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Where to Put Your Investments - Part 1: The Investor's Dilemma

Where to Put Your Investments
Part 1:  The Investor’s Dilemma

May 4, 2016

By:  J. André Weisbrod

SUMMARY

  • Global economies are shaky with some bright spots, but with many problem economies.

  • The U.S. economy is sluggish, though still growing.

  • Interest rates are near historical lows and will probably rise over the coming years.

  • Inflation has increased in spite of low gas prices.  Inflation and interest rates are generally linked over long periods of time.

  • Rising interest rates cause the value of bonds to go down.  A rise of 2 percentage points could result in longer term bonds losing as much as 20% of their value.  That is stock market kind of risk.

  • There are few places to place investments that have a good probability of offering a “real return” above inflation and taxes over the next 10 years.

  • This fact has helped support the stock and real estate markets.  Other than companies and real estate, there is nowhere else to put your money that can make you a real return.

  • However, stock markets are looking shaky and showing signs of another retreat after recovering from the early 2016 drop.  Values have risen and now earnings and revenues appear to be slowing.

  • Long term, it is unlikely that you will make a sufficient real return above inflation and taxes unless you have a significant portion of your investment capital in stocks and real estate.

  • Therefore your stock and real estate allocations and the management of them are critical.

Consider a retiree’s challenge.  If inflation

is assumed at the long-term average of 3%, then your investment portfolio needs to return at least 3% more than your income withdrawal rate if you are going to be able to keep pace with inflation  If your inflation rate averages 3%, your living expenses will double if you live 24 years.    It is, therefore, critical that your investments return more than the inflation rate so that your capital grows at least at the rate of inflation. 

Chart A shows the capital required to create an inflation-adjusted income at various rates of return.

CHART A: Capital Needed to Produce Income

 

 

 

 

Annual Income Goal*

$25,000

$50,000

$75,000

$100,000

$150,000

$200,000

Total Return Needed

Withdrawal Rate

Capital Needed @ withdrawal rate below

@3% inflation

3%

$833,333

$1,666,667

$2,500,000

$3,333,333

$5,000,000

$6,666,667

6%

4%

$625,000

$1,250,000

$1,875,000

$2,500,000

$3,750,000

$5,000,000

7%

5%

$500,000

$1,000,000

$1,500,000

$2,000,000

$3,000,000

$4,000,000

8%

*Gross Income Before Taxes.  Social Security not considered, so this is the income needed above Soc. Sec.

 

If your gross income, including taxes, needs to be $75,000 per year, and Social Security pays $25,000, then you need $1.67 million of investments to create sufficient income ($50,000) if you assume a 3% withdrawal rate and a total return on your investments of 6%.  If your investment portfolio can return 8% you “only” need $1 million.

So how can you make 6%-8% total return on investments?  The options are limited.  One thing we can say with surety, you can’t do it in money markets, CDs, bonds or fixed rate annuities.  In fact if inflation runs at 3%, all of those alternatives are actually producing negative real returns.  That’s right, investing in guaranteed rates is actually going to cause you to move in reverse, getting poorer and poorer every year.

So what are the alternatives and the pros and cons of each?  I’m glad you asked.  I have provided a chart at the end that shows the major investment options, reasonable return expectations and pros and cons for each.  Skip it if you don’t like digging into details.

My conclusions are these:

  • If you are young, avoid interest bearing accounts except for shorter-term savings for targeted expenses such as vehicle purchases, home purchase, education and other large expenditures that are within three to five years.

  • Put the rest into a diversified portfolio of equities including stocks, real estate, commodities and even some collectibles.  Mutual funds and exchange traded funds offer a good beginning point and may be adequate all your life.  But individual stocks and investment real estate along with collecting assets such as art or numismatic coins can be appropriate as your wealth grows.  Know how much you have to save and invest at a given rate of return above inflation for you to reach your goals.  There are on line calculators or qualified planners, investment mangers and/or accountants can assist in this.  Our web site has some basic Cool Tools to assist you or we will be happy to help you with your planning in person.  Just call us at 412-367-9076. 

  • If you are near, at, or in retirement use interest-bearing instruments for major expenses anticipated within three to five years or to lower volatility risks in your overall investment portfolio.  However, consider the following conclusions.

  • Being too conservative will make failure more likely.

  • Considering history combined with the current economic and market situation, the reality is that few of us will be wealthy enough that we can afford to live 20 or 30 years beyond “retirement” by investing in conservative interest-bearing vehicles.  They are highly unlikely to keep pace with inflation and that virtually guarantees a financial crisis before you die. 

  • In fact, bonds are poised to lose money if indeed inflation and interest rates rise over the next five years.  At best interest-bearing instruments can act as a drift anchor.  They may keep a portfolio from being as volatile, but they will also certainly slow it down.

  • This means that investors of all ages will need to be owners, not lenders, with most of their investments.  Primarily they will want to own companies and real estate with some commodities and possibly some collectibles.  Indeed these have been the main sources of wealth creation for thousands of years and fear should not keep us from being owners.  Let me be blunt.  If companies (i.e. public and private) don’t make it, your interest-bearing accounts won’t be worth anything.  Lenders, including banks and insurance companies will be bankrupt because the economy will be gone… if companies don’t make it.  The only option the government would have is to print more worthless money and all of a sudden we become Venezuela or any number of countries that have gone bankrupt over the course of history.  And that picture isn’t [pretty. 

  • You and I can’t control history, but we can make decisions that set us up for a higher probability of success.  And one of those decisions is to become owners of valuable assets. 

  • To live off of interest-bearing investments for a long period of time and still keep pace with inflation, you will need a lot more capital that will allow you to withdraw no more than 1% per year of the previous year’s ending balance.

  • Unless you are that wealthy, you will have to take some risk, but it should be measured risk that is appropriate (suitable) to your situation.

  • This means you will need to have a good portion of your investments in equities, including stocks, real estate and possibly some collectibles.

  • You will need to diversify appropriately.  It’s the old “eggs in one basket” adage.

  • You will probably benefit from professional management.  However, choose your advisers carefully.  Experience, knowledge, wisdom and how they get paid are key criteria.  Make sure the arrangement assures that the adviser is working for you and not someone else (a company or companies that are more interested in selling you high commission products than they are in your overall well being).

If you desire the detailed comparison of assets, consider the following chart.  Its core assumption is that inflation will average 3% per year for the next 10 years.  Of course there is no way to predict inflation with surety.  If it goes higher some of the assumptions of the chart might need to be changed.  For instance, in times of high inflation real estate and small company stocks tend to do better.  But let’s assume today’s starting point with gradually rising interest rates over the next 5 years and then more or less leveling out for the next 5 years.  (This is actually a rather benign scenario.  Higher inflation would be worrisome, but continued low interest rates would mean a recession is near or, worse, deflation and a deep recession or depression.)

 Chart B:  Comparison of Major Types of Investment Assets

Major Asset Type

10 Yr Highest Ann. Ret.*

10 Yr Lowest Ann. Ret.*

Reasonable Expected Ann. Ret. Range

Pros

Cons

Inflation

5.0%

0.5%

2.0-4.0%

(3.0%)

 

 

Money Markets, Savings Accts.

5.5%

0.1%

1.0-3.0%

(2.0%)

Liquid.  No market risk.  Most often Government insured.  Good for managing daily and monthly expenses.

Low rates won’t provide real return, insurance doesn’t guarantee when you get your money back.

CDs

6.0%

0.7%

2.0-4.0%

(3.0%)

Same as above. Good for short-term targeted investing such as a car or education in 1-3 years.

Same as above.  Early withdrawal penalties.

Fixed Rate Annuity

6.0%

1.0%

2.5-4.5%

(3.5%)

Rates slightly higher than banks, no market risk, tax deferral.

Low rates won’t provide real return.  Early withdrawal penalties typically 5- 7years or more.  Subject to creditors of insurance company, which is “investment risk” (you can lose some or all of your money if insurance company goes under.)  High commissions can motivate advisers to push these.

Government Bonds (Taxable and tax free)

5.0%

0.5%

2.0%-3.5%

(2.8%)

Government guaranteed. 

Low rates won’t provide real return.  If it is a state or local government, defaults are not necessarily backed by insurance.

Corporate Bonds

7.5%

1.5%

2.5-4.5%

(3.5%)

Can get higher income rate than government bonds and CDS.

Low rates still unlikely to provide real return.  Investment risk if company goes bankrupt. 

Indexed Annuities

8.0%

0.5%

1.5-5.5%

(3.5%)

Some stock market participation without market risk.  Typically a cap of 8% with a guarantee of 0%.  Tax deferred.

Early withdrawal penalties typically 5-7 years or more. Subject to creditors of insurance company, which is “investment risk” (you can lose some or all of your money if insurance company goes under.)  High commissions can motivate advisers to push these.

Preferred Stock

8.5%

1.0%

3.0%-5.5%

(4.3%)

Higher dividend than for common stock.  Appreciation potential.

Market and investment risk. (See below)

Large Co. Stocks

12.0%

0.0%

6.5-9.5%

(8.0%)

Higher return potential. Established companies, can offer dividends as high as bonds, tax deferred principal growth,  if held longer than 1 year get preferential capital gains tax rates upon sale.

Market risks (regardless of a company’s financial health it can go down in price when the whole market goes down). Investment risks (If you buy one company it can go bankrupt and you can lose all of your investment).

Small Co. Stocks

14.0%

1.0%

7.0-10.0%

(8.5%)

Smaller companies offer higher growth (return) potential.  They can pay dividends. Historically, small cap indexes have higher returns than large established companies.  Tax deferred principal growth.  If held longer than 1 year get preferential capital gains tax rate upon sale.

Generally higher volatility than large company stocks (market risk).  Investment risk (If you buy one company it can go bankrupt and you can lose all).

International Stock

11.5%

0.0%

6.0-10.0%

(8.0%)

Similar advantages as U.S. stocks.  Owning the world offers hedging against currency exchange changes.  If the dollar retreats, that will help international equities.

Market risks, sometimes higher volatility.  Investment risks.  Political risks. Currency risks. Depending on countries and companies selected, risks can be greater than U.S.

Investment Real Estate

10.5%

3.0%

6.0-10.0%

(8.0%)

Higher return potential. Rental real estate, can offer income as high as or higher than bonds.  Tax deferred principal growth. If held longer than 1 year get preferential capital gains tax rates upon sale.  Land and buildings rarely have $0 value unless they are highly leveraged (in debt).

Unless bought in REITs (real Estate Investment Trusts) or ETFs (Exchange Trade Funds) or mutual funds, real estate is not liquid (Cannot be sold quickly).  Market risks.  Investment risk if individually bought or have only a few properties.  Management - time and money if you own yourself.

Private Equity/Financing

25.0%

-10.0%

8.0-15.0%

(11.5%)

This is the old fashioned way of making big money, by investing in entrepreneurial ventures and real property that is not available in public markets.  This is “Shark Tank” investing.

Requires expertise, time and enough wealth to afford the risks.  Generally limited liquidity or no liquidity for periods of time.  Higher return objectives assume higher risks, especially if not diversified enough. Unfavora-ble structures can favor promoters over the investors.

Precious Metals

10.0%

-5.0%

2.5-6.5%

(4.5%)

The main attraction of gold and silver is as an inflation hedge or the fear factor.  Another plus is the industrial and fashion uses that can affect demand.  The value of metal you actually hold would never go to 0.

Over the past 50-100 years gold has barely risen more than inflation (about 1% per year more).  The metals themselves have no employees, don’t produce anything and do not pay out income.  High Commissions or wholesale/retail spreads can be unfavorable to investors who want to actually hold the metal in ingots or coins.

Commodities

10.0%

-5.0%

2.0-6.0%

(4.0%)

Commodities’ value goes up with the demand for them in industrial and other activities.  Unless we go back to the caves, there will be demand for oil and gas, wood and paper, water and the like. 

It’s hard to own commodities directly.  There isn’t a “coin” of would you can buy and hoarding oil or other commodities is unrealistic.  Therefore you must own them in stocks of companies or in funds.

Collectibles

12%

-10%

3.0-7.0%

(5.0%)

Collectibles can be a fun and monetarily rewarding investment activity.  Rare coins, baseball cards, art, antiques and more have produced both joy and wealth for many.  Tax deferred and can qualify for capital gains tax treatment when sold.

You need to know what you are doing.  Unlike stocks or mutual funds the entry costs are high. Retail prices are often 40% higher than wholesale prices.  Liquidity is a problem, especially because of the high cost of buying and selling.  If you can’t afford to wait at least 10 if not 20 years or more, the chances of making a big return are questionable.

Notes:  Best interest rate returns are based on today’s starting point and assume average maturities of 3 years or less so that you can get some higher returns in the later part of the 10 year period.  Best stock and real estate rates are based on average inflation and GDP growth rates of 3% and a wide diversification of holdings  These are not actual historical high and low returns, though the low returns are closer to the historical lows.  Our expected return range for stocks is less than the historical averages going back to 1926.  Our estimates consider that stock and bond portfolios have expenses and reflect that reality.  They also reflect current economic conditions, which do no t favor excellent returns such as we experienced in the 1990's. I hope I am wrong and that there is a greater upside, but it is better to plan with pessimism and be happily surprised.  The argument today is whether one should just invest in broad indexes or engage professional active management.  This discussion  would take too much space here, but my experience indicates that active management pays for itself in bear markets and markets that are short-term irrational.  Finally – and I will examine this in an upcoming blog – be aware that how advisers get paid can influence their recommendations significantly.  For instance, insurance company products such as annuities can pay agents 4%-8% or more in up front commissions.  Compare that to an asset based adviser fee that averages less than 1% per year or brokerage “trailers of .25% per year.  The insurance agent can get up front what another, perhaps more objective adviser, might get in 4 to 10 years! 

Here is one more chart, which provides some actual historical returns of major asset classes.

Since 1926*, the worst, best and average returns plus recent trailing returns for representative investment categories:

Chart C:

Asset Class

Worst Calendar Year

Best Calendar Year

Avg Annual Tot. Return Since 1926

Worst 10 Yr Ann Return

Best 10 Yr Ann Return

10 Year** Trailing Ann Return

T-Bills

-0.02%

+14.7%

+3.5%

+0.2%

+9.2%

+1.2%

Intermediate Gov’t Bonds

-5.1%

+29.1%

+5.3%

+1.3%

+13.1%

+4.1%

Long Term Corp/Gov’t Bonds

-11.5%

+41.5%

+5.9%

-0.5%

+15.9%

+4.9%

Large Company Stocks

-43.3%

+54.0%

+10.1%

-1.4%

+20.1%

+7.3%

Small Company Stocks

-58.0%

+142.9%

+12.1%

-5.7%

+30.4%

+6.8%

International Stocks (EAFE)*

-43.1%

+69.9%

+9.7%

+1.6%

+22.8%

+3.0%

 

 

 

 

 

 

 

Inflation

-10.3%

+18.2%

+2.9%

-2.6%

+8.67%

+1.9%

 

(Figures derived from multiple sources including the Ibbotson Associates 2015 yearbook and Morningstar database for periods ending 12/31/2014.  This data publication was discontinued in 2016, but these numbers are still helpful in understanding category returns vs. risks.  Ten year performance is for the period ending 12/31/15.  Note also that these returns are from indexes that have no expenses.)

*Data only from 1970. In US Dollars.  ** Period ending 12/31/2015

 (Part 2 will follow soon.  In that missive I will discuss how to allocate your investment capital.  I will address the issue from different perspectives, including young people starting out to middle class families to those nearing or already in “retirement.”)

-----------------------------------------------------------

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J. André Weisbrod is founder of STAAR Financial Advisors Inc. and the STAAR Investment Trust headquartered in Pittsburgh, PA. He has been named a 5-star Wealth Manager in Pittsburgh Magazine and is among the longest tenured fund managers with over 20 years managing the same funds. He is also co-founder of the Strategic Assets Fund 1, LP, a private equity fund for accredited investors. He is an author and speaker and has been interviewed, quoted or had articles published in a variety of media including Investors Business Daily, TheStreet.com, The Wall Street Journal, Business News Network, the Pittsburgh Post-Gazette, USA Today, KDKA TV and Reuters TV.

Actively involved in church and community affairs, Mr. Weisbrod is committed to the well being of individuals, families and businesses. Avocations include competitive masters swimming, scuba diving, painting and photography, acting and music.

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