Economics of the downturn – thoughts for investing

Researchers are still trying to explain why we had a bubble that burst, or if we had a bubble at all….

The January 11, 2010 issue of the New Yorker has a great article on Posner, the Chicago School of Economics and other matters that have come from the sub-prime mortgage mess (a summary appears below).

Also, there is a humorous video on line, comparing Keynes and Hayek on their approaches in rap format at: http://hayekcenter.org

Let me know what you think

Thanks,

Steven

John Cassidy, Letter from Chicago, “After the Blowup,” The New Yorker, January 11, 2010, p. 28

Read more: http://www.newyorker.com/reporting/2010/01/11/100111fa_fact_cassidy#ixzz0dTnxDHJm

ABSTRACT:

LETTER FROM CHICAGO about the state of the Chicago School of economics after the financial crash. Earlier this year, Judge Richard A. Posner published “A Failure of Capitalism,” in which he argues that lax monetary policy and deregulation helped bring on the current economic slump. Posner has been a leading figure in the conservative Chicago School of economics for decades. In September, he came out as a Keynesian. As acts of betrayal go, this was roughly akin to Johnny Damon’s forsaking the Red Sox Nation and joining the Yankees. Ever since Milton Friedman, George Stigler, and others founded the Chicago School, in the nineteen-forties and fifties, one of its goals has been to displace Keynesianism, and it had largely succeeded. In the areas of regulation, trade, anti-trust laws, taxes, interest rates, and welfare, Chicago thinking greatly influenced policymaking in the U.S. and many other parts of the world. But in the year after the crash Keynes’s name appeared to be everywhere. In “A Failure of Capitalism,” Posner singles out several economists, including Robert Lucas and John Cochrane, both of the Chicago School, for failing to appreciate the magnitude of the subprime crisis, and he questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis and the rational-expectations theory. In Posner’s view, older, less dogmatic theories better explained how the problems in the financial sector dragged down the rest of the economy. In the course of a few days, the writer talked to economists from various branches of the subject. The over-all reaction he encountered put him in mind of what happened to cosmology after the astronomer Edwin Hubble discovered that the universe was expanding, and was much larger than scientists believed. The profession fell into turmoil, with some physicists sticking to existing theories, while others came up with the big-bang theory. Eugene Fama, of Chicago’s Booth School of Business, was firmly in the denial camp. He defended the efficient-markets hypothesis, which underpinned the deregulation of the banking system championed by Alan Greenspan and others. He insisted that the real culprit in the mortgage mess was the federal government. Mentions John Cochrane. Gary Becker, who won the Nobel in 1992, says that Posner and others raised fair critiques of Chicago economics. Mentions Robert Lucas and James Heckman. If the economic equivalent of a big-bang theory is to emerge, it will almost certainly come from scholars much less invested in the old doctrines than Fama and Lucas. Mentions Richard Thaler. Raghuram Rajan, an Indian-born Chicago professor, is one of the few economists who warned about the dangers of the financial crisis. In 2005, he said that deregulation, trading in complex financial products, and the proliferation of bonuses for traders had greatly increased the risk of a blowup. In a new book he’s working on, “Fault Lines,” Rajan argues that the initial causes of the breakdown were stagnant wages and rising inequality. With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit. The side effects of unrestrained credit growth turned out to be devastating. The impact of the financial crisis shouldn’t be underestimated, especially for Chicago-style economics. “Keynes is back,” Posner said, “and behavioral finance is on the march.”

Read more: http://www.newyorker.com/reporting/2010/01/11/100111fa_fact_cassidy#ixzz0dTnmPgW5

Let us know if you have questions or comments. Thanks,

Steven

Irrationality and investing

The Morningstar article reprinted below on Investor Irrationality is worth reviewing in these challenging times

The article makes the case for asset allocation, with a long-term view, and to holding on and not attempting to time the market.

Implicitly, the article makes the case for having a good advisor work with you to avoid falling into these traps of irrational investing. We hope are guidance has worked!

Thanks,

Steven


In Practice: Patterns of Investor Irrationality

by Jim Licato and Alina Tarlea | 10-15-09

We value your feedback. Leave your comments, insight or criticism at the end of this article.

Here are some common ways issues of behavioral finance show up in practice.

The Melting Pot

Despite the recent run-up in the stock market, it is safe to assume that investors are still a bit hesitant to get back into the market (or to stay in the market), let alone consider the riskiest of investments. What investors should understand is that separate types of investments perform differently from one another, which has made it possible to lower the risk of volatile assets by combining them with other types of investments.

Allocation Return Risk

Large Stocks 20% 9.4 17.3

Small Stocks 20% 11.7 25.1

Bonds 20% 8.8 11.8

Cash 20% 5.8 0.9

International Stocks 20% 9.8 19.1

Total Portfolio 9.8 11.0

Mental accounting is a pattern of investor irrationality in which an investor mentally compartmentalizes investments while neglecting to focus on the portfolio as a whole. Mental accounting can often impede investors from making sound financial decisions.

This investor behavior is often evident when international investments are introduced. Risks that often raise red flags when investing internationally include currency, economic, political, and market liquidity. When clients view this particular investment in a vacuum, they are usually less receptive to include it in their portfolios. They are dismissing the potential diversification benefits of international investments and possible improvements in the risk/return trade-off.

While the relative safety of cash and bonds may be soothing, especially during this day and age, investors are sacrificing long-term growth. Some investors may be willing to sidestep greater returns because the volatility of stocks may be too intimidating. As shown in the table, by focusing on the whole portfolio (and not just the individual components), an investor would actually experience a risk level that was lower than bonds and a return that was comparable to stocks.

It is important to note that some mental accounting may be helpful for your clients. For example, if it is helpful for them to mentally account for investments in terms of the goals they are trying to achieve (retirement, college savings, etc.), mental accounting could be warranted. In most cases, however, where your clients are reluctant to get back into the market, or to just stay the course, having them concentrate solely on the total portfolio may help pacify them.

Short-Term Focus

It’s tempting for clients regularly to monitor their investment accounts. Instant access to real-time quotes and a barrage of media reports on daily stock market fluctuations can make it difficult for clients with a long-term investment horizon to stay focused on their goals. In reality, these daily market movements may not be as extreme as they seem. As investors look longer term, their perception often changes. (1989-2008 probability of losing money in the market: daily 46%, monthly 37%, quarterly 30% and annually 25%)

Short-term market fluctuations can be quite volatile, and the probability of realizing a loss within any given day is high. However, the likelihood of realizing a loss has historically decreased over longer holding periods. The [parenthetical above] illustrates that while the probability of losing money on a daily basis over the past 20 years was 46%, the probability dropped dramatically to 25% when analyzing an annual time period.

Periodic review of an investment portfolio is necessary, but investors shouldn’t let short-term swings affect their view of the future.

Investor Returns

Time and time again, financial experts have recommended a long-term approach to investing and have cautioned investors against market-timing attempts. Despite these warnings, a typical trait of investor behavior is overconfidence. People exhibiting this behavior believe they have the ability to identify market highs and lows, and they invest based on this belief.

It is extremely difficult, however, to consistently time the market, which is why overconfidence can lead to disappointing results. (related graph available on request) Contrary to their desired strategy, many investors end up buying high and selling low, which drastically diminishes their returns.

Morningstar Investor Returns measure how a typical investor performed over time, incorporating the impact of cash inflows and outflows from purchases and sales, as opposed to total returns, which assume investors held the investment for the entire time period. The graph compares average investor returns for stock and bond funds to the returns of stock and bond benchmarks. For all but two time periods analyzed, investor returns have been consistently lower than market returns.

Regret and Risk

Investors often react emotionally after realizing an error in judgment has been made. Investors prone to regret may base investment decisions on regretful decisions they made in the past, encouraging them to become either risk averse or to take greater risks.

Consider the situation of each of the following investors. Client A purchased shares in Company ABC on Jan. 1, 2007. He sold the shares at the end of June 2007 because the stock’s performance was flat. Client B considered purchasing shares in Company ABC on the same day Client A sold his shares, but she decided to take a pass. Company ABC went on to triple in price from July 2007 through July 2009. Which investor is unhappier as a result of his or her decision? The outcome is the same; both investors should have the same amount of regret. However, studies show that the regret of having done something is greater than the regret of not having done anything. Therefore, Client A has more regret than Client B.

There’s another layer to regret. Daniel Kahneman and Richard Thaler asked 100 wealthy investors to bring to mind the financial decision they regretted most. Most participants reported that their greatest regret was from something that they had done. Those who reported a regret of not having done something were shown to take on more risk; they held an unusually high proportion of their portfolio in stocks.

Jim Licato is Morningstar’s research and communications manager. Alina Tarlea is a Morningstar research and communications analyst.

Let us know if you have questions or comments. Thanks,

Steven

In divorce, do you keep the house or the 401(k)?

Real Estate: Bubble or not? How does it effect our Divorcing clients

By Howard I. Goldstein and Steven A. Branson

This article was wrtiten a few years back and appears at the following link on line at DivorceHQ.com, http://www.divorcehq.com/articles/realestatebubble.html and on Howard Goldstein’s site. However, the financial calculations are still relevant.

Copyright 2005. Steven A. Branson and Howard I. Goldstein

Sticking to your asset allocation strategy works over time

The article below sites examples of how the advice we gave last fall of holding has paid off.

The article also notes that “buy and hold” is short hand for

“a ‘strategic policy with rebalancing.’ As Paul [Kaplan of MorningStar] points out, buy-and-hold benefits greatly from rebalancing. And, of course, while the rebalancing would have been no fun at all during 2008, it would have maintained a healthy allocation in the REITs, small-value stocks, and other such fare that have rebounded so strongly over the past six months.”

So, now in hindsight, we have proof that the recommendations last fall were well founded

Let me know if you have questions on rebalancing now or any other matters.

Thanks,

Steven

Posted: by John Rekenthaler | Bio

09-10-09 | 7:31am

In Praise of Buy-and-Hold

If there was one abiding lesson to come from 2008, it was that buy-and-hold strategies based on long-term strategic allocations had failed. They were the product of a bull-market mindset. Rather than a static policy, investors need a flexible investment approach that recognizes current market and economic conditions, and which responds accordingly.

Or so I have been told, at conferences, and on television, and in Internet articles, and pretty much everywhere, as far as I can tell. Morningstar’s own Investment Conference this past May had not one but two panels that poked at the conventional wisdom.
How does this work in practice, though? It doesn’t, I would submit. Morningstar’s Dan Culloton recently noted the following figures: Vanguard REIT Index Fund, up 82% since March 9; Vanguard Small Cap Value Index, up 75%; and Vanguard Small Cap Index, up 70%.

Wonderful stuff. The sudden surge that occurs only once every several years, at very best–the rare payoff that accrues to those who have the courage to own risky assets.

But let’s say you had followed a flexible investment policy, and cleared your house at some time in 2008 of these illiquid, value-oriented securities, which you correctly surmised would be dragged far, far down during the recession.
I’m saying right here, right now, had you sold those securities in the name of flexibility, you never would have gotten back in them to enjoy their gains.

I remember early March 2009. I was at an institutional investment conference, with stocks dropping daily, the knowledge that bottom-fishing over the previous 18 months had meant nothing but disaster, relentlessly bad economic news, and a series of depressing presentations from Wall Street’s top economists showing absolutely no turnaround in sight. Who was buying?
Well, somebody was, of course, as those stocks stopped falling as of March 9 and started to rise. However, I strongly suspect that the actual buying power was quite modest, that the rally kicked off simply because the sellers were exhausted, and there was a bit of fresh money among those who had never left the market in the first place, to reverse direction. I highly doubt that the truly flexible investment managers decided right then and there, to get back into the market. In fact, I know they didn’t, because as a group the hedge-fund industry missed the March rally entirely.

This is how it always goes. In 1988, in 1991, in 2003, and now in 2009. It seems sound looking back to the previous year to acknowledge the failure of blind, dumb strategic policy, and to embrace common sense. But somehow common sense isn’t all that common when it comes to getting back into the stock market after the decline has occurred. It wasn’t in 1988 and 1989, when the heroes of the 1987 crash lagged dramatically; it wasn’t in the early 1990s; it wasn’t in the middle 2000s, and it won’t be over the next couple of years, either.

There is a time for flexibility. There is a time when we should listen to those who talk about the virtues of not being fully invested. Unfortunately, that time is not now. Not after the losses have been sustained. That time is when the DJIA is at record highs, when people are buzzing about what they saw on CNBC, when Morningstar.com’s boards are buzzing with speculative stock selections.
But who listens then?

To echo Mr. Churchill, buy-and-hold is undoubtedly the worst form of investing–except for the alternatives.*
*Paul Kaplan of Morningstar wishes to inform the audience that Rekenthaler’s term of “buy-and-hold” is a shorthand term for “strategic policy with rebalancing.” As Paul points out, buy-and-hold benefits greatly from rebalancing. And, of course, while the rebalancing would have been no fun at all during 2008, it would have maintained a healthy allocation in the REITs, small-value stocks, and other such fare that have rebounded so strongly over the past six months.

Duly noted.

To convert or not – traditional IRA to Roth IRA …

Converting a traditional IRA to a Roth IRA results in current income taxes. Also, certain taxpayers with high income cannot avail themselves of converting

If you have money outside your IRA that can cover the taxes, you are more likely to want to convert the IRA. The reason for doing so is that no taxes are due on withdrawals during retirement. Also, the asset passes to heirs with no income tax.

However, you are trading the taxes now, lessening your total investments, for future taxes. So you need to work through the decision to convert carefully

The calculation is complicated and, for example, if the traditional IRA were to be subject to taxes at a lower rate than now, converting might make sense.

A list of concerns appears below. If you are considering making this conversion and want help with the decision, let us know.

Thanks,

Steven

___________________________________________________
First, Bob Keebler is a CPA with a major accounting firm, Baker Tilly, in Appleton, Wis., and author of The Big IRA Book. Here’s his reaction to the article:
“The math of the conversion is more complex than this author addresses:
• When rates are going down the conversion likely makes no sense.
• When rates are going up the conversion is more likely to make sense.
• Conversions are likely better for the person who does not need the funds to live off.
• Conversions are generally better for the person that has outside funds to pay the taxes.
• Conversions for a couple before the first death can make sense.
• Conversions with the intention to monitor the market often make sense.
• Conversions for a person with an estate tax problem will make more sense than for a person without an estate tax issue.
• Conversions to leave a Roth to grandchildren often have merit.
• Conversions for a person with an NOL or other carryforward can make sense.
“This question is very complex and a calculator cannot replace the professional’s judgment.”