The Long Game

April 16, 2017

Happy Easter!

Successful investing requires a far sighted vision. At the end of each year Vanguard sends its customers their long term outlook. This last one contained a few caveats: “the investment environment for the next five years may prove more challenging than the previous five, underscoring the need for discipline, reasonable expectations, and low-cost strategies.”

Vanguard’s ten year estimate of annualized returns is about 8% for non-US equities, 6.5 – 7% for the US stock market, 5% for REITs (real estate) and commodities, and 2% for bonds.

Vanguard’s team projects that a diversified portfolio of 60% stocks/ 40% bonds will return 5.6% annually over the next ten years. An agressive 80/20 mix they estimate at a 6.6% return, and a very conservative 20/80 mix at about 3.3%. Insurance companies typically adopt this safe approach. (Source)



Investors near or in retirement must often turn to their investments for supplemental income. Annuities are sold as a safe “set it and forget it” solution, but they come with upfront fees and currently pay low interest.

In early 2008, before the fianncial crisis, a 65 year old man could get an average annuity (the average of a 10 year and life) for 5.5% a year. That provided a guaranteed income that was more than the classic 4% “safe” withdrawal rate for retirees. That 4% withdrawal rule would normally ensure that a retiree did not run out of money before they died.

The average annuity rate for that same age is now half that interest rate (Source). For an investment of $100K, a 67 year old male living in Colorado can get a lifetime annuity of $7212 per year (CNN Annuity Calculator) For 14 years, the insurance company providing the annuity is essentially returning the investor’s money to them. If that male investor lived for 20 years till age 87, they would receive a total of $144K, an annual return of only 1.84%. If the retiree lived to 97, their annualized return would increase to 2.5% over the thirty year period. Clearly, an investor is paying for safety.

Wade Pfau is a CFP whom I have cited in previous blogs. Here he compares the advantages and disadvantages of investments vs. insurance. He makes an argument that an annuity that covers one’s essential needs allows a person to take more risk with the rest of their portfolio. The potentially higher return from the investment side of the portfolio can thus make up for the lower returns of the annuity, an insurance product. He does caution, however, that most annuities do not protect against inflatiion. A investor who needed $1000 extra dollars in monthly income in 2017, would need more than $2000 in 30 years at a 2.5% inflation rate.

Managed Payout?

One alternative is a managed payout fund. The Vanguard Managed Payout Fund VPGDX lists the fund’s holdings as 60% stocks with an almost 20% allocation to alternative strategies. Alternatives vary in volatility depending on the intent of the investment but let’s treat them as though they were mostly a stock, giving the fund a simple effective allocation of 75% stock, 25% bonds. This fund lost 43% from April 2008 through March 2009, less than the 50% loss of the SP500 index but not by much. A broad composite of bonds (BND) actually gained 3% in price during that time. Here is some info from the investing giant Black Rock on alternative investments.

The return of the fund since its inception in April 2008 is 4.28%. Vanguard’s broad bond composite fund VBMFX, with far less risk, had a ten year return of 4.12% and gained value during the financial crisis. Although some mutual funds have trade restrictions, the prospectus on this fund lists no such restrictions, so that one could set up a monthly withdrawal from the fund.

A Vanguard target date 2030 fund (VTHRX), which has an allocation of 70% stocks, 30% bonds, had a ten year return of 5.31%. That fund lost 45% during the eleven month downturn in 2008-2009, slightly more than the Managed Payout Fund.  The additional 1% annual return is the reward for that slightly greater drawdown. A 1/4 of that additional 1% return can be attributed to lower fees.

The advantage of a Managed Payout Fund – simplicity and regularity of income flows – does not outweigh the disadvantages of volatility and some tax inefficiency. An investor could conveniently set up a monthly withdrawal from a broad based bond fund and enjoy the same return with much greater safety of principal, lower fees, and control over the withdrawal amount, if needed.

When it comes to retirement income, most investors would prefer the simple arithmetic of our grade school years.  Both Social Security and traditional defined benefit pension programs use that kind of math.  Each year, a retiree gets ‘X’ amount that is adjusted for inflation.  No choices needed.  However, most employees today have defined contribution, not benefit, plans. A retiree owns their savings, the capital base used to generate that monthly income, and it is up to the retiree to  navigate the winding channel between risk and return.

Portfolio Allocation and Timing

November 15, 2015

Gone Fishin’ Portfolio

I found this portfolio in a pile of old paperwork.  The idea is to allocate investment dollars in a number of buckets, then more or less forget about it, rebalancing once a year.  The portfolio is 60% stocks, 30% bonds, 10% other

I compared this broadly balanced portfolio #1 with a simpler version #2: 60% stocks, 40% bonds.  Because the Vanguard mutual fund VTSMX is weighted toward U.S. large cap stocks, I split the stock portion of the portfolio with an index of small cap value stocks VISVX.  The 40% bond component is an index of  intermediate-term corporate grade bonds VFICX.  I also included a very simple portfolio #3 without the split in the stock portfolio.  The 60% stocks is represented by one fund VTSMX.  The results from Portfolio Visualizer  include dividends.

Note that there is little difference between Portfolios #2 and #3 over this time period.  Although the Gone Fishin’ portfolio lagged the other two during this time period, it did do better during the period 2000 – 2006.


Market timing

Another approach is a fairly simple market timing technique as shown in this paper “A Quantative Approach to Tactical Asset Allocation”  There is no heavy math in the paper.  The timing rule is simple:  buy the SP500 when the monthly close is above the 10 month moving average; sell when the monthly close is below the 10 month average.  Using this system, an investor would have sold an ETF like SPY on the first trading day of September this year  because August’s close was below the ten month average.  After the index rebounded in October and closed above the 10 month average, an investor would have bought back in on the first trading day in November. The average “turnaround,” a buy and a sell signal, is less than one a year.  These short term swings are sometimes called “whipsaws,” where an investor loses several percent by selling after a quick downturn then buying in after prices recover quickly.  The payoff is that an investor avoids the severe 50% drawdowns of 2008 and 2000.

The author of the paper performed a 112 year backtest on this system. He excluded taxes, commissions and slippage in the calculations and used the closing price on the final day of the month as his buy and sell price points. He notes some reasons for these omissions later in the paper which I found inadequate. I recommend using the opening price (ETF) or end of the day price (mutual fund) of the day following the end of the month as  a practical real world backtesting strategy.  Very few individual investors can buy or sell at the closing price and there can be a lot of price movement, or slippage, in the final trading minutes before the close.

Commissions can be estimated at some small percentage.  To exclude commissions is to estimate them at 0% and present an investor with unrealistic returns, a common backtesting fault of many trading or allocation systems.  The same can be said for taxes.  Even if the guesstimate is a mere 1%, it is better than the 0% effective estimate of tax costs when excluded from the backtest.

The difference in annual real, or inflation-adjusted, return between this timing model and “buy and hold” is 4/100ths of 1% per year (p. 23) Because the timing model avoids the severe portfolio drawdowns of a buy and hold stratgegy (p. 28), that tiny difference translates into a difference in compounded return that is less than 1% which produces a huge 250%+ difference in portfolio balances at the end of the 112 year testing period.  None of us will be investing for that long a period but it does illustrate the effect of small incremental differences.

The author then combines an allocation model with the timing model using five global asset classes: US stocks, foreign stocks, bonds, real estate and commodities, assigning 20% of the portfolio to each class.  He backtested this allocation with the same timing strategy vs a buy and hold strategy (p. 30-31).  The advantages of the timing strategy are apparent during severe downturns as in 1973, 2000 and 2008.  A buy and hold strategy took eight years after 1973 to recover and catch up to the timing strategy.  The buy and hold strategy never caught up to the timing strategy after the 2000-2003 downturn in the market.  In 2008, it fell even further behind, highlighting the superiority of the timing strategy.

Returns are important, of course, but volatility and drawdown are especially critical for older investors who do not have as many years to recover.  From 1973 – 2012, the timing model has only one losing year – 2008 – and the loss for the entire portfolio was a mere 6/10ths of a percent (p. 32).


October jobs report

A few weeks ago I linked to an article on Reagan’s former budget director David Stockman.  On his web site, he presented a sobering and thorough analysis of the October jobs report.

Stockman breaks down the numbers into “breadwinner” higher paying jobs and the relatively lower paying leisure and hospitality jobs that account for too much of the jub creation in the past fifteen years.  Goods producing jobs – those in manufacturing, construction, mining and timber – are still far below 2000 levels.

“massive money printing and 83 months running of ZIRP [zero interest rate policy of the Federal Reserve] have done nothing for the goods producing economy or breadwinner jobs generally.”


Obama’s numbers

A president has far less effect on the economy than the political rhetoric would have one believe.  Despite that fact, each President is judged on his “numbers” as though he were a dictator, a one man show.  With one year to go in his second term, here are the latest numbahs from the reputable FactCheck.


January 11, 2015

Price movement continued to be volatile in this second week of the year.  Despite all the price gyration, the SP500 is down only 1% since the first of the year.  On Monday, light crude oil broke below the $50 price barrier, helping to usher in a rush to safety, namely U.S. government debt.  As the prices of long term Treasuries climb upwards, who is buying this Federal debt?  As the chart below shows, foreigners already hold the majority of Federal Debt.

As the dollar continues to strengthen, institutional investors around the world buy Federal Debt to enhance the return on their savings. Let’s say a European investor bought $132 of Treasury debt on September 1, 2014 for €100. Now that same investor cashed in that U.S. Treasury bill this past Friday.  What does the investor get back?  €111.46, without any accrued interest or fees included. In a little over 3 months, they have made almost 11-1/2% return, an annual rate of more than 40%.

On the other hand, the “carry trade” is getting squeezed.  The carry trade involves borrowing money in a country with a low interest rate, or borrowing low, and buying debt in another country with a higher interest rate, or loaning high.  This is a great deal – easy money – IF the currency of the country where an investor borrowed the money doesn’t start rising in value as the U.S. dollar has done recently. The problem is particularly acute in emerging countries which have higher interest rates to attract capital.

To keep the example simple, let’s use the euro again.  On September 1st, a European investor bought €100 of  French BTFs paying 5%.  Because interest rates are so low in the U.S., the  European investor was able to borrow the money in the U.S. for 1/2%, making 4.5% for doing nothing.  The investor borrowed $131.30, converted it to €100 and bought the BTFs.

This past Friday, the U.S. bank calls the investor’s loan so the investor cashes in her €100 BTF and gets only $118.42 at the current exchange rate.  They are short $12.88, an annualized loss of almost 36%.  What makes this simple scenario even more dangerous is that, in the real world, the investor has often leveraged their money, multiplying the losses.

The problem becomes particularly acute for companies headquartered in an emerging market (EM) country but which have a U.S. subsidiary.  The subsidiary borrows money at a low interest rate in the U.S., much lower than the prevailing rate in the EM country, then converts those dollars to the currency of the EM country to fund expansion.  If the EM currency loses value against the dollar, the company finds it increasing difficult to make payments on their loan because each time they convert their EM currency to U.S. dollars, the EM currency buys fewer dollars.  This is another kind of squeeze that may cause the bank to call the loan, or escalate the loan to a higher interest rate, creating even more financial pressure on the company.

This is the first time in fifteen years that the U.S. dollar has gained in strength against all major currencies.


Purchasing Manager’s Index 

As expected a few months ago, a composite of employment and new orders in the services sector continued to moderate in December.  In September, these two key factors of production were at the highest levels in 17 years, so some decline was anticipated toward the end of the year.

The CWPI, a composite of manufacturing and services sector activity in the country, continues to run strong, although it has also moderated from the higher peak set in October 2014.  The wave like pattern of economic activity is getting stronger over the past several years.  The peaks are coming closer together and now the strength of activity has quickened.

Despite these strong economic indicators, investors are worrying again (see October blog)  that the rest of the global economy is faltering. Why investors showed less concern about the global economy in November and December remains a puzzle. To longer term investors, the market seems to have the attention span – and frenetic activity – of a three year old.



In December, employment rose 2.1% year over year, almost besting the high set in March 2006 for yearly growth.

There were several positives in this report.  Job gains for October and November were revised up 50,000 total.  The core work force, those aged 25 – 54, continued a steady rise. The number of people employed at part time jobs because they couldn’t find full time work fell again in December by 60,000 and is down 13% over the past year.  However, there are still 50% more involuntary part-timers than during the 2000s.

The number of long term unemployed people has fallen 28% in the past year but – that word “but” rears its ugly head again – are still high.

Investors tended to focus on the negatives in this month’s report.  The number of discouraged workers, those who are available for work but haven’t looked in the past month, was up 42,000.

As a percent of the labor force, the long term unemployed and discouraged are still at historically high levels – more than five years after the official end of the recession.

Hourly wages declined by .05 to $24.57 but the influx of seasonal and part time jobs at the holidays and year end may have had some impact.  Last month’s slight increase in hourly wages sparked hope that employees might be gaining some pricing power, indicating an underlying strong demand from employers.  This month’s data suggests that lower gasoline prices will have to substitute for wage growth in the near term.

The Labor Force Participation rate edged down .2 and seems to be stuck in a range just under 63% for the past year.  If the labor market were really growing strongly, we would expect to see some upward movement as more people tried to enter or re-enter the job market.


Social Security Calculator

Last year the Wall St. Journal reviewed several social security claiming calculators.  Social Security (SSA) has some very complex rules, particularly for married couples.  Remember that this is a system designed by politicians and the Washington bureaucracy, the same people who, after 9-11, designed the multi-colored terror threat warning system that seemed permanently stuck on yellow, or elevated threat.
Given the complexity of the Social Security rules, noted economist Lawrence Kotlikoff heads a team that designed an online calculator  to help people maximize their benefit.  The program has a fee of $40 and looks very easy to use.  An 11 minute video demonstrates using the tool for a married couple born in 1958 and 1952.  Curl up on the couch and get out the popcorn.

The mutual fund giant Fidelity has a good discussion of various claiming options for married couples.  The third example is rather interesting.  The younger person in a married couple files early and receives a reduced benefit. The older person files and suspends his own benefits at full retirement age (FRA) but takes a spousal benefit based on the fact that his wife has already retired.  Here’s the kicker: his spousal benefit is based on what her benefit would have been at FRA, not the reduced benefit she receives because she retired early.



We learned about allocation while playing Monopoly.  It is better to put up a few houses on both the Green and Purple property groups than put all of our money into hotels on the pricey Green group only.

Vanguard has a questionnaire to help investors determine an appropriate allocation mix of stocks, bonds and cash.  You don’t need to be a Vanguard customer to answer the questionnaire.


Final Word

The price of oil is unusually low.  The U.S. dollar is unusually strong.  Interest rates have been unusually low for several years.  Central banks around the world have provided an unusual level of support for their economies.  A confluence of unusualness, a new word, leads to greater price swings.  Market volatility (VIX) has been low – below 20 – for most of the past two years and this relative calm tends to bring more people into the market, helping to lift stock prices.  We may see a return to higher volatility levels similar to early 2012 and late 2011.


July 27, 2014

This week I’ll take a look at the latest home sales reports, a few trends in Social Security, and the latest reading in the Consumer Price Index.  Lastly, I’ll ask whether a home should be included in an investor’s bond allocation.


Home Sales

Existing home sales rose in June, topping 5 million but are still down 2.3% on  a year over year basis.  The Federal Housing Finance Agency reported that home price increases have slowed slightly, notching a 5.5% year over year gain.

The bad news this week was the 12% year-over-year drop in single family new homes sold in June, falling from 459,000 in June 2013 to 406,000 in June of this year.

The comparison was a tough one because June 2013 was the best month for new home sales in the post recession period.  However, the year-over-year comparison of the three month moving average of new home sales shows a falling trend as well, down 6% from last year.  The decline began in January and shows little signs of improvement.

I will remind readers of a 2007 paper presented by economist Ed Leamer in which he demonstrated that falling new home sales tends to precede a recession by three to four quarters.  I wrote about it in February this year.


Jobless Claims

In contrast to the disappointing report on new home sales, jobless claims fell unexpectedly to 284,000, dropping the 4 week moving average to a post-recession low of 302,000.  No doubt this will raise expectations for a strong employment report next Friday.

Social Security Trust Funds

When the U.S. Treasury collects more in Social Security taxes than the Social Security Administration (SSA) pays out in benefits, the Treasury “borrows” the money from the Social Security Trust Fund by selling it non-marketable Treasury bonds that the SSA holds.  The interest rate for each new bond is an average of the yields on intermediate and long term Treasuries. The Treasury credits this interest to the trust funds every month.  SSA has a web page where a reader can select a year and month and see the average interest rate that the trust funds were earning on that date.  In December 2013, the average annual yield was about 3.6%, down significantly from the 5.25% being credited at the end of 2005, when interest rates were higher.  At the end of 2012, the trust funds had a balance of about $2.7 trillion, earning about $100 billion annually, enough to make up the $75 billion shortfall each year projected by the Trustees of the fund.

The Disability Insurance (DI) portion of the trust fund is projected to run out of money by 2016.  This Do-Nothing Congress will not resolve the problem in this mid-term election year,  promising to make the issue a contentious one for the 2016 election cycle.  If the problem is not resolved by then, current law requires that benefits be reduced accordingly.  The Trustees estimate that Disability beneficiaries will get about 80% of their scheduled benefit.  Democrats will likely use the issue to paint Republicans as Meanies who care only about the rich and big corporations while Republicans portray Democrats as tax-and-spenders who buy votes with government charity.  It’s all coming to a TV screen in our homes.  Can’t wait.


Consumer Price Index

June’s inflation numbers from the BLS notched a 2.1% year-over-year gain, slightly above the Fed’s 2% target.  The core CPI, which excludes more volatile energy and food prices, is up 1.9% y-o-y.  Gasoline jumped 3.3% in June but year over year gains are at target levels of 2%.

Over the next few years, we will hear increasing calls for a switch to what is called a chained consumer price index, or C-CPI.  The chained index attempts to more closely replicate a cost of living index by taking into account the substitutions that consumers make in response to changes in price.  The CPI may calculate that the Jones Family bought the same amount of hamburger meat even when it rises 20% in price.  The Chained CPI calculates that the Jones Family may buy a little bit less hamburger meat and a bit more chicken if chicken remains relatively stable in price.  The two indexes closely track each other but the CPI tends to be slightly higher than the Chained CPI.

At various times in budget negotiations with the Republican controlled House over the past two years, President Obama has said that he was open to a discussion on transitioning from the CPI as it is currently calculated to the chained CPI.  Social Security payments are one of the many benefits indexed to the CPI.  The current political climate and the upcoming mid-term elections undermine the chances of any adult conversation on the topic.   Republicans are likely to retain the House and want to take the Senate.  A discussion of the CPI invites accusations from Democrats that Republicans – yes, The Cold Heartless Ones – are going to throw seniors under the bus if Social Security payments are decreased by even $5 a month because of a change in the calculation of the CPI.

The reason younger people don’t vote much may be that they hear the rhetoric of most political campaigns and realize that the discussions are much like those they heard in middle school.


House = Bond?

Let’s crank up the wayback machine and travel to those heady days of 1999 when the stock market was booming.  Current profits did not matter.  New metrics were invented. Customers were revenue streams whose future value could be used to justify the present value of customer acquisition costs. Investments were made to position a company as the dominant player in the sector space of the internet frontier.  These metrics have some validity but the stumbling block was the simple fact that current profits do matter.

About that time some finance professors made the case in a Wall St. Journal editorial (sorry, no link.  WSJ doesn’t go back that far) that most households were overweighted in bonds. How so? A house is like a bond, they argued, relatively stable in price and pays the owner the equivalent of 6% – 7% annually.  House prices do average about 15 – 16 times annual rents according to the real estate analytics firm Jacob Reis.  At the height of the housing boom in the mid-2000s, houses were selling for 25x annual rents.

Secondly, it did not matter whether the house was paid for or not.  To illustrate this rather dubious viewpoint, let’s consider a renter who pays $12,000 annually in rent for an apartment.  She has a $500,000 portfolio, $300,000 of it in stocks, $200,000 in bonds, a 60/40 allocation split.  The bonds generate a 6% annual return of $12,000 which she uses to pay her rent.  A responsible financial advisor would not say “Oh, those bonds don’t count to your allocation mix because the income they earn is used for rent.”

Now, let’s look at a homeowner with the same $500,000 portfolio and the same allocation, 60% stocks, 40% bonds.  She owns a home valued at $200,000 which, if she rented it out, would net her $12,000 annually.  Her PITI  (mortgage payment and taxes) and maintenance repairs is also $12,000 annually.  Like the renter, the homeowner uses the $12,000 in income from her bonds to pay the house costs.  Unlike the renter, she is building some equity in the house by paying down principal.  On average, the value of her house is gaining about 3 – 4% per year based on historical patterns.  In short, the house is generating an unrealized gain that is ignored in conventional allocation models.

So, how would one compute the asset value of the house?  By imputing it from the income and unrealized gains that the house generated.  So, if a homeowner paid $3000 annually toward principal reduction and the house appreciated 3%, or $6000, the house generates a value to the homeowner of $9,000.  Using the historical 6% average return on a house, this would make the asset value of the house $150,000.  Adding that to the stock and bond portfolio gives a new total of $650,000, $350,000 of which is in bonds and the house, a bond-like asset.  Using this method, the allocation mix is 46% stocks, 54% bonds, perhaps more conservative than the homeowner desired.

After reappraising their portfolio in this manner, the professors suggested that homeowners might sell some bonds and buy more stocks to get the desired allocation mix.  To achieve a true 40% bond mix in this example, the target total would be $260,000 in the house and bonds.  Subtracting the $150,000 house value, the homeowner would want to have $110,000 in bonds.  To achieve this, the homeowner would sell $90,000 in bonds and invest in the stock market.  The investor would then have $390,000 stocks and $110,000, slightly above a 75/25 stock/bond allocation mix.  Older readers may shudder at this mix, thinking that it is quite risky.

So, let’s come back to the present day, after the housing bubble.  The calculations are not based on the actual price of the house but 1) on the income that it would generate if it were rented out and, 2) the principal pay down.  The finance professors did not factor in homeowners who were “under water,” i.e. owing more on the house than its current market value, because the debt on a house or any asset did not count in this model.

Let’s say that a homeowner bought at the height of the market in 2005, paying an inflated $300,000 for a house that would later be valued for $200,000.  The principal paydown is so small in the early years of a mortgage that it has only a small effect on the calculation.  Secondly, rent prices were under pressure during the housing boom, making the calculation of the asset value of the house lower.  In fact, a person using this method and contemplating the purchase of a house at that time might have asked themselves “Why am I paying $300,000 for an asset whose income and unrealized gain generates an asset value of $200,000 at most?”

As to the timing, whoa, boy!  What a bad call, selling $90,000 in bonds and putting it into the stock market right before the dot-com bubble popped.  By June 2001, long term bonds (VBLTX as a proxy) had gained almost 10% in value and were paying about 6%.  Our homeowner was not a happy camper.  Over two years, she had lost about $9K in value and another $10K in dividends on that $90,000 in bonds that she sold.  At mid-2001, she had lost an additional  $4,000 in value on the $90K that she invested in stocks near the height of the dot-com boom.

By the end of 2013, twelve years later, she still had not made up for those initial losses.

By including a housing value in the allocation calculations, our investor had an approximately 75/25 mix of stocks and bonds.  During those 14 years, a 75/25 stock/bond mix had about the same total return as a 60/40 stock/bond mix.  There is one clear advantage to the 60/40 mix, however: the risk adjusted return is much better.  The average annual return as a percentage of the maximum drawdown, or the CAR/MDD ratio,  was much higher and the higher the better.

This ratio could be called the sleep ratio.  Let’s say an active investor makes $50K profit in a year on a $500,000 portfolio, but during the year, the investor’s portfolio lost half its value before recovering.  Then the sleep ratio is $50K/$250K, or .2.  Not much sleep for all that activity.  As a benchmark, a buy and hold strategy in the stock market had a CAR/MDD ratio of .2 from 2001 – 2013.

The conventional 60/40 mix had a sleep ratio of .6 during this period.  The 75/25 mix had a sleep ratio of .35, making it the poorer risk adjusted model.  Interestingly, a buy and hold strategy in long term bonds had a sleep ratio of .48, showing that some balance between bonds and stocks produces a better risk adjusted return.

While the rationale for including a house in one’s bond portfolio mix might seem to be a good one, there was a timing disadvantage over this 14 year period.  Long term investors should remember that the past 15 years have been a rather unique combination of two severe downturns in the stock market and a housing bubble.  Such a combination is sure to test even the soundest theory.



New home sales are down while existing home sales continue their moderate growth trend.  Jobless Claims are at a post-recession low.  Fixes to the Disability trust fund and any transition to a chained CPI are off the discussion table till 2015, at least.  An allocation model that includes a home’s value in an investor’s bond portfolio may have merit over a long time horizon.

Next week come four reports that are sure to fire up the market if any of them surprises to either the upside or downside:  GDP growth for the 2nd quarter, Employment gains, Motor Vehicle Sales, and the Purchasing Manager’s Index for the manufacturing sector.  

Investment Allocation and Housing

December 1st, 2013

While cleaning up some old files, I found a 1999 “Getting Going” column by Jonathan Clemens in the Wall St. Journal.  That year was rather turbulent, rocked by Y2K fears that the year 2000 might play havoc with older computers still using a two digit date,  and a intensifying debate about the valuation of stocks.  Looking away from the hot internet IPOs of that year,  Clemens interviewed several professors about the comparatively mundane subject of home ownership.

 “A house is not a conservative investment,” says Chris Mayer, a real-estate professor at the University of Pennsylvania’sWharton School. “Any market where prices can fall 40% in three years is not a safe investment.” 

Remember, this is 1999.  At that time, what 40% decline is he talking about?  It would not be till 2009 or 2010 that house prices tumbled down the hill.  In the past, declines of this magnitude were confined to particular areas of the country where a fundamental shift  in the economy occurred.  The Pittsburgh area of Pennsylvania, the Pueblo area of Colorado and the Detroit area of Michigan come to mind. In the first two examples the collapse of the steel industry had a profound effect on home prices as people moved to other areas to find work.  In case a homeowner thinks “it can’t happen here,” I’m sure many homeowners in Detroit felt the same way during the 1960s when the car industry was at its peak.

“William Reichenstein, an investments professor at Baylor University in Waco, Texas, suggests treating your mortgage as a negative position in bonds.”  

What does this mean?  Let’s say a person has $100K in stock mutual funds, $100K in bond mutual funds, owns a house valued at $200K with $100K still left on the mortgage.  Subtract the remaining balance of the mortgage from the amount in bonds and that leaves $0 invested in bonds.  Why do this?  When we buy a bond we are buying the debt of a company, or some government entity.  A mortgage is a debt we owe.  So, if a person were to pay off the mortgage, trading one debt for another, they would sell their bonds to pay off the mortgage.

Should the house be included in the investment mix?  There is some disagreement on this.  An investment portfolio should include only those assets which a person could access for some cash flow if there was a loss of income or some other need for cash.  An older couple with a 5 BR house who intend to downsize in five years might include a portion of the house in the portfolio mix.

For this example, let’s leave the house out of the investment portfolio to keep it simple. Using this analysis, this hypothetical person has 100% of their assets in stocks, not a 50/50 mix of stocks and bonds.

Now, let’s fast forward ten years from 1999 to 2009.  An index mutual fund of stocks has lost a bit more than 20%.

A long term bond fund has gained about 100%.

[The text below has been revised to reflect the above bond fund chart.  The original text presented numbers for a different bond fund.]

Let’s say the mortgage principal has been paid down $60K over those ten years.  Assuming that no new investments have been made in the ten year period, what is this person’s investment mix now?  The stock portion is worth $80K, the bonds $200K less $40K still owed on the mortgage for a total of $240K, with a net exposure in bonds of $160K.  The person now has 33% (80K / 240K) in stocks and 67% in bonds, a conservative mix.  If we didn’t account for the mortgage as a negative bond, the mix would appear to be 29% (80K / 280K) for stocks and 71% for bonds.  What is the net effect of treating a mortgage balance as a negative bond?  It reduces the appearance of safety in an investment portfolio.

Now let’s imagine that this person is going to retire and collect a monthly Social Security check of $1500.  To get a 15 year annuity paying that monthly amount with a 3% growth rate, a person would have to give an insurance company about $220K (Calculator)   There are a lot of annuity variations and riders but I’ll just keep this simple.  Throughout our working lives our Social Security taxes are essentially buying Treasury bonds that we start cashing out during retirement.

If we were to add $220K to our hypothetical investment mix,  we would have a total of $460K: $80K in stock mutual funds, $200K in bond funds, -$40K still owed on the mortgage, $220K effectively in Treasury bonds that we will withdraw as Social Security payments.  The $80K in stock mutual funds now represents only 17% of our investment portfolio, an extremely conservative risk stance.  If we have a private pension plan, the mix can get even more conservative.

The point of this article was that many people in their 50s and 60s may have too little exposure to stocks if they don’t account for mortgages, pensions and Social Security payments into their allocation calculations.


In October 2005, the incoming Chairman of the Federal Reserve, Ben Bernanke, indicated to Congress that he did not think there was a bubble developing in the housing market. (Washington Post Source)

In September 2005 – a month before – the Federal Reserve Bank of New York published a report on the rapid housing price increases of the past decade:

Between 1975 and 1995, real [that is, inflation adjusted] single-family house prices in the United States increased an average of 0.5 percent per year, or 10 percent over the course of two decades. By contrast, from 1995 to 2004, national real house prices grew 3.6 percent per year, a more than seven-fold increase in the annual rate of real appreciation, and totaling nearly 40 percent in one decade. In some individual cities, such as San Francisco and Boston, real home prices grew about 75 percent from 1995 to 2004, almost double the national average. 

Remember, these are real, or inflation adjusted prices.  Now it is easy, in hindsight, to go “ah-ha!” but it should be a lesson to us all that we can not possibly hope to consume all the information needed to mitigate risk.  There is just too much information.  A professional risk manager, Riccardo Rebonato, discusses common flaws in risk assessment in his book “Plight of the Fortune Tellers” (Amazon). Written before the financial crisis, the book is surprisingly prescient.  The ideas are accessible and there is little if any math.

On Monday, the National Assn of Realtors released their pending home sales index. These are signed contracts on single family homes, condos, and townhomes. The index has declined for five months but is still slightly above normal (100) at 102.1.  At the height of the housing bubble, this index reached almost 130.  At the trough in 2010, the index was below 80.

This chart was clipped from a video by an economist at NAR (Click on the video link on the right side of the page).  The clear and simple explanation of trends in housing and interest rates is well worth five minutes of your time.  Sales of existing homes have surpassed 2007 levels and are growing.

Demographia surveys housing in m ajor markets around the world and rates their affordability.  Their 2012 report found that major markets in the U.S. are just at the upper range of affordable.  As Canada’s housing valuations have climbed, their affordability has declined and are now less affordable than the U.S.  Britain’s housing is in the severely unaffordable range.

Next Friday comes the release of the monthly employment report.  I’ll also cover a few long term trends in manufacturing and construction employment that may surprise you.