Wednesday, October 31, 2007


Few people are stock market "wizards." The good news is that one does not need to be a good stock picker to make lots of money. The asset allocation decision is the most important factor in investment success.

The bad news and the good news is that the great majority of investors achieve returns that are less than average. The reason this is good news is that the under performance of the many makes it very nice for those who decide to take above average returns.

The best way clear up the above comments is by way of examples. The actions of family A and family B tell the whole story.

A and B live almost identical lives. The primary bread winner in each family has the same job and makes the same money. Both families live in $300,000 homes in the same neighborhood. The big difference between the finances of the two families is that family A is paying off their home at a more rapid pace than family B. Family B has made smaller monthly payments each month but has invested the difference in a total world stock market index.

Family A has equity in their home of $200,000 and family B has equity of $100,000 in the home and another $100,000 equity in the whole world stock market index. Each home, being in a good community has appreciated just slightly above the average long term rate for homes and the stock market fund has also appreciated at just about average long term expectations. The following are the expected returns for the next 12 months.

Family A will see their home appreciate by 6% of $300,000 -- $18,000. Their return on equity will be $18,000 divided by $200,000 or 9%.

Family B will see their home appreciate by 6% of $300,000 -- $18,000. They will also see their stock account appreciate by 12% or $12,000. Family B will pay 6% of $100,000 or $6,000 more in interest on their home than family A. Thus the total return of family B will be $18,000 plus $12,000 minus $6,000 or $24,000. Their return on equity will be $24,000 divided by $200,000 or 12%.

The primary reason family A wants to get the home paid off early is for their "peace of mind." Forty years later, when family B has extra equity of $5,000,000, which is $6,000 invested and compounded annually for 40 years, I submit that it will be family B who has "peace of mind."

Family A feels good in the short run, family B feels good in the long run. Both have a huge advantage over family C because family C has run up $10,000 on credit cards. The annual cost of $1,800 could be invested at the stock market average of 12% to produce $19,000,000 during a lifetime. Family C gives up $19,000,000 in order to buy some stuff this year rather than waiting until next year.

In the examples above, Family A is the below average return investor, Family B is the average investor and Family C is the family who enjoys punishment. Now let's look at Family D, the family of high risk according to the jealous comments of A, B and C.

Family D also lives in the neighborhood in a $300,000 house. This family made the smallest down payment allowed and refinanced to a 30 year fixed rate loan when interest rates were low. They have zero equity in their home but they have $200,000 equity in the total world market index fund. Indeed, they actually own $250,000 of the fund and they have a $50,000 loan against the account. Over the next 12 months, again assuming returns equal to the long term averages, Family D will see their home appreciate $18,000. Their stock account will appreciate $30,000. They will pay $12,000 more in interest on their home than Family A (in this example I am using the payment toward the first $100,000 as the "owners rent"). They will pay another $3,000 in interest on the $50,000 stock loan. Their increase in net worth will be $18,000 plus $30,000 minus $12,000 minus $3,000 or $33,000. Their return on equity will be $33,000 divided by $200,000 or 16.5%.

The following are the returns achieved:

Family A 9%
Family B 12%
Family C 8.1%
Family D 16.5%

Like I said, family D will be perceived by the others as the family who takes high risk. The reality is that family D will achieve great wealth partly because family D has reduced its risk.

Let's suppose all four heads of household are laid off from work. Which families have a source of cash? Family B has $100,000 liquid and family D has $250,000 liquid!

Which family would have the negotiating power to miss a few house payments if push came to shove? If family A is behind on its house payments, it is in big trouble. The pressure in on his neighborhood banker to reduce non performing loans. If the bank forecloses on family A, the bank will get a non performing loan off the books without taking a financial loss. Family D will be last on the foreclosure list. Family D has no equity in the home so the bank will likely lose money should it foreclose on this loan.

Financial Advisors are by nature risk adverse. Big money is made by the Financial Advisor who can convince his clients to broadly diversify into high fee mutual funds. Many an advisor has built themselves annuities by accumulating large positions in funds. Year after year the advisor "earns" his fee without any additional work on his part. Advisors often promote Mutual Fund Families for "annuity reasons." If a client gets frustrated with the performance of one fund, they might switch to a different fund in the same family and keep the river of fees flowing to the investment advisor. Financial Advisors know that frogs will boil to death if heat is added to the pot slowly. They also know that rapid changes will cause the frogs to jump. Financial Advisors make big money off of those people who are willing to sit for years in funds that offer mediocre returns. Advisors frequently promote "lifestyle funds", "balanced funds", "income funds" and many other variations and combinations of "diversified" funds. The result is the problem noted by John Maynard Keynes so many years ago, that with maximum diversification there is no profit.

The moral of this story is that it is easy to be an above average investor. All one has to do is allocate ones assets for long term growth while avoiding paying high fees.


I was asked if I thought Merrill Lynch is a good investment now that it has dropped so much in price. My answer is an emphatic NO!

On several occasions I have described the economic turn as being similar to turning around a battleship. It takes a long time to turn around an economy or a battleship and once the turn is made, each will run in the new direction a long way. In each sector, there are first half and second half stocks. In the financial sector the first half stocks are the big investment banks but in the second half it is the small regional bank. During the second half of the cycle, small companies grow their business. When they expand, they are likely to borrow funds. The typical small business will do its borrowing from the small regional bank. The merger and acquisition fee train will slow during the second half as the Merrill Lynch's of the world will not be involved when the typical small business opens one new factory.

Another reader wants to know how I can be so sure that there is abundant supplies of energy? My answer is that I have seen the coal trains leaving Wyoming and Colorado. Did you know that there are 150 new coal fired power plants projected for construction in the USA over the next 10 years? DID YOU KNOW THAT CHINA IS ADDING AN AVERAGE OF ONE NEW COAL FIRED ELECTRICAL PLANT PER WEEK? DID YOU KNOW THAT THE NUMBER OF GAS RIGS DRILLING FOR NATURAL GAS IN THE USA HAS FALLEN BY 95 IN RECENT WEEKS AND THE REASON IS THAT THERE IS NO MORE STORAGE ROOM FOR NATURAL GAS?

The fact that China is building electric train engines to haul their coal is perhaps the most powerful way for me to get my point across. The law of substitution is more powerful than the rules or regulations of any government. Yes, it is a time consuming process to replace transportation fuels. The first step is to continue the process of removing oil from the power generating equation. This process is well underway. Everyday, trillions of decisions are made to increase the us of electricity and to reduce the use of the internal combustion engine. Over the next several years, more and more oil refineries will come on line, but even more importantly, enough time will have passed for substitution projects to have "kicked-in."

At the turn in 1995, the price of oil or gold did not collapse at the first hint of the turn, however, by late in the year, the dollar was soaring in value and the price of gold and oil was falling. Over the past 5 years, oil in dollar terms has risen about 240% but in Euro Dollar terms it has risen half as much. Once the dollar starts to appreciate, it will be the Europeans that feel the heat of the price of oil.


This morning, the GDP report came in at 3.8%! No recession here! However, as we know from recent data and from the price of treasury securities, the economy has slowed. The risk of recession has grown. This is one of those "bad news is good news stories". The pressure is on the FOMC to reduce short term rates. A cut in these rates will provide the "fuel" for economic recovery from the mid cycle correction. Investors should be sure to remember that the market leads the economy by at least 6 to 9 months. The weakest of economic numbers this cycle will be reported over the next two quarters. The market is already looking past this economic down turn and to the boom, boom, boom of the election year. Join the party now. Don't sheepishly accept below average returns! There is safety in keeping more of your assets in liquid investments that perform best over the long term!