Create Tax Free Income for Life with Municipal Bonds

Now that you’ve read the somewhat salacious title of this article, the real question becomes “is there any truth to it”? A second question might be similarly, “what’s the catch”? Well, I hate to disappoint you but there is no catch and it is possible to create a tax-free income stream for life. But how? It is done with an asset that has been around for literally ages—bonds.


Now that you’ve read the somewhat salacious title of this article, the real question becomes “is there any truth to it”?  A second question might be similarly, “what’s the catch”?  Well, I hate to disappoint you but there is no catch and it is possible to create a tax free income stream for life.  But how?  It is done with an asset that has been around for literally ages—bonds.

In particular, this strategy can be executed successfully by using tax-free, non-AMT municipal bonds (what is a AMT bond?).  Most investors shy away from bonds because they yield (or return) less than equities and tend to be more complex in nature.  However, the global bond market is larger than the global equity market by $30 Trillion (see here) although the portion we will discuss in this article is much smaller at just shy of $4 trillion.  So, why might you want to invest in municipal bonds to create tax free income for life?

What Are Municipal Bonds

First, municipal bonds represent an “I.O.U” issued by a governmental entity—usually state or local.  They get their “tax-free” status because the money raised by the bond issue is usually for a “public good or service” like schools or roads.  Money raised for these type of bonds are labeled as “general obligation” bonds and are backed by the full, faith and credit of the issuing entity’s taxing power.  Generally speaking, the more taxing power, the better the backing.  The idea behind tax-free interest from the bondholder comes from the fact that many schools and roads are usually funded by a large portion of taxpayer dollars.  Thus, tax-exempt interest was born to incentivize the public to keep paying their taxes to fund projects.  Ok, seems like a good deal, so why not use bonds in 100% of your investment portfolio?

There’s Still No Free Lunch

Well, like it’s been said before “there is no free lunch” and it is no different for municipal bonds. The rules of asset diversification apply even in the compelling case of tax-free income.  Bonds have historically had little correlation to equities except in market crises situations, so creating a portfolio of both equities and bonds makes a whole lot of sense as a long-term investor.  But when considering other fixed income vehicles like annuities or real estate which both generate taxable portfolio interest, individual municipal bonds make a good alternative.  Take the case with your typical annuity (fixed or variable) that carries an average 2-3% annual expense charge when you consider:  administrative, mortality and expense, mutual fund costs.  And although you may not see it, don’t forget there will be a commission paid to the broker that sold you the annuity.  So first year charges, can easily exceed 8%.  Finally, you still have to pay taxes on the annuity income stream on all gains beyond your cost basis.  Alternatively, you can invest the same amount into a diversified municipal bond portfolio and pay no taxes and receive tax free income until the bonds are called or mature.  As an added bonus, your estate will receive a “step-up” in basis at your date of death greatly reducing any potential capital gains.

Why Not Use a Bond Fund?

This is a good question, and the short answer is that individual bonds are actually cheaper and a much more effective way of achieving “tax-free income”.  Similar to annuities (mentioned above), bond funds have both explicit and implicit expenses.  The explicit expenses like marketing, administrative, sales loads, etc. show up in the annual expense ratio.  Granted, you can find a really low-cost index fund, but like actively managed funds, they have implicit costs which are not in the annual expense ratio.  For example, what happens when the fund manager receives new capital in the fund and is compelled to buy bonds in an expensive market, or alternatively faced with selling bonds into a cheap market.  This is referred to as liquidity premium (the former) or discount (the latter).  There is also “cash-drag” where the fund manager may hold extra cash just to satisfy “potential” fund redemptions.  Being a former portfolio manager myself, I realize not all bond fund managers effectively navigate these risks which translate in lower returns to fund investors.

“Buy and Hold”

Not the sexiest, but the “buy and hold” strategy for individual municipal bonds is by far the smartest.  Here’s a brief example of the power of compounding in this article.  Not only do you save the costs and expenses mentioned above, you also greatly reduce many of the risks that run off several other investors thereby creating a golden opportunity for the patient and savvy investor.

Check out these resources:

P.S. I apologize for the infrequency of written posts to my readers.  I’ve used the extra time to work on a book that I hope to have finished later this year.  Until then, enjoy the podcasts and these sporadicly written posts!


Post Election Portfolio Advice

“Which is more valuable–advice given in a noisy, crowded room or advice given in an empty forest? Neither, no one is listening…”

–The Maven of Financial Literacy

“Which is more valuable–advice given in a noisy, crowded room or advice given in an empty forest?  Neither, no one is listening…”
 –The Maven of Financial Literacy
I consistently read Howard Marks’ “On the Couch” memos as he is probably one of the best distressed investors of our time.  He and other investment sages have great wisdom that investors should heed.  The propensity to rush into a “buy or sell” decision in light of recent market volatility is compelling but not always rewarding.  Jason Zweig recently wrote about the post-election history of markets and how in some instances they were contrary to “conventional” wisdom. (It’s worth the read.)  Thus, setting the tone for this pre-Thanksgiving post about some things you should and should not do when it comes to your investment portfolio.


You SHOULD NOT react, but you SHOULD think…
If your investment strategy is long-term in nature, then there are probably no immediate adjustments that need to be made.  Stop and think about what investment goals you have for your entire portfolio of assets.  (See this post on Human Capital or this one on portfolio construction.) Long-term growth will likely be achieved regardless of current or interim political changes especially if your own a well-diversified portfolio.


You SHOULD NOT blow up your current plan, but you SHOULD strategize…

If you are working with a financial advisor, this is probably where your guy or gal really earns their fee. Many investors will do something in their portfolios they will regret (e.g. buy high and sell low) unless they are working with a financial professional that is giving good advice.  I’d highly recommend scheduling a strategy session with your person to work through different market scenarios.  Even if no action is ultimately taken, the meeting will likely give you peace of mind about your current plan that is in place.  (Shameless plug:  Get our free year-end tax planning guide here.)

You SHOULD NOT rush to a decision, but you SHOULD procrastinate…

This is likely the only time where advice to “procrastinate” is acceptable.  With the recent market volatility, it is probably good to sleep on what you feel is a good decision for a night or two.  Good ideas are usually good ideas two or three trading days later (especially in the case of long-term investors) and this allows time to consider any potentially impulsive, emotionally biased decisions.

Whatever your method for portfolio construction and investment, remember the wise words of Sir John Templeton:

“history shows that time, not timing, is the key to investment success.”

Invest Wisely!

The Fallacy of Chasing Market Returns – Part 2

A formula for not chasing after market returns…

So the last post, we began discussing the extreme fallacy in trying to beat the markets.  Although I believe it is truly a fool’s errand, I won’t spend as much time or words ranting and pontificating (so you can thank me later!) in this post.  Today will be spent giving you what you should be doing or at least thinking about.  As always, these are merely suggestions.  Any advice I give you here should be considered in context of your entire financial plan, so be sure you consult with a financial professional prior to implementing anything.

 Leave behind the days of “in and out” of the market. 

One of the more insightful quotes of Sir John Templeton was when he said,

“The best time to invest is when you have money.  This is because history suggests it is not timing which matters, but time”.

Now, who are you and I to question one of the most successful investors of all-time?  Let’s explore his perspective because there is a simple wisdom behind what he says.  Googling Sir John’s history is helpful, because it will uncover that he and his family survived some of the worst times in US economic history.  Despite the struggle his outlook remained positive.  My observation in all my years of helping individuals invest their money is that, rarely is the focus not on the myopic goal of beating the market.  Sir John’s simple wisdom suggests a singular focus,  but on something much more valuable than the money we invest—it is time.  All around us we see the result that time has on nature (probably the most profound of all) and in all aspects of our lives.  And although we all learn the lesson of compounding interest from books like The Richest Man in Babylon or the lesson of discipline and frugality from The Millionaire Next Door those lessons are not applied.  Whereas, if the average investor spent less than he or she made, invested 15-20% of their gross income in low cost funds into a qualified retirement plan, he or she would have accumulated a tremendous amount of capital to live on throughout retirement.  However, more often than not, news and print media panic individuals into buying and selling their investments far too often incurring fees and taxes that erode their investment capital leaving them frustrated and effectively poorer.  My simple suggestion is to let time be your ally.  If you are in your 20s and you are reading this, good for you.  You can literally start a savings discipline that could last the better part of 40 years and the older you will thank the younger you for it, trust me.  For those of us that are older, we can still start with the caveat of less time, but hopefully with enough wisdom not to repeat foolish mistakes of the past.

Diversify not just across asset classes, but goals. 

If I have mentioned it before, it deserves another mention, I consider The Aspirational Investor by Ashvin Chhabra a must-read for the DIY investor.  If you consider yourself smarter than the average bear based on your current portfolio, please do yourself a favor and pick it up. He establishes a good foundation for how investing should be broadened to include our life goals and not just the pursuit of better than market returns.  I think he uncovers something key and it leads to my next suggestion.  Finding more contentment in your life will be the key to increasing your net worth (and thus your wealth).  We all see the struggles that some “wealthy” people have and wonder why their money doesn’t bring more happiness in their life.  This is because wealth does not bring happiness to you unless you are already content.  Contentment has to do with understanding that what you value and what you believe is worth more than just money.  This inevitably leads to finding ways to use your money to promote your values and what you believe in.  This is the “quan”, as it were, that Cuba Gooding, Jr. mentions in the movie Jerry Maguire.  In the movie, although he chases the big contract, Cuba’s character realizes it means nothing without his values and the people he loves around him to enjoy it ( (his “quan”).  This realization hits Tom Cruise’s character also when he realizes that what he values is not the chase of being this hot shot agent, but being there for people.  This becomes his source of true contentment. (Pardon my Rotten Tomatoes review!)  What’s my point?  Understand what you value, then use your money for those things.  This will lead to financial contentment, which will inevitably lead to increasing your net worth.  All of which have nothing to do with beating the market.

The Fallacy of Chasing Market Returns – Part 1

In the classic movie, The Wizard of Oz, there is the memorable scene that has the wizard being revealed as the small little man that he is. By this time though, Dorothy et. al. have gone through enough trials to have confidence in dealing with a “bully” as it were. The quote that I’m referencing is, “pay no attention to the man that’s behind the curtain”. And although I rarely do this, I’m going to give you the punchline of this blog right up front. Resist the urge to try to keep up with the markets. There you have it. I am proverbially “dropping the mic”, and exiting stage left. (For those of you that want just a little more, read on.)

As a veteran of the industry, I feel I should justify my position. After all, I ran a municipal trading desk for nearly five years and booked annualized returns of 7%, so I’m not talking out the side of my face. For years though, I felt the elixir that the financial markets was drinking seemed too good to be true.  And regardless of my gloating a few sentences ago, I realized then (and am acutely aware of now) that I was not the smartest guy in the room, so I often spent time asking [a lot of] questions of a lot of people. The majority of them echoed the same sentiment…”things are weird out there”. They meant in both the bond and equity markets. (I realize there are more asset classes than just those two, but they cover most of what retail investors have to choose from.) So that led me to evaluate what was so weird….

# 1 Weird thing…Equity markets have gone up [way] more than corporate profits.

So you might say, Dominique, this will always happen because investors look at P/E ratios and are essentially willing to pay for earnings that have yet to happen. But let me warn you, there’s a reason that “past performance is no guarantee of future results”.  So here are some facts for you.  Per the Shiller PE ratio, the market trades at an average 16x multiple, although it is currently at 27x.  Also, understand that on average, and a fairly recent average (e.g. 1984-2014), equity markets returned 10%.  So here comes the weird…I began to realize that nearly every investor, especially those with most of their investable net worth in company retirement plans: a) rarely has the option of building a fully diversified portfolio (more on that later), or b) has the discipline to stick with an investment strategy for more than one market cycle. So let me address two major issues that I just ran past. The first is that the market by nearly any estimation is overpriced as it relates to actual corporate earnings.  Next, is the lack of “real” choice in 401(k) plans combined with investor psychology. I’ve written previously on corporate profits and market valuations here, but the refresher course is that corporate profits have actually appreciated about 38% (since about July 2008, whereas equity markets [measured by the S&P 500] have appreciated about 87%.  Could it be that 401(k) deposits are pushing the market higher instead of corporate earnings? Quite possibly.  This wide variance can also be attributed to the result of a lot of stock buybacks by corporations due to the relatively inexpensive carry trade. Corporations have used the low-interest rate environment as an opportunity to issue debt at phenomenally low rates and use the tax shield provided by the interest deduction to lower their tax rates. This concoction allows company XYZ to raise a lot of cheap funds by issuing bonds while using the cash to buy their stock.  More buyers of stock, raises the price and begins to inflate valuations. Next point. Defined contribution retirement plans force most participants into a “long-only” [mostly equity] position regardless of their risk tolerance and time horizon with a menu of 10-15 funds (and I’m being generous). I’ve looked through several 401(k) plans and have been left scratching my head at the dilemma for plan participants.  And if after you finally decide on an allocation, then you get to read and hear all the “doom and gloom” of BREXIT, China’s economic implosion, Japanese helicopter money and the like.  The majority of investors are thrown into a panic in which they end up selling too low and buying back in too high. This is the reason that while the S&P 500 averaged 10% from 1984-2014, the average investor only made 3%.

#2 Weird thing…Short interest is high in equities and bonds.  

The smart money (as it is sometimes called) has seen the trends I’ve named above for years now and have promptly taken the other side of the trade.  So if not smart, definitely enterprising.  As Mr. Ray Dalio says, “if you’re at the poker table wondering who the sucker is, then it’s probably you”.  This crass use of Ray’s words will hopefully help me bring home a point I intend as a gut punch to all individual investors reading this blog right now.  There is a grand fallacy in trying to beat the market. Between all the computer programs that trade markets in hundredths of a second, and the mountain of institutional cash out there with access to up-to-date information, the average investor is up to an insurmountable task in trying to beat market returns. The collective market is hard to beat.  Then, why should you?  Before I answer that…I was saying, the smart money has taken the other side of the trade and sold short a lot of what the average investor might be buying in the company 401(k). Sorry if this was a big secret to you, but it is happening. I recently was reading that this year has only seen 5 weeks of positive equity fund flows, but yet the market is up 6% as of this writing. Well how is the market still going up in the face of so much selling? This is when it helps to realize that the buying that is taking place is actually the covering of short positions. How much short covering? A lot.

So what does all this mean? It means that trading in your 401(k)—regardless of how large it is—is up against a huge wall of money going the opposite way “in trend”. Which means that if you try to keep up with beating the market you might wind up feeling like the carpet has been pulled from beneath you before long. This necessitates you looking at your investment strategy totally different and with a disciplined perspective—not a in and out mentality.

#3 Weird thing……Low interest rates.

Now, low-interest rates are not exclusively weird since there has been precedent. Also, easy money policy or low-interest rate policy (“LIRP”) serves to induce spending to stimulate an economy and keep it from deflation. Trust me, when choosing between deflation or inflation you want inflation—see Japan. So, my point is that this is not a discussion on whether or not interest rates are artificially low (they are) or that the government is printing too much money (who cares). I want you to take a look at the macro picture which I feel is really the only thing that matters.  Think of the US Central Bank’s current monetary policy as potentially disruptive to global economic growth, since many countries are still attempting to recover from the 2007-2008 financial crisis. Most economies abroad are still having problems growing GDP (as are we). Let me back into the explanation….a country can’t raise its interest rates as long as growth is stalling. So instead, they lower interest rates to induce spending (and spur growth).  But what can happen as a result? First, your currency can depreciate which is not all bad because it can give you a competitive advantage with [relatively] cheaper goods to sell.  However, there are other ramifications to consider.  Alternatively (or co-currently), lower interest rates can drive investment capital offshore to higher interest rate economies.  Since capital generally seeks the highest return, this has been seen in some emerging economies.  This can dovetail into eroding the competitive edge gained by currency depreciation and cheaper goods.  The eroding effect happens when the foreign capital headed for “greener pastures” is due to be paid back in a devalued currency.  Quite literally, the cheap currency has bought an advantage that they can’t capitalize on because the interest and principal due on the foreign loans is much more than what was borrowed.  Ideally, a depreciated currency would have stimulated enough economic activity for the foreign capital to remain in the economy.

The fallacy of chasing market returns graphic

However, other factors in an interdependent global economy don’t allow for the ideal all the time.  A recent example of this was the commodity panic in 2015 on the back of lower oil prices.  Only the strongest of emerging economies have survived the revaluation of their currencies.This is what I feel is the most alarming about global economics and another reason why I maintain that the US is still the “cleanest dirty shirt”.

So what do I suggest? Well, that will have to be saved for part 2 because after nearly 2 decades in the industry I feel there is a way to overcome this market weirdness, but it has nothing to do with trying to beat the market.


What the FED is Doing is Irrelevant and Here’s Why!

In talking to many clients, I realize there may be a false notion going around that suggests the FED is not doing a great job executing fiscal and monetary policy.  Actually, economic theory suggests that our government (separate from the FED) is responsible for determining fiscal policy (e.g. taxes, trade, etc.) while the FED is to carry out monetary policy. However, these two roles have been co-mingled over time, so it seems worth evaluating the question of whether the FED is doing a good job or not.  In the 1940s, an economist named Abba Lerner explored the doctrine of functional finance. It basically states that:

The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce.

In that context (which I deem as very sound), let’s tackle some simple questions…

Q.  What is the goal of monetary and fiscal policy?  

A.  To keep aggregate demand (e.g. total spending in the economy) at the level of aggregate supply (e.g. total amount of goods and services in the economy).

Q.  What is the result of any imbalance?  

A.  This is a very loaded question.  But when aggregate supply exceeds aggregate demand this will result in unemployment since the level of goods and services being offered has not enough demand to consume them all.  The providers of those goods and services will then be forced to lower prices which will cut profits and cause less business expansion thereby reducing the need for labor (e.g. a decrease in the rate of employment).  When aggregate demand exceeds aggregate supply this will result in inflation since the level of goods and services being offered is not enough for all that would like to consume them.  Thus the providers of those goods and services will tend to raise prices causing the consumer’s purchasing power to be eroded.  Although inflation is always a much easier problem to handle (vs. unemployment) the government only has two ways to control it:  raising taxes (e.g. adjusting fiscal policy) which reduces the amount of income left available for consumption or raising of interest rates (e.g. adjusting monetary policy and carried out by the FED) which makes consumers less inclined to borrow to bring future consumption forward into present-day consumption.

Q.  How does the government get into the picture?

A.  When the FED is ineffective in employing its tools to regulate the economic cycle, economic theory would suggest the government get involved as a last ditch effort to “save” an economy from recession or depression.  One example would have been the Great Recession (2007-2009) where the government raised the level of consumption by purchasing government bonds.  How did this help?  When the government bought bonds the proceeds from the transactions where passed to the holders (e.g. banks, financial institutions) through “quantitative easing”, thereby giving these institutions the wherewithal to increase their lending facilities.  The more money a bank has on deposit the more it can lend to prospective borrowers.  This was designed to compel consumers to pull future consumption forward by borrowing more at much lower interest rates.  However, this has its consequences as inevitably interest rates can not remain artificially low for an extended period of time less too much borrowing occur or the effect of quantitative easing becomes moot.  I believe the last 7 years are evidence both happened.

Q.  What is the effect of too much borrowing by the government?

A.  Not much, especially if you subscribe to Lerner’s doctrine.  Ultimately the government’s control of how much currency is in circulation nullifies the rate at which it repays its debts.  The more important focus is the government’s use of borrowed money.  It is usually to increase aggregate demand or increase the level of spending.  The question is always then how effective is this employment of borrowed funds, not how much have they borrowed.

Q.  What is the effect of too much borrowing by non-government entities?

A.  Since low interest rate policies (“LIRPs”) don’t place restrictions on who can and cannot borrow, one popular outcome is the carry trade.  One example of this has been seen in the last several years, in which USD was borrowed at low interest rates to buy foreign securities and currencies that paid higher rates of interest.  The difference between the cost of borrowing and the interest paid was called the “carry”.  Many analysts believe this phenomenon artificially pushed up the value of securities in the global financial markets causing market valuations to trade well beyond their actual worth.  On the other hand, there is also evidence pointing to borrowed cash being “sidelined” or not invested and just hoarded inevitably waiting for the next financial collapse.  The latter theory is less popular, in that, in the short run this is a relatively costly trade because there is no return being earned on sidelined cash.

Q.  What is the “so-what” of all this?

A.  Ahhhh. A much easier question to answer with a definite answer.  Regardless, of all the economic theory that can be supposed, we are living in very unconventional times.  The need for investors to earn a return for assumed risk should be paramount, but has taken a backseat to the need to avoid market volatility. At the end of the day, financial market complexity may be at its apex thereby justifying the need for prudent asset selection with constant monitoring.  An investor should consider setting realistic goals in a systematic way with the assistance of a financial professional.  Whether you think the FED is doing a good job or that government spending is out of control, your investment plan will need to be constructed to withstand the test of time; inevitably requiring it to resist the ups and downs of several economic cycles.  Time after time, I’ve seen the most successful investors create a sound plan and remain with that plan to achieve their financial goals. In that context, it really doesn’t matter what the FED does as much as what YOU do.

Invest wisely!

Falling Down the Rabbit Hole–Don’t!

Many investors might be feeling a bit like Alice in Wonderland as they relate the feeling of fantastical events in today’s investment environment.  Similar to Alice, the boredom associated with the hum drum of market cycles often lull investors into ignoring signals of reality around them.  Like Alice, investors might find themselves succumbing to the “BUY ME” and “SELL ME” signs that pepper today’s investment landscape.  So, what is the answer?  My opinion is to face reality and save adventurism to romantic vacations and to leave it out of your investment portfolio.  In other words, don’t get too cute!

It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.  – Charlie Munger

Are US stocks near a top or poised to go much higher?

For regular readers, you know my answer to this already–no.  There are a lot of reasons I think this is the case but I’ll try to focus on a couple I’ve not mentionedbefore.  Here they are:  US dollar strength and US corporate earnings.  With the US set to raise interest rates (however slow or quick) and other major economies set to lower interest rates (e.g. Europe, Japan, China, etc.), this differential causes inevitable currency wars.  Consumption and demand for goods and services drive the economic engine of all economies and ultimately each country wants to gain an advantage (usually through trading) in that equation.  Typically speaking, higher interest rate economies will attract capital thereby driving the value of a particular currency higher.  Speaking for the US, this makes the dollar relatively expensive to other currencies causing less goods and services to be demanded which affect US companies looking to make profits.  Stressed profit margins lead to layoffs and economic slowdown.  Investors should be focused on monitoring this cycle and how corporate earnings fare in the interim.   Here is a chart of the US Dollar Index (DXY), since the recession.  (courtesy of BigCharts)

What asset classes are still reasonably priced?

I will have to be very careful here since the operative word is “reasonably”.  I will confess though, that experienced investors that have had some semblance of victory in several market cycles agree that everything is not expensive–just most things.  I’ll be upfront and just give away the secret–focus on total return.  Ultimately, you want every dollar you invest to return more than that dollar.  One of the simplest ways to do that is to find investments that pay a dividend or an interest payment.  Naturally, this would turn your focus to dividend-paying stocks, real estate investment trusts, fixed income, or funds that invest in one or all of the previous categories.  Within that universe, you can begin to identify asset classes that are historically cheap.  “Historically cheap” would be defined as something that hasn’t been seen in at least one market cycle (e.g. 7-10 years).  A good example (and much publicized lately) are high yield bonds.  Because of the energy crisis that began in late 2014, yields (inversely related to prices) on this asset class started to rise during 2015 and peaked in mid-February 2016.  Although these levels sometimes signal default-like risk, for some investors it presented an opportunity to invest in a basket of securities (paying current income) in hopes that a few deeply discounted investments would handsomely reward their courage and patience.  Here is a chart of the iShares iBoxx High Yield Corporate bond ETF (HYG) since the recession. (courtesy of BigCharts)

As my grandmother liked to say, “Baby, keep the main thing, the main thing”.  I think these are words to live by, because as an investor your main goal is to grow your capital.  It often doesn’t pay to try new things and fall down the rabbit hole like Alice.  What makes more sense is to stick to what you know and understand, to focus on total return, and to exemplify patience and discipline.

Invest wisely!

Dow 18,000…What Now?

You don’t have to be a genius to realize it will be hard to find growth for a while.  Stagnant global economic growth may be a theme for some time.  Major central banks have used unorthodox methods like monetary policy stimulus to urge consumers to buy goods with cash or credit (mostly the latter) to produce economic activity.  The latest remedy to this chronic sickness of global stagnation?  Negative interest rates.  As an aside, I was just told by the firm that custodies our client assets that they will be passing on the charge to any account holding foreign currency positions.  This just means that with negative interest rates, you now pay the bank to hold your funds.  With all of this, it could be quite compelling to just sit in cash or worse, stick your head in the sand and wait for all the madness to end.  However, I have a better plan…

With the Dow Jones approaching all-time highs once again, investor anxiety is likely correlated with the upward motion.  Let’s look at the last 5 Dow milestones:

-Dow 14000 happened on June 19, 2007
-Dow 15000 happened on May 7, 2013
-Dow 16,000 happened on November 21, 2013
-Dow 17,000 happened on July 3, 2014
-Dow 18,000 happened on December 23, 2014

It seems strange that the Dow has made such highs so rapidly.  Especially considering additionally that, Dow 10,000 happened in 1999, while 14,000 happened 8 years later.Yet, it has increased at a much more increased rate since then (remember the Dow hit a low of 7,000 in February 2009).  I think this is why many feel a crash (or at least a decent pullback) is imminent.  However, successful investors like BuffettTempleton, and Swensen have one thing in common in their success (besides financial genius!)  They all have used the discipline of patience to exploit the concept of total return.  I truly believe that total return is a concept that is lost on many investors today.  Capital appreciation is desired, but having a myopic focus on just this metric under-utilizes the concept of total return and stifles portfolio growth.  Last December, I covered this but I feel it is worth a refresher in light of what we face in the markets.  When I was taking undergraduate finance courses at Prairie View A&M (go Panthers!), my professor called it the “magic of compounding interest”.  It was the concept that your original investment earned a return and that return earned a return, so on and so on.  But if you think about how powerful that principle is for a minute, it will really revolutionize your investment strategy.  Using the rule of 72, if you found an investment paying 10% interest (and there are some out there) you could use the interest payment to buy more shares paying 10% interest and repeat until you ran out of money, you would double your money in just over 7 years.  For someone starting this discipline at age 25 with consistency, they would receive 6 doubles before full retirement age.  Now, they would probably have difficulty in finding such a high paying investment during the whole time, but I think you get where I’m coming from.  Successful investors have not waited as much for the Dow to go up in value as they have simply waited on the passage of time!    Come to find out, the most valuable thing isn’t money…it’s just time.

Check out this graph illustrating the power of compounding interest (courtesy of JP Morgan Asset Management):

This most important element in executing a portfolio strategy that exploits this power is consistent investment.  Making monthly or quarterly deposits into high income generating assets and re-investing the subsequent income payments has benefited many investors throughout time.  Do you think you can let time work for you (instead of against you) for a change?  If so, you are well on your way to outstanding portfolio returns.

Invest Wisely!


Hold Up, Wait a Minute!

Last week I was invited on NetWorth Radio to discuss the municipal bond market (link to interview here).  Afterwards, I thought of the dilemma most investors must be in when it comes to deciding on what asset classes they should hold in portfolios.  This is an interesting topic of discussion and worth the time to visit at least two points of contention investors may run across.

Point of Contention #1: Can I use a traditional mix of 60% stocks/40% bonds to make money in this market?

The short answer is probably not.  Why you can’t is an in-depth discussion but revolves around relatively slow global growth and divergent monetary policies (just Google “divergent monetary policy” to see what I’m talking about).  Historically, investors could associate expected return with the amount of risk being assumed with an investment.  The risk being assumed is referred to as a risk premium.  The risk premium is the amount of return over the risk free rate you expect to be compensated.  The risk-free rate has always been assumed to be positive, but in certain economies it is now negative.  This does two things mainly:  it lowers the amount of expected return of most asset classes since the risk free rate is now negative and it forces an investor into riskier asset classes to avoid negative returns.  So, using traditional investment methods may not achieve investment goals.  This may lead to the next obvious (or not so obvious) conclusion: Does this flight into riskier asset classes foreshadow the collapse of the market for risky asset classes?  Possibly.  What usually happens when everyone piles into a good idea…

Point of Contention #2: What are the implications of using a non-traditional asset mix to achieve my investment goals?

One implication, which is probably the hardest to hear, is that investors will need more financial capital.  Investors should be prepared to work longer and delay retirement.  This does two things to improve their situation:  it produces more actual dollars to retire on, and it shortens the length of time in retirement.  Traditionally, stocks have averaged between 7-10% annually (I’m using both high-tide and low-tide averages), but this has lately not been the case and will not be the case in the future.  Consider that most pension plans are underfunded because of their utilization of traditional investment strategies to produce 8+% returns for future liability payments to plan participants.  If pension plan managers have struggled to achieve returns for the millions and billions they invest, why would it be any different for individual investors?  The answer is that it isn’t.  That said, individual investors have the advantage of using non-traditional asset mixes to achieve their goals.  Portfolio construction with non-traditional asset classes can be a refreshing drink of water to parched portfolios.

Point of Contention #3: Ok. You’ve got me thinking, what should I do?

Consider getting the perspective of an investment professional for your investment goals. I’m happy to say that day in and day out, I gladly assist investors in navigating what can be a very confusing and intimidating investment landscape. Consider that the Department of Labor just issued rules on how investment professionals should interact with investors’ retirement assets, so you may realize a change in how you receive investment advice. I won’t go into the rule in this writing, but the implications for the investor could be higher costs as firms adjust to comply with the rule. These firms will be those that have not been operating at the fiduciary standard all along. Natural to this process may be shifts in and out of asset classes (e.g. fund flows) that will affect future investment returns. With literally thousands of retirement plan participants and trillions of dollars at stake, investors should be prepared to hire an investment professional to help co-pilot what could be a bumpy ride.

Great Portfolio Construction: The Case for Bonds

Back in December, I wrote about the 5 Keys to Great Portfolio construction.  I thought that based on the recent positive market performance, a lot of investors would start coming off the sidelines.  As an asset manager and investment consultant, I am always asked questions about the timing of investment and my answer is that “time in the market is more important than market timing”.  With that, I realize investors may be looking for where to put money.  I believe the notion of portfolio construction is worth revisiting based on recent market movements.  Here we go…

As seems to be the case every 7 years or so, bonds can become really cheap.  I probably will receive a lot of flak on that statement depending on what kind of bonds are being bought.  But as most pundits will even admit, the compensation for holding “junk bonds” has gotten as cheap as levels close to 2008-09.  As has been disclaimed in previous writings, my expertise is found mostly in municipal finance, but the ideas I put forth are time-honored for nearly all credits—sovereign, corporate or municipal.  So how do you choose which ones to buy?

 Bond Funds

If you want to play it safe you can always buy a bond fund which will invest in several bonds and fundholders receive the benefit of the aggregate cash flows and any capital gains after fees and expenses [for the fund are taken out].  Arguably the greatest benefit of mutual fund (bond or otherwise) investing is diversification.  This takes the importance out of credit selection and places it onmanager selection.  With longer and mostly positive track records garnering the most attention and money flow.  However, what happens when everyone piles onto the best fund manager investment?  The law of supply and demand takes over and the fund becomes expensive.  As many times is the case, investors may be left with little yield after fund fees and expenses.

 Individual Bonds

On the other hand, you could take a foray into building a bond portfolio of various maturities and payment schedules.  The primary concern usually becomes liquidity (especially for smaller portfolios).  That is to say when you want to buy or sell, could you find a willing partner?  Unlike stocks, bonds are not “exchange-traded” and are primarily traded in an auction-like format.  This is the foundation for my advice to any investor wanting to buy individual bonds:  use a buy and hold strategy.  The time and expense an individual investor would consume as opposed to an investment professional trading individual bonds becomes astronomical in comparison.

 The How

In either case you should be aware of the 3 C’s of credit selection:

  •         Cash flow and ability to pay.  Not enough can be said about cash flow.  Any enterprise worth investing in should be able to demonstrate cash levels appropriate for daily operations.  In the hundreds of credits I’ve researched, this is my primary focus.   Balance sheets and income statements are often idolized when in fact an enterprise’s cash flow statement ties the two together and presents the most accurate picture of true solvency.  It is beyond the scope of this piece, but suffice it to say, becoming intimately knowledgeable of the inter-workings of financial statement interdependence is paramount.
  •         Covenant strength.  When or if things go bad (i.e.  missed interest payments, bankruptcy, etc.) bond holders are protected by bond covenants.  Within the bond covenant lies the legal remedy for bond holders to pursue recourse for violations by the borrower.  However, investors should be aware that the legalese found in most bond documents is byzantine and ironically enough written by bond counsel which represents the issuer of the bonds.
  •         Collateral.  What backs the principal and interest payments?  Real assets are usually pledged in this instance. First and exclusive right to gross revenue is also common.  However, these pledges may often be divided among senior and junior debt holders, the latter having a lesser claim.  When considering real estate as collateral I advise investors to look for recent appraisals for determining value as opposed to relying on book value.

Naturally, investment in either bond funds or individuals involve investors weighing the risk-reward trade off.  But as always, with extra effort you can be handsomely rewarded with a gem of an investment opportunity.

Invest Wisely!

The January Effect—Not!

It has been said that although history does not repeat, it surely rhymes.  According to the Stock Trader’s Almanac, the direction of January’s trading predicts the course for the year 75% of the time.  If this is the case, the infamous January effect for 2016 would seem to be ominous for investors, right?  I hope to make the case that with the right approach, investors can likely ignore the performance of their portfolios in January as it only represents yet another cog in the machine.  Long term results in a goal-based investment plan is what investors should covet.

What the January effect is and what its results have been

This article describes the January effect pretty well so I won’t use this blog post to do us.  Suffice to say, the formula is pretty accurate in most years.  However, I believe the power of the effect often gets lost.  I will explain.  The power of the January effect happens to be the depressed pricing of stocks relative to normal levels.  And how do they get to these depressed prices?  Well, typically investors (both retail and institutional) will sell stocks to trigger a taxable event. (You can read more of why this happens in an earlier post.) This tremendous selling pressure results in prices for stocks being lower relative to where they have traded the whole year.  Subsequently, investors realize that prices are lower and do a lot of purchasing in the month of January.  But perhaps the only reason this even happens during this time of year is because the IRS imposes a deadline to claim investment losses as a deduction by December 31st.  My point being that bargain prices can be sought for assets at any time and the power of the effect comes when selling pressure is exerted on the market.

How a goal-specific investment plan will help calm investor anxiety regardless of market performance

So now you may be saying that is great, but how does that help my investment portfolio.  I would argue that it will if you are not trying to trade the market via timing or any other method.  However, if you are investing with a specific long-term goal of gains exceeding inflation along with current income, you can benefit nicely.  I think that most investors fail to realize the merit in this approach because they “chase returns”.  Further, they fall prey to anchoring bias, by focusing on one piece of largely irrelevant information to formulate their investment strategy.  The benefits of using a broader perspective is rarely sought and they subsequently underperform the market.  Whereas, if they approached investment with a goal to earn x% over a set period of time, adjusting for live events and other important considerations they would find much more success.  I have conversations all the time with clients that agree that this approach makes sense, but several obstacles stand in the way of their “follow-through”.  More than likely, their fear of repeating a disastrous loss in the past outweighs the logic of a sound plan for the future.

What you can do to formulate a goal-based plan

Some of the best work I have read on goal-based investing is by Ashvin Chhabra.  His approach is an expansion of modern portfolio theory with the incredible insight to consider what I would call “life checkpoints”.  Each investor has in their mind what would send them into poverty, keep them at their current lifestyle or catapult them into another tax bracket. These three checkpoints provide all the context needed to form a goals-based plan. Incorporating these into an investment plan allows both the investor and adviser to have a language to communicate what defines success.  Rather than it being a number that is basis points above or below a market index, it becomes a way to articulate “how we are doing”.  Regarding Chhabra’s approach, a recent blog sponsored by the CFA Institute read how it “goes beyond modern portfolio theory by shifting investment strategy from a focus on the securities held in your portfolio to a consideration of your personal objectives” — for example, saving for college, retirement, or to start a business.”  These tangible objectives should help to ease anxiety during market turmoil.  Why?  Because if you have set aside enough capital to live on for the next 2-3 years regardless of what the market does, you will rest easier if you see your portfolio going down.  This does not mean you may not need to make an investment plan adjustment, but it should keep you from calling your adviser requesting him or her to sell everything.  Just some food for thought.

Invest wisely.

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