The United States government. The National debt skyrockets
while we lower taxes that are needed to reduce it. We go to war and
borrow the money to do it, previously predicting that oil from the
conquered nation will pay the entire cost of the war. To expect this
lack of economic intelligence to provide security to you when you retire
is foolish. If Social Security or equivalent programs generate
significant sums to you when you retire, consider it frosting on a cake.
14. HAVE THREE MONTHS COST OF LIVING IN
READY FUNDS. Add up your monthly nut (including taxes) and
develop an emergency reserve to utilize if things go badly for a few
months. Put the money in money market or equivalent so you can access it
immediately. In that manner, you will not have to sell longer term
assets at a loss due to pressing need. More, you will not have to go
into debt.
15. UNDERSTAND THE IRON LAW OF RECOVERING
LOSSES. If you lose ten thousand dollars you will not earn
interest on it to make up the loss when the market recovers. You have to
use other funds to recover. Thus, losing ten thousand means that when a
recovery occurs and one can make eight percent on money, you will not
make eight hundred dollars annually on that lost amount. As such, the
more you go down, the harder it is to generate an income flow to
recover. It is thus better to earn less than to earn more, lose more,
and try to recover. Put even more simply, it is better to make a steady
9% than 12% which averages twelve by going up and down over a multi year
period…since when down, you will be making 12% on far less principle.
16. HAVE SOME WILD MONEY.
Utilizing all the above rules will probably eventually make you a good
return in most economies. There are no guaranties but that is a likely
result. However, nothing will save you in a very bad economy. Only cash.
One problem with the above plan is that it is boring as well and
investing needs some excitement. Put aside perhaps five percent of your
portfolio and invest in some likely investment that may truly make a
great deal of money. You almost certainly will not, but you will also
find yourself truly interested in that investment and it will stop your
tendency to play around with your other investments.
17. MUTUAL FUNDS ARE BETTER THAN STOCKS…IF
NO LOAD. Again, the studies have shown that attempts to get
good return from investing in individual stocks is extremely difficult
minus very long term investing and a good deal of luck. Mutual funds
which are no load (do not charge you to invest at first) have experts
but, more importantly, have diversification. And, as noted above,
diversification is almost always better than concentration on a single
investment. The studies have consistently demonstrated that your chance
of a return if investing in mutual funds rather than picking individual
stocks is almost doubled. There are so many mutual funds now existing
that you should be able to select one for almost any class of
investment. Check their history during bad times…for if you are
investing for ten years or more, those bad times must come. Again,
avoiding going down in bad times is more important than going up very
fast in good times.
18. DO NOT LOAN MONEY TO FAMILY OR FRIENDS.
DO NOT INVEST IN YOUR BROTHER IN LAW’S BUSINESS. An elderly
client put it to me quite well. If he invests in family, either via
loans or buying part of a business, he considers the money a gift and
expects no return. The alternative…to create ill feeling in the family
or a feeling of victimization…is simply not worth it. “I make money from
strangers where I can be as tough as nails. Family is for giving.”
Underlying this approach is an understanding that cutting losses and
enforcing rights is an inherent part of protecting one’s assets…and very
difficult if family is involved. It is true that most businesses in the
world are family businesses and most people who work in business work in
family businesses. What we are speaking of here is loaning money and
investing.
19. LIFE INSURANCE IS TO INSURE LIFE, NOT
TO MAKE MONEY. Over the years the types of life insurance
available have greatly accelerated with plans and methods of great
complexity. Some claim to be good investments. However, some simple
analysis will indicate they cannot be. If a company has to put aside
enough money for the contingency of paying you money upon death, it
faces a liability that requires reserves that are available thus what
you pay to them is already discounted for their own investment purposes.
How on earth can they generate income to you that is competitive with
that disadvantage? Life insurance does serve useful economic purposes.
It can provide security for a family or business. It has tax advantages
for estate and trust planning. It is not, however, a good investment
vehicle unless one needs it for those other purposes as well. And,
again, get advice on insurance from people not earning a commission on
selling it to you.
20. IF YOU DO NOT UNDERSTAND AN
INVESTMENT-SKIP THE INVESTMENT. As just seen with hedge
funds, and, indeed, with the plethora of acronym laden investments of
the last twenty years, investment professionals love to create extremely
complex vehicles which, quite often, seem to generate good returns for
some years. But with few exceptions, the more complex they are, the
sooner something is likely to go wrong and the collapse seen is usually
severe. The reason is simple: most such complex structures boil down to
using someone else’s money to achieve margin investments of high
proportion. Eventually, usually when the market retreats, the margin is
due and without equity, the whole scheme collapses. This does not mean
they are illegal. It means they are fragile.
Any investment that you put your money in should be simple and
straight forward enough for you to quickly grasp what it is about. If it
is so complex you need a battery of experts to explain it to you…find
something simpler and utilize that. Complexity does not mean
sophistication or value. It simply means…complexity.
21. EMOTION HAS NOTHING TO DO WITH IT.
Another elderly client had a rule that is intriguing. He
stated that if he found he was getting excited about the investment and
its potential he does not invest in it. (In that case it was solar
energy in the 1980s.) “Investment is to make money. It is not to have a
hobby. I cannot be hard minded if I truly enjoy what the investment is
trying to do in the market. I want it to succeed too much. And cutting
losses is often critical.” If you find yourself defending an investment
with other than economic criteria, examine your motivation. You may be
confusing politics and preoccupations with investing.
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CUT LOSSES AND RUN WHEN APPROPRIATE.
To take a loss and finally sell the investment you were foolish
enough to make can be the most important economic decision of your
life. It is hard. It is tempting to hold until there is a recovery
and if one’s outlook is long term, that can be a valid approach. The
problem you confront is that as your investment declines, you lose
the ability to make money on each dollar lost when the recovery does
return and to pull out, stay in cash, then reinvest, may be
appropriate. This writer has often found that emotion can play a
role here. Admitting error in choice of investments can be difficult
and one can always find someone to argue that the investment’s
recovery is just around the corner. This is one of those areas that
outside advice can be useful since the person advising you does not
normally have the burden of having been the one to select the losing
investment. See the Iron Law of Recovering Losses described above.
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IGNORE SHORT TERM VARIATIONS IN THE MARKET.
The corollary to the above rule is not to overreact to short terms
ups and downs in your investment. All investments will show upward
and downward trends at one time or another. A good rule is to adopt
the “three month” criteria. If your investment remains declining
after three months, consider cutting losses and parachuting. If
still down after six months, seriously consider selling. Get tax
advice since the loss may be useful if your other investments are
appreciating.
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IF YOU ARE AWAKE AT NIGHT, CHANGE YOUR INVESTMENTS.
Everyone has their own level of comfort. If every vagary of your
investment causes deep concern, invest more conservatively. You may
not make as much money but the money should still be appreciating if
you follow the above rules and making a little less will allow you
to sleep.
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CHANGE YOUR GOALS AS YOUR LIFE CHANGES.
The younger you are the more risk you can take since you have time
to recover from losses. Further, the closer you are to living off
the income from your investments, the more appreciation is of less
value and income flow important. Usually, equities decrease and fix
income assets such as bonds increase as one ages. Nevertheless, the
mix may change but do not invest solely in a single asset as
discussed previously. A typical mix when thirty five years of age
is eighty percent equities and twenty percent fixed income. A
typical mix when sixty five years of age is reversed. The market and
your own plans will alter this basic rule but the overall trend is
usually the one to implement.
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USE THE FIFTY WORD RULE.
Another very smart client advised me that he had a fifty word rule.
Any investment portfolio that could not be explained in fifty words
was too complex to trust. For example, “I have fifty percent in
bonds, thirty percent in stocks, twenty percent in second deeds of
trust.” Or, “I have most of my wealth in my business 401K and sixty
percent of that in equities and forty percent in bonds. The rest is
in my home.” That may be extreme. But he died a multi millionaire
and slept most nights.
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