Wednesday, September 29, 2010

Rat-e of Return & Me Inflation

It’s not how much you make, but how much you keep after tax, after ‘me inflation’ (or ‘me deflation) (1), risk adjusted (with the least nerve racking fluctuation ‘volatility’) to make each particular personal financial life goal.

The rest, as Rabbi Hillel would say, ‘is commentary. Go study.’

Instead, be it for external comparative validation or just ‘let me cut off my brother’s head so I can be taller,’ joining the Rat-e of Return race is for rats.
Inflation or better termed ‘me inflation’ (of deflation -me deflation) differs with each goal, your income status, and age in life cycle) ll as ‘me deflation.’
Do you really give a rat’es ass to beat the Dow if you meet your goal – and with less volatility? If yes, why- and take a minute to call your shrinks, others talk to yourself and kvell.

After Tax Rate/Rape of Return

As of today, the maximum long term capital gains and dividend tax rate is 15% (assuming you are not into the alternative minimum tax). The maximum marginal income tax rate on wages, short term gains, interest and other ordinary income (not sheltered by depreciation, depletion etc.) is not just 36% but closer to 38%+ given phase out of certain deductions at specified adjusted gross income precipices.
State taxes aside, on the same 10% gross rate of return before taxes, long term capital gains nets 8.5% whereas wages, interest, short term gains at the maximum rate nets 6.4% to 6.6% a 22%-24% net after tax difference in rate of return. (Discussions of the advisability of taxing capital and passive income sources differently than income is an aside. However, remember, long term capital gains and dividend preferred taxation – is not preferential – as there is double taxation involving these sources.)

Inflation adjusted Rate of Return

I gotta be me, I gotta be me, who else can I be than what I am?
Sammy Davis, Jr. “I Gotta Be Me”

Now let’s assume in the above example of 10% gross rate of return, 8.5% after tax return if derived from long term capital gains and dividends, 6.4% if derived from other sources of income, general inflation is 3%. The net rate of return drops respectively to 5.5% and 3.4%.
But WAIT, as the infomercials implore us – inflation is not inflation is not inflation. One’s inflation rate is dependent on:

· income level,
· where you are in the life cycle
· the particular goal in question

Thus, each of us has an overall ‘me inflation’ overall as well as a ‘me inflation’ relative to each goal.
A 60 year old married couple making $150,000 with their kids college education costs out of the way (and the kids finally having self supporting jobs after too long of a boomerang back to their house and food ticket) and no longer with mortgage or those durable good purchases facing them – has an overall ‘me inflation’ rate different than even a 30 year old married couple making $150,000 with two kids, saving for college, with a mortgage, and paying off student loans.
If the consumer price index of inflation is 3% overall, the overall ‘me inflation’ might be 1% (except for health insurance) for the 60 year old couple but 5%+ for 30 year olds!
More importantly, me inflation differs per goal.
Higher education costs (personal financial ebola because it cannibalizes, castrates and or defers the work free retirement due primarily to tenured unaccountable condescending Scholar Barons on the Honor Dole – another discussion) has been running 250% to as high as 400% over the consumer price index of inflation. Long term care costs (nursing homes, assisted home care) has even exceeded the education ‘me inflation’ rate – compounding at one point by over 9% (400% over inflation in some recent years.)
Back to our example of 5.5% and 3.4% after tax:
Given a higher education ‘me inflation’ rate of 6% - there would be a negative after tax after inflation rate of -.5% to -2.6% given the income is derived from ordinary sources (wages, interest, ordinary income, short term gains).
Isn’t that comforting, Bunkie, as you write out those tuition checks and wonder will you be a greeter at Walmart to make ends meet?

For whom does the inflation rate bell toll?
For ‘Thee’s Inflation’ (per goal) – not The Inflation.

Risk Adjusted After Tax After Inflation Rate of Return

That’s okay in practice but how doe it work in theory?
The French

Reality, not theory, is that it is volatility/fluctuation which is equated with risk (be it measurements such as beta, standard deviation etc.).
And fluctuation/volatility is nerve racking on the downside to most.
We have a risk capacity and it is related to:

· fluctuation (volatility) which rightly or wrongly becomes synonymous with ‘risk’
· the proximity to the timing of the goal – the closer to the objective the lower the risk capacity

In theory, risk capacity should be related to probability(P) and magnitude (M) or (PxM) but in reality, those are just words when the fluctuation hits the fans.

Nothing kills rates of return – on the ground, in the trenches – than fluctuation. Proof: Dalbar’s study of investor rates of return versus the S&P showed that the average equity investor earned 1.87%/yr. (overall inflation during the period was 2.89% a year) which the S&P index averaged 8.35%. The average bond investor earned .77% versus 7.43% for the index during the same period.
Furthermore, the rate of return of investors in mutual funds has lagged the rate of return of the mutual funds they are invested in.
The reason: investment returns are far more dependent on investor behavior than the fund/index performance. Thus: risk capacity is a behavioral function.
And people (especially those without a grip on the after tax, after inflation, risk adjusted required rate of return they need to meet the goal) regardless of their chest pounding bravado about their ‘risk tolerance’ hate fluctuation/volatility and equate it with loss. (And remember risk is really the chance/probability of not making the goal!)

So what do – recognizing fluctuation is a risk proxy in reality and remembering ‘the flaw of averages’ and ‘Monte Carlo probability analysis’ from previous sections?
In light of the fluctuation/risk equivalency (rational or not), beta – better yet ‘return on beta’ is a useful tool (1)

Beta, a measure of volatility, is the ratio of a stock or mutual fund’s fluctuation compared to an appropriate benchmark index (i.e. the S&P 500).
Let’s say you require after tax, after inflation, a 4% real rate of return (pretax rate of return 10%, after tax 8% and after inflation 4% yielding a 4% real rate of return). Now Mutual Fund A which you are considering had a rate of return, for argument’s sake, of 12% with a ‘beta’ of 50% when the market was up 12%! The return on beta is 24% (12%/.5%). You would have made 12% (all things being equal) with ‘half the volatility/risk’ of the index (in this case representing the US Stock Market). Goal for the year accomplished after tax, after inflation risk adjusted (12%x.8 tax rate ((inverse of tax rate of 20%))-inflation 4% = 5.6%. The risk adjusted return on beta after tax and inflation is 11.2%!
Fund B, in the same year, did 24% outperforming the index by 12% and made the goal after tax, and after inflation (24%*.8 ((inverse of tax rate)) -4% = 15.2% outperforming fund A. But did it when considering volatility/risk? Given a 300% beta, the rate of return after tax and inflation is 15.2% outperforms the index and fund A. But then when the after tax after inflation rate of return has beta applied the 15.2% becomes 5.06%. Now think, if instead of 24%, the rate of return, the return for Fund B was 16% with a 300% beta – the rate of return on beta becomes 2.93%. Thus, the goal adjusted for ‘risk’ is not made.
Is the heartburn worth it?
More demonstrable is applying rate of return on beta to the gross rates of return. At 12%, Fund A had a return on beta of 24% (24%/.5) whereas Fund B had a return on beta of 8% (24%/3.00).

However, none of this return on beta matters – if the rate of return after tax and inflation isn’t met – given the same present funding levels of the goal per year..
Please remember, return on beta is just a financial tool – and unlike Sears Craftsman tools, it does not come with a lifetime guarantee.

Now could there be an instance where, despite a lower return on beta, one can go for the higher rate of return? Yes (though typically not advised) where the client has a low personal beta.
What the heck is a personal beta?
A gastroenterologist’s income is more stable – varying little with the economy (though moreso with the increasing or decreasing demographic of 50 years old+ individuals who will require colonoscopies every 5 or 10 years. (It is reputed that gastroenterologists believe they are in a ‘sh*tty business’ and ‘love it.’). In contrast, a big ticket commercial real estate developers’ income have a high probability of varying widely with the economy. The gastroenterologists have a low personal betas from which income can more reliably go to fund their goals year in and year out in contrast to the big ticket commercial real estate developers whose income fluctuates (thus having a high personal beta) moreso with the general economy. As a result of the cushion of the low personal beta, the gastroenterologists have the cushion/tushion (though not advisable in most cases) to go for a higher nominal rate of return even if those investments result in a lower return on beta. The scenario for the gastroenterologists taking ‘higher risk’ for ‘greater nominal though lower return on beta’ returns would be that for some reason (divorce etc.) the gastroenteologists cannot maintain the funding level necessary in some year or two and the objective is 10+ years in the future.

Finally, the other risk measure is the probability of funding the goal. Some planners use 80%, others require 90% and still others 95% probability using Monte Carlo analysis previously discussed. Be aware that relative to asset accumulation goals (education, slow down, retirement etc.) the higher the probability required, the ‘more’ assets required (an Assets under Management compensation financial planner’s dream come true annuity). And even at the 95% probability level, there is the possibility of the Black Swan like in 2008.

Next: Constraints, Criteria & Other Ground Rules

(1) For purposes of this commentary, inflation is being assumed rather than the more rare over time deflation – spousal me deflation of one’s character and value is a different question
(2) others may prefer tools like standard deviation which asses the the extent to which a portfolio return differs from the mean. Still others like r2 or downside risk DVR measures.

Saturday, September 18, 2010

Temptation, More & Character

When the game is over, the king and the pawn go into the same box.
Italian Proverb

When the game of life is over, the only thing we take with us is our character.
Ironically, necessary for character building is tests (nes) in form of life temptations.

Temptation, however “presented,” manifests as ‘more, better and or now’ (1) as the ‘present situation’ is ‘not enough.’ If what we are and what we have was ‘enough,’ there would be no temptation nor would there be succumbing to temptation.

Ironically, temptation’s aim is not succumbing but rather it is an ally to character building – completing (shelemut) our incompletions.

Otherwise, without temptation how would character flaws, incompletions be limited, restricted or conquered?

Temptation is character’s foil or foil (down fall)

Consequently, temptation, manifested as ‘more,’ is both acculturated and hard wired. As a result, enough, be it ‘enough to live for, enough to live on,’ healing financial anxiety putting money in its place to proceed to significance – why I am, what I am meant to be do and be,’ is an uphill struggle, losing ‘more’ often than the Washington Generals lose to the Harlem Globetrotters, as there is never enough. Enough is futile though not delusional.

“As soon as you win the fight for hotdogs, they want hamburger, and after they get
hamburger, they want steak”
Saul Alinsky (yes, Saul Alinsky, my conservative friends as he has been mischaracterized)

The insatiability for more is originates from the fear of bodily physical extinction (identified as oneself) which germinates the delusional strategy of acquisition (Cain in Hebrew – yes, Cain – means acquisition). Thus Temptations (2) manifest one way or another) as more, better, now (not enough). Though temptation is the parasite we are the hosts.

Character pawn of a king, foil or foiled character – that is man’s work this year and every year relative to the his entry into the Book of Life on Yom Kippur.

(1)- more, better, now typically, in time, becomes ‘less, worse, later.’
(2) – on stage next: The Four Tops – sloth, anger, gluttony & pride

PS The above is why Enough (enough to live on; enough to live for) is a struggle

Thursday, September 16, 2010

Correction 9/15/10 Blog

see correction in bold

Personal Financial Life Planning RISK (Part B – Monte Carlo Analysis) – Part III Setting A Personal Financial Life Goal

If the Platte River an average depth of 3’ deep, most people over 3’ tall should be able to walk across without drowning. However, at some points, the Platte River is but 2” and other points 20’, so even Wilt Chamberlain would drown at the 20’ depth.

Wednesday, September 15, 2010

Personal Financial Life Planning RISK (Part B – Monte Carlo Analysis) – Part III Setting A Personal Financial Life Goal

If the Platte River an average depth of 3’ deep, most people over 3’ tall should be able to walk across without drowning. However, at some points, the Platte River is but 2” and other points 20’, so even Wilt Chamberlain would drown at the 2’ depth.
Thus, the average rate of return - The FLAW of AVERAGES – applied to personal financial life objective(s) is very ‘risky’ business – ironically increasing the risk that you won’t make your personal financial life objective(s).

Yet, average rate of return is still the employed by many financial planners, and cpas. Worse is that average rate of return is the predominant measure employed by actuaries determining the adequacy or inadequacy of public employees’ pension funds understated by multiple billions. (What does this mean to you? Higher taxes but that’s another story with the actuaries and politicians foolishly trying to obfuscate or defend average rate of return with accepted state of the art horse pucky. As one former Colorado Union official stated to me to paraphrase, “PERA (the Public Employee Retirement Association) funding is the nuclear bomb on the State of Colorado Finances.” And that statement was just on the underfunding using an ‘average rate of return.’

It is the sequence of the rate of returns that matter – not the average rate of return!

An example per Dr. Sam Savage’s Flaw of Averages.

“ Suppose you want your $200,000 retirement fund invested in the Standard & Poor's 500 index to last 20 years. How much can you withdraw per year? The return of the S&P has varied over the years but has averaged about 14 percent per year since its inception in 1952. You use an annuity workbook in your spreadsheet that requires an initial amount ($200,000) and a growth rate for the fund. "I need a number," you say to yourself, so you plug in 14 percent. Now you can play with the annual withdrawal amount until your money lasts exactly 20 years. If you do this you will be pleased to find that you can withdraw $32,000 per year.”

At the end of 20 years using the 14% average rate of return, your capital would be exhausted and the investment finished.
Here’s the rub – REALITY IS NOT AVERAGE RATES OF RETURN. Rates of return are volatile – they fluctuate – they are not smooth like Original Skippy Peanut Butter – but are chunky and can wipe out your duration in a JIF.
Given real market rates of return starting in the following years, here is how long the $200,000 would last:.

1973 – out of money in 8 years
1974 - capital intact despite 20 years of payouts at the end of 20 years
1975 - out of money after 13 years
1976 - capital exhausted in 10 years

How come?
The Dow Jones was 1020 at the beginning of 1973 but by the end of 1974 it was 616 or a 40% decline whereas by the end of 1975 having invested in 1974 the Dow Jones when the Dow was 616 was up 38% to 852!

In rate of return and the probability of making the goal, its SEQUENCE, SEQUENCE, SEQUENCE!

It’s the sequence of rate of returns NOT average rate of return!

Beware of averages alone – except in Lake Woebegone – or your personal financial life goal will woe be gone.

Therefore, employing average rates of return, alone, is RISKY and deluding. (Again, Risk is defined as the whether you make the goal or not per PART A. At a gut level: RISK is the danger of not making the goal – the failure to achieve the goal causing negative consequences.)

Okay, what then is an additional standard metric to employ besides ‘average rate of return’ and it’s flaws?

Monte Carlo Modeling.

Simply stated, Monte Carlo Analysis (which goes back to the Manhattan Project) models multiple (often many thousands) alternatives to come up with the probability (as stated as a percentage) of making one’s goal.
Thus: given w amount of resources, deployed in x allocation (% of stocks, bonds, cash etc) for y period of time, at Z payment per year, a existing asset level of assets, beginning in b etc – what is the probability of making the goal?
It should be noted that Monte Carlo Analysis did not save clients and their planners from the financial meltdown ‘black swan’ recently where 15 of 16 asset classes declined. Monte Carlo gives probability not certainty. It also should be noted that Monte Carlo, which typically requires a larger if not much larger funding level to achieve the goal, is an AUM financial planner’s dream of increased fees.

If all you know is a hammer, everything will look like a nail
Dr. Abraham Maslow

What is an AUM financial planner?
The compensation for this financial planner is based to assets under management. Thus, the “more” assets under management the “more”, he or she gets paid.
There is an inherent conflict between this type of compensation and it conflicts with the concept of Enough which is based achieving the financial goal with the less risk possible. The conflict occurs where the goal can be still be reached at a lower rate of return with the trade off being less risk (risk of not making the goal!). Thus, AUM planners inherently are MOREons though their pat answer would be ‘if we aren’t making the goal, we’d be fired – which serves as a check and balance.’ However, offsetting this response is AUM tends to make the goal relative to an external comparison – ‘how did I do versus the Dow Jones, the S&P, etc.’ rather than the internal goal!
There are good reasons and real reasons. Increased compensation – consciously or unconsciously – is the real reason – for the AUM compensation model (the hammer) with too many clients getting ‘nailed.’

(On a continuum of commission/transaction financial planners and flat fee, bracketed or hourly financial planners, I consider the AUM planner’s compensation a faux fee only planning or fee only planning not lite.)

In any event, Monte Carlo most likely will require additional assets under management therefore I prefer the assistance of a fee only planner who charges a flat fee, an hourly, or a bracketed fee (no less than, no more than based to an hourly but capped).
In summation, relative to making the goal, not running a Monte Carlo analysis, regardless of it’s windfall to AUM financial planners, would be close to malpractice – which is exactly what state governments like Colorado are doing which will wind up costing taxpayers and harming your personal financial funding. How? They plans which are underfunded on the ‘flaw of averages’ are way way way understated – in worse shape given monte carlo analysis. To get to the 90% or 95% funding level would require some or all of the following (assuming an actuarial emergency gets the states out of their locked in obligations):
· Increase in taxes or lowering of services
· Increase in bonds from the state – lowering credit rating, paying higher interest from general funds thus lowering services unless there is an increase in taxes
· Additional state and or employee contributions – again increasing or lowering services

Remembering it is not what you make but what you keep, if state taxes go up, your net rate of return goes down. You will then either have to increase your contribution to the goal and or increase the risk (really volatility of rate of return and remember ‘sequence, sequence, sequence’) to get a higher rate of return or lower the amount of the goal and or its start and duration.

Here is the effect of a .5% net increase in state tax rate on the growth of $100,000 for 20 years (7% net versus 8% net – inflation is not taken into account for this example) in reducing your assets:
8% grows to $466, 100
7.5% grows to $424,800

Thank the politicians (who are members of the state pension plans) for costing your goal $42,000…EVEN USING AVERAGE RATE OF RETURN!

State underfunding of employee/politician pensions, the personal financial ebola of higher education costs paying for Scholar Barons on tenure, and long term health care costs converge to cannibalize assets that otherwise would go to funding your goals and requiring less volatility, resulting in the delay or reduction of the goal or worse taking on more volatile ‘risky’ assets even illiquid assets – to meet the goal.

Tuesday, September 7, 2010

Personal Financial Life Planning RISK (Part A) – Part III Setting A Personal Financial Life Goal

Man seeks certainty, permanence, and continuity yet there is no fruit unless one goes out on the limb

Before elaborating on rate of return or even risk adjusted rate of return, lets deal with the question of risk

The following are definitions or ‘risk’:

· A Four Letter Word
· A Game by Parker Brothers (also makers of Sorry)
· Downside Volatility (Fluctuation) (1)
· Hazard or Peril
· Loss of Capital/ Principle Loss
· Beta, Standard Deviation, R2 and other financial measures/metrics/standards (2)
· Types: interest rate, political, inflation, longevity, deflation, credit, liquidity, currency, market, getting caught with your spouse’s best friend, etc.
· Probability/chance
· Gambling
· Being Wrong according to your insignificant other/spouse (correction: this is not a definition of risk but certainty!)

From the perspective of ENOUGH, all the above definitions of risk, whether qualitative or quantitative, are incorrect.

RISK is whether you make the goal or not.

The rest is commentary (i.e. probability of making the goal, return on beta etc.)

At a gut level: RISK is the danger of not making the goal – the failure to achieve the goal causing negative consequences.

Translating this definition to the most common fear (spoken or unspoken): risk is the fear of outliving one’s resources at retirement (and thus being dependent & or beholden).

(When I was in practice, when prioritizing personal financial life goals with clients, it has been my experience that the ranking of income replacement upon disability initially is ranked very low. However, then I employed an exercise for reprioritization. On one side of the page, the client would put his personal financial goals on one side (i.e slow down, retirement, education for kids, income replacement upon disability, income adequacy for spouse upon either’s passing etc.) Then on the other side of the page, I would have then write next to each goal what they would LOSE if the goal was not achieved. In the case of income replacement upon disability, most would write ‘being dependent, being beholden’ and some ‘having to take from my kids.’ When each goal was translated into the underlying value, they would re-rank the goal with the value attached. The re prioritization upon re-ranking with values were typically significant with income replacement upon disability always rising!
Try this exercise – but don’t if you are just going to lie to yourself.)

As am precocious child, I would play checkers with my Poppi. Often, he would let me jump one of his checkers only to find out it was a set up for him to take three of mine.

It is risky to sacrifice (risk a goal) what you have for what you don’t have – unless it is to reach a higher priority goal. Otherwise, Poppi Schwartz is just setting you up.
Besides, in the end, the king and the pawn (or checkers) all go in the same box.

Now there is a distinction between risk and uncertainty. Though I prefer to define risk as the danger of not making the goal in relationship to uncertainty (and there is a difference), author Frank Knight, makes the following distinction: risk has an unknown outcome, but we know what the underlying outcome distribution (of outcomes/results) looks like. Uncertainty also implies an unknown outcome, and we don't know what the underlying distribution looks like.

Insurers accept the risks with exclusions, don’t insure certainty except death, and fight uncertainty trying to establish it was not covered by the policy.

The risk of making a goal can often be quantified and dealt with. But planning for uncertainty, the black swan, is highly doubtful. Of the 16 asset classes during the last financial meltdown, only one, treasuries, increased during the crash.
So why didn’t one market time? Well, the probability of successful market timing over time, studies have shown is less than .00000004 whatever amount of zeros. In the ‘90’s the Dow was up something like 16% per year but if you missed the top 15 or 20 days your annual rate of return was in the 5% area.
So risk is either we make the goal or not. The probability of achieving the goal will be dealt with in greater detail next week in Risk (Part B – Monte Carlo Analysis) Part III Setting A Personal Financial Life Goal

Insurance is the transference of risk (hazard in this context). In return for transferring the risk of a large loss, one pays premiums (a small loss). Thus one substitutes a small loss to avoid a large loss.
When we seek a rate of return, after tax, that is greater than necessary to make the goal taking on riskier assets (whether for external validation, locker room bravado material, a thrill down their Chris Matthews leg, or whatever), we are increasing the probability of not making the goal. In doing so, one in seeking More potentially is sacrificing Enough – which makes one a MOREon.
Sacrificing what you need for what you don’t need – now that’s Risky Business without Tom Cruise in white socks.

And Schwartz Poppi would call you a nudnick.

Risk of not making a goal is interactive with achievement or non achievement of other goals.

For example, for whatever reason, your retirement goal is not funded as of yet. However, due to health reasons and vocational reasons, you are unable to secure good disability coverage (or what I would prefer to call income replacement upon illness or accident due to partial or full disability to avoid capital depletion).
Without your earnings if disabled, there is no retirement goal funded to your desires.

Thus, you would have to self insure the risk to the goal (or find employment where there is disability insurance on a guaranteed issue basis – but let’s stipulate that that option, marrying rich, nor getting a large inheritance are out of the question as well as getting social security disability payments as you are merely partially disabled).

All of a sudden, the risk/probability of not making the income adequacy upon partial disability impacts the rate of return you may get for your retirement or slow down prior to retirement goal.


You may make the decision that you’ll need two to three years of cash flow that is not subject to the volatility/fluctuation of the stock market or illiquid assets you hold because you can’t transfer this partial disability risk through insurance.
The effect may be starting the retirement or slow down period later (decreasing the duration of those goals.)

The point is – the amount of the goal, the duration of the goal, and risk are once again all interrelated.
You pull on the string on the sleeve on the sweater and sometimes the neck bent out of shape..

And that’s what happens when you play chicken (more, more, more) with your goals.

(1) Fluctuation/volatility is confused with the risk as defined as loss of capital. Fluctuation isn’t loss of capital
(2) The problem with beta, standard deviation, r2 is they begin with a reference point instead of what worries the investor most

Next: Risk (Part B – Monte Carlo Analysis) Part III Setting A Personal Financial Life Goal