APRIL 1995
COMMENTARY ON INVESTMENT AND PLANNING ISSUES
ERROLD F. MOODY JR. BSCE, LLB, MBA, MSFP, PhD
CERTIFIED FINANCIAL PLANNER
REGISTERED INVESTMENT ADVISER
MUTUAL FUNDS: Almost all mutual fund ads are reviewed by
the National Association of Security Dealers. But about 3% of mutual fund
companies do not sell through the NASD and are therefore exempt from NASD
guidelines. So the ads they put out- like the Kaufmann Fund- are apt to portray
statistics that are not in conformance to everyone else and may be misleading.
Caveat Emptor.
TAXES: The rich DO pay a lot. The richest 1% of all taxpayers paid
more than 25% of all federal income taxes in 1992. The top 10% paid in over
60%. Just 67,000 who reported over $1,000,000 in income paid 10% of all federal
income taxes in 1992. The bottom half of all taxpayers paid a total of JUST
5%. The rich also pay more overall. The share of their income paid went from
19% in 1982 to more than 27% in 1992. And a tax rate increase was NOT the
cause. The rich simply got richer.
PROSPECTIVE PAYMENT SYSTEM: Medicare used to pay for everything when
a patient had to enter a hospital- and in any amount. Obviously that was
not good for cost containment, so in 1983 Congress instituted the prospective
payment system that indicates how much Medicare will pay for a particular
procedure. Medicare made a list of 500 or so illnesses which are defined
within a Diagnostic Related Group (DRG). Each DRG has a reimbursement amount
and the number of approved hospital days. That's one of the reason why people
are discharged "quicker and sicker" compared to years prior. Each hospital
knows how much it will get paid for a period of hospitalization so that's
how long you (normally) stay.
SENIOR CITIZENS: National Council of Senior Citizens, 925 15th St.
NW, Washington, DC 20005 has information on long term care and other health
issues.
A New Jersey Bill of Rights protects their resident's civil and legal
rights in that they can
1. Manage their own affairs
2. Wear their own clothing
3. Retain and use personal property in their immediate living quarters
4. Receive and send mail unopened
5. Have unmonitored access to telephone
6. Retain the services of a personal physician
7. Obtain complete, current and understandable medical information
8. Refuse medical treatment
9. Engage in unrestricted communications
10. Discharge themselves from the home, unless legally declared incompetent.
LIMITED LIABILITY CORPORATIONS: Regular corporations have limited liability but any profits are first taxed at the corporate level and then again at the personal level. Partnerships, though with liability, allow profits and losses to flow directly down to the individual partner and avoid the double taxation. Now comes along the limited liability corporation which is currently accepted in 46 states- with several more pending. Under the LLC, profits are taxed only once. Losses may also be easier to write off than under a limited partnership veil. And unlike an S corporation which is limited to 35 members, a LLC has no limitation. One of the major attractions is that an LLC protects all member's personal assets from debts and lawsuits- only the LLC's assets may be attached. Another attraction is that the members have a say in running the show- it isn't solely left to a managing general partner. To receive partnership tax status, the LLC cannot have more than two of the following characteristics: 1. Limited Liability, 2. Centralized management, 3. Continuity of Life and 4. Free transferability of interest.
NONQUALIFIED DEFERRED COMPENSATION: Under old law, if an employee
made $155,000 and deferred $20,000, he would pay Medicare tax of 2.9% on
only $135,000. But Congress revised the tax for all compensation-even if
the monies were deferred. Many thought that would severely reduce deferred
programs, but apparently the mathematics prove otherwise. It's not worth
while to defer if the deferral is only for a couple of years and at interest
rates of less than 5%. But over longer periods of time, consultants say it
works. But there are a lot of grey areas that still need to be addressed
so check with an authority before you decide on deferred comp
agreements.
REAL ESTATE AND DIVORCE: If a residence was held as community property,
the parties got divorced and the property sold, each divorced person would
be responsible for paying their 50% portion of the capital gains or in rolling
over their ownership by buying a new home within 24 months. If they owned
the property jointly, then each is responsible for the capital gains taxes
in the proportion they own- 75/25, etc. In both instances, one partner could
use his/her portion to buy a new home within the two year limits and avoid
tax while the other could use the cash to pay the capital gains tax. Ask
for IRS publication 504 "Divorced or Separated Individuals" by calling 1
800 TAX FORM.
CARE MANAGERS: (Planning for Long Term Care)
1. How long have you been in practice and what is your training
2. How many clients do you serve
3. What are your work hours, and are you available in an emergency (especially evenings, weekends and holidays)
4. Does someone cover for you when you are not available
5. What are the services you provide directly, and which do you broker or arrange for
6. What are the fees
7. What is the license or certification that allows you to practice independently
8. Will you provide references from other clients.
COLLEGE COSTS: I have commented previously about the high and rising costs of college. While many families hope to pay for their kids education, many should consider taking out loans since they easily may not have enough left for their own retirement. But recent studies show that that is also fraught with problems. Borrowing has been on such an upsurge that debt ridden graduates may be forced to spend decades paying back their loans.
Nationwide, college borrowing rose by 41% between 1992/93 and the 1993/94 school years according to a study of 350 college and universities by the American College on Education. Among students at all schools, borrowing rose by 36% to $22.5 billion in 1993/1994.
Researchers say that in the last two years alone, students borrowed 22% of the entire $183 billion that the federal government has loaned them since 1966.
Bottom Line- parents should still do what they can to help a child.
But don't mortgage your future life as a martyr for your child's education.
ELDERLY: A study by Dr. Caro at the Gerontology Institute of the
University of Massachusetts of seniors living outside of institutions showed
that 20% needed help with cooking, cleaning, feeding, washing, shopping,
basic housekeeping or personal hygiene. For those over 86, more than 50%
required help.
NURSING HOME ACTIVITIES: Check the following
1. Do special activity rooms exist and are they stocked with useful items such as games, cards and craft materials
2. Is there a full time social or activity director
3. Are both individual and group activities planned.
4. Are trips planned
5. Are provisions made for religious observances
PAST PERFORMANCE: (Investment Adviser) Most investors who do any
review of investments invariably look at past track records as an indication
of how they fund might do in the future. But that really doesn't work (long
term) and never has. The future performance is based on a randomness that
means all funds will tend to even out over time. A study by Barksdale and
Green of 144 institutional equity portfolios over the rolling 10 year periods
between January 1, 1975 and December 31, 1989 showed that portfolios that
finished the first five years in the top quintile were actually the least
likely to finish in the top half over the next five years. The results were
entirely random. The results, averaged together over all six rolling time
periods, looked like this:
Performance Ranking % that finished in the top
in the first five years 50% over the next 5 years
Top 20% Performers 44.83%
Second 20% performers 47.67%
Third 20% performers 51.50%
Fourth 205 performers 52.33%
Fifth 20% performers 50.00%
Another study by Robert Ludwig effectively noted the same results.
He looked at portfolios that finished among the top 25% of all equity funds
tracked by SEI Corp for the previous five years and the bottom 25% for the
same period. Next he looked at how many of those portfolios finished in the
upper half of all performers for the next five/four/three/two and one year
periods. Performance of these top performers and bottom performers was then
compared relative to the median performer over subsequent periods. The results
showed that among the top performers from the five year evaluation period
of 1981 to 1985, only 48% performed above the median over the subsequent
five year period, 1986 to 1990. This means that 52% if the top performers
in the first period ranked BELOW the median in the second period. Surprisingly,
50% of the bottom performers performed above the median in the second period.
The figures below showed that the past
Performance Ranking Percentage In the top 50%over prior 5 year periods over selected time periods
1986-90 1987-90 1988-901989-90 1990
Top 25% 47.9% 46.4 50.0 48.2 53.3
Bottom 25% 50.0 50.9 39.7 51.8 41.1
performance of investment managers and mutual funds had virtually NO predictive ability for future long term performance.
Another study reviewed the Forbes Honor Roll over periods of 1980-
1984 and 1986- 1990. Only once did those in the honor roll outperform, in
the aggregate, the S&P 500 index- and that by a very slight margin in
the first five year period. Further, the group never outperformed both the
index and the average equity fund during any five year periods.
So is there any connection at all? Lipper found that, In the extreme, with the very good and the very bad funds, there does tend to be repetitive performance under similar conditions. But the key here is similar conditions. If you can be relatively certain of the conditions existing in the future, then a correlation does appear for predicting how well a fund might do on past ranking. So is this really easy to do? Well, if it was, everyone would be doing it and everyone would be millionaires. Realistically, the effort is almost futile, save for the immediate future and a remarkably objective and intuitive insight. William Sharpe noted that on a net of expense basis, in the aggregate, fund and institutional managers will tend to underperform the market by an amount equal to the fees that take for managing the portfolio, plus associated costs. Vanguard's Bogle's study of the Wilshire 5000 Index from 1971 to 1990 tended to show exactly that- professional managers underperformed the index by an average of 1.8% per year- approximately the cost of managing the fund; 1% for management fee, 0.5% in fund transaction costs and 0,3% due to cash positions required by investor inflows and outflows. Another study by Brinson, Hood and Beebower (mentioned previously) of the quarterly returns of 91 large pension funds between 1974 to 1983 compared the returns from the asset classes they were investing in. 93.6% of the return was explained by the movements In the underlying asset classes they were investing in. They also showed that active managers, in the aggregate, underperformed the benchmarks by 1.10% a year. In other words, the active selection of stock did little to nothing to the overall return- it was where the money was invested that made the difference.
So where does that leave us- and me, since I manage money? First and foremost, asset allocation is the main key to investing. While it may be good to use the "hot fund" in the asset class selected, it's not nearly as important as identifying the asset class in the first place. How does one do that? Basic knowledge and constant reading. Does it work in reality? Take for instance, what I did in the 80's. A review of, then, current national and international economics and finances really focused on the fact that interest rates might come down. Not only did that happen, but it also appeared that they could continue to come down. In that scenario, stocks could do very well. But, then, so could bonds. I opted more for bonds and over many years was able to see a total return of 12% to 15%. Was that good? Some people might say no since some stock funds did over 20%. Were stocks therefore better? If you addressed pure numbers, yes. But what happens if you then factor risk into the equation? I got good returns on bonds with about HALF the amount of risk than stock funds did. (Some of the stock funds had very high betas.) Therefore, on a risk adjusted rate of return, bonds did far better. Now, I did not put all monies there- asset allocation still prevails and other type funds were used- some index, closed end, real estate, etc. Further, different type of bond funds were used as well.
Nonetheless, does that mean that bond funds would continue to do
as well. Absolutely not since most people are aware that Greenspan raised
rates throughout 1994. Additionally, and most importantly, it also shows
that one type or system of investing may be good for a particular economic
scenario, but are almost invalid when the situation changes- particularly
when most analysts are expecting a very volatile latter 1990's. Additionally,
new methods of analysis come into the field (computers) and more analysts
enter the arena as well (international stock), so you have to adjust to new
conditions.
STATISTICS: As a continuation on the above commentary, it is true that some managers may bring a level of skill into the playing field- at least for the short term. If you could identify which ones they were, it could be possible to handily outperform the basic index funds. Some analysts say that additional skill could provide up to 5% greater return than index funds. (While I generally agree with that, I think it is more prevalent in non efficient markets where indexing is not highly recognized- in the most recent past that has been international markets.) Over the past 10 years however, some actually did show a big spread over an index. So something must be going on- or is it? First, I believe that in a solidly increasing market, management skill may be worthwhile since the analysis of financial statements in an increasing market may actually identify those companies that could provide a return above the norm. Unfortunately, it is almost always after the facts are in that the trend may have become apparent. In any case, simply picking a fund with a higher past return still doesn't meant that you are getting skill. Secondly, some managers may have been lucky. The kicker here is that it is almost impossible to determine who is lucky and who is skillful. For example, if you have a manager beating the market by 200 basis points, it could take more than 70 years to know with a 95% degree of confidence whether it was luck or skill. Of course, by that time both you and he are already dead.
There is also the issue that even if you did identify a manager that
actually did provide skill, is there any guarantee that he/she will continue
to provide it? Nope, primarily because in most situations, the conditions
in which the returns came are already gone and the manner and style the manager
used is no longer productive.
MARTY ZWEIG: A well known adviser, his comments tend to put market timing in perspective. "Market timing has gotten a bad name because some people practice it as an all or nothing strategy. They make wild spectacular calls on the market"..... and say the market is fully invested or this or that. "When they are wrong, they're wrong big time which catches everyone's attention". But he...."moves in small increments and strives for relatively modest, steady results".
Lastly, "if you want to be fully invested all the time because you
think, in the long run, you can make more money....fine, go ahead. To do
that, you've got to be willing to take the pain of living through severe
bear markets. I can't because I can't tolerate losing money". If you note
my comments and actions over past years as well as my other comments herein
on selling investments in down markets, they follow this same reasoning.
I try to get 70% to 95% of an up market and reduce my exposure to a down
market by around 85%. I won't hit winners but I can keep most of the gains
and reduce exposure to loss to around 10% maximum. That's O.K. by me.
PARENT CARE: An insurance company did a study and found that 30%
of its employees over 30 were providing care to a friend or relative age
55 or older. The average amount of time spent was 10 hours per week.
GOVERNMENT ASSISTANCE: When Social Security started in 1937, each
recipient was backed by 40 contributors. By 1993, each recipient was backed
by only 3 contributors. About one third of the work force pays more to social
security than to the IRS.
JOB LOSSES: While 6.8% of all white workers lost their jobs in the 1990/91 downturn, 7.9% of Blacks and 9.0% of Latinos lost their jobs. But for many the news will never be good. The National Commission for Employment Policy did a study of 5,00 families and offered the following conclusions.
In short, the benefits of national economic policies between 1979
and 1990 trickled down to far fewer people that the previous economic policies
did. The chairman of the commission ended comments by stating that "continuing
to pursue the economic policies of the 1980's would seen to ensure continued
turbulence in the American labor markets".
ENTITLEMENT SPENDING: Mandatory spending in 1993 came to more than
$750 billion and is expected to grow at 3%. In the past three decades, these
programs have gone from 23% of the budget to 47%. They are projected to reach
58% by 2003.
TAX INEQUITIES: (USA Today) In 1954 when the Democrats began their long political run, entitlement were 2.2% of GDP. Today they consume 7.7%. But to make matters worse, all other federal spending actually declined by 2.5% of GDP. And though it appeared that the Republicans want to reduce some of that extra spending, present indications are that they will attempt to give more tax breaks to some seniors by attempting to roll back the 85% taxation on social security benefits and allowing those over age 60 to age 70 to earn as much as they want without a reduction in social security benefits. Before you say that the elderly should get more money, take a look at the disparity between the taxation on a young couple making $30,000 a year in Virginia and the tax impact on an elderly couple with the same income.
$30,000 INCOME
Young Couple Elderly Couple
US Income Tax $2,127 $0
Social Security Tax 4,239 0
VA income tax 930 0
Real Estate Tax* 1,188 0
Total Tax 8,474 0
% of income 28% 0%
* $100,000 home
$60,000 income
Young Couple Elderly Couple
US Income TAX $6,837 $4,143
Social Security Tax 8,478 0
VA income tax 2,523 5
Real Estate Tax* 2,377 2,377
Total Tax $20,215 6,525
% of income 34% 11%
* $200,000 home
So whether you give the elderly more money through direct entitlement
or offset what they have to give back, it's just another form of a subsidy
for the older paid for by the younger. Young workers are paying 30 times
more taxes (in inflation adjusted dollars) than they did in the pre democratic
era. Boy, I just can't wait to get old.
HEALTH CARE: (FW) The article noted that one way to reduce health
care costs is to make such costs unmistakably clear to those covered by health
insurance. Health insurance is currently the second largest non taxed benefit
that the American citizen enjoys. (Want to guess the first? Interest on mortgages
for homeowners.) The cost to the treasury of taxes lost on health care premiums
was over $54 billion in 1994. Financial World suggested that this non cash
income should be subject to income tax (phased in) as should government paid
Medicare benefits that are not now taxed. Their most valid point is that
it would be an incentive for consumers to be far more selective in their
insurance coverage and their use of medical care. Absolutely agree.
TAXES: Qualified individuals for tax preparation should belong to
the AICPA- American Institute of Certified Public Accountants, 201 938-3000,
or be federally licensed as an- Enrolled Agent. 800 424-4339
ADULT DAYCARE: National Institute on Adult Daycare, 409 3rd St. SW,
Washington, DC 20024
NATIONAL EASTER SEAL SOCIETY: 2023 West Ogden Ave., Chicago, Illinois
60612, 312 243-8400
MEDICAL INTELLIGENCE BUREAU: If you have ever been turned down for
insurance - life, health, disability- you have probably ended up on a computer
database with the MIB located in Westwood, Massachusetts. Once on that file,
you may simply be declined further insurance in the future due to your bad
health, tendency to engage in risky activities and other "documented risk
factors". But mistakes do happen so you may want to write for a copy of your
file to MIB, PO Box 105, Essex Station, Boston, MA, 02112 or call 617 426-3660.
There is no charge and you should receive a report in 30 days. You cannot
eradicate wrong information yourself- you must document the facts with other
physicians reports. One insurance exert says "we advise people all the time
that they should discuss the issue of medical privacy with their physicians
long before they ever apply for insurance, in the interest of making certain
that as little information as possible is disclosed to the insurers, and
potentially, to the MIB". Don't forget the above- you may never hear about
it again.
SHARPE: Bill Sharpe won a Nobel prize for his work on investments.
But he recently commented on a major change in statistical analysis and investor
confidence and expectations. And as such, much of the commentary and arguments
addressed by planners and investment analysts regarding prior investment
returns may be meaningless. Stated as simply as possible, investors have
been told and should expect some short term volatility, but that, over time,
they could expect reasonable assurance that they could expect "x" return.
But Sharpe's recent statistics show that that, given a constant standard
volatility and constant risk premium, the return range would vary over 25
years from a 1% to 10% with everything else in between. Sharpe also noted
that the situation is actually much worse since the risk premium is not constant
but everchanging based on an investor's interpretation of the economy and
the stock market. In fact, when reviewing large cap stocks over rolling 20
year periods from 1946 to 1993, he found that it was as high as 15% in 1952
dropping to 10% for all periods to 1969 and then staying at a 5% amount for
the 20 year rolling time frames since then. (Risk is defined as excess return
per unit of volatility.) If that wasn't bad enough, he also noted that standard
deviation is also not constant. It dropped from a high of 30 for the 20 year
periods ending in 1948, to slightly below 15 till about 1981 and then slightly
above 15 till 1993. What's the impact on the investor? It means that simply
putting money away hoping, or assuming, that, over time, you could feel
reasonably secure in the outcome is not true. But then I have said so in
the past. For example, look at my comments on the mid 70's. You would have
lost 40% of your assets and have taken up to 12 years to equate to the return
you could have posted on Treasury instruments. Or how about the new material
in Investments by Bodie, Kane and Marcus that points out that even if you
did use the standard statistical evidence, a one time full deviation loss
can means you would end up with 40% less money than anticipated. Bottom Line?
You or your adviser must stay on top of current economics and any changes
in statistical data. Be aware however that you are NOT trying to time the
market but make structural adjustments based on the current and objective
information. If you don't like that much involvement, I've got the name of
a broker at Merrill Lynch where you can buy some derivatives.
CORNELL: As continuing commentary on this new investing evidence were some questions as to why the risk premiums and standard deviations were changing. Cornell University did a study where it said that investors tend to focus on changes in wealth rather than the amount of wealth itself. Secondly, investors have a relatively short time frame for investing- about 11 1/2 months (say one year). They simply change their risk premium depending on how the market/economics changes. I have found that to be true of some of the investors and clients I have met and counseled. Clients change their risk tolerance as the market/economics adjust. In a bull market, they have lower demands since the market is going up, up and up. And they are willing to pay higher and higher prices as well. But when the market drops, they put greater and greater pressure on their investments to produce- and when they don't, they want to get rid of them, or are at least are grumbling about the lower- and certainly uncertain- returns.
As I have looked at the issues, most investors, regardless of how much their net worth is, are woefully unknowledgeable about the inner workings of the market- or have simply read one or two issue of Money magazine and think they know it cold. Either way is fraught with error. But that said, no matter how sophisticated, almost all investors are loss adverse no matter how much money they have made in the past. Frankly I believe the fear of loss it is entirely justified. I think the market's movements do not lend themselves to easy way outs as "just give it time". True, time will adjust for any losses sustained, but is it two years, five years, ten years, fifteen years? I don't know, but in the interim, and due to the uncertainties of life, I am unwilling to take a 20%- 40% loss and will sell in a down market. Admittedly you sustain some taxes on any prior gains, but they might be lessened by using tax exempt retirement funds & IRA's.
The way to calm investor fears is through constant communication about what is going on and adjusting the portfolio so that any loss absorbed or "expected" per certain economic conditions should not exceed a previously defined limit. Or as you have read here previously, never buy an investment unless you already have determined how and when you will sell it. My conditions for an entire portfolio means that an investor should never suffer more than a 10% loss overall regardless of how bad the economics are. You simply sell off investments, usually the higher risk first, as the market or investment declines and move into more cash positions. If you are paying attention, I almost guarantee it works. If you are not paying attention- like Orange County, you could lose- well maybe not billions- but lot's.
WOMEN! WILL THEY NEVER LEARN?:Actually, in regards to investing, they are learning quite well. As mentioned previously, those women who undertake an interest in investing actually do better then men. The National Association of Investors Corporation, the trade group for investment clubs, noted that all female clubs have outperformed all male clubs in each of the last five years. The real problem that women have (74% of respondents in a 4,200 American woman survey) is the fear of failure and ignorance in selecting the right investment/stocks/funds. More than half postponed financial decisions for fear of making a mistake. But even when they do take the plunge and save for the future, 72% are still choosing the low risk and low returns of money market accounts and CD's. Supposedly they realize they should invest more aggressively, but they just aren't doing it. The problem apparently emanates from their underlying personality. Those that have taken charge of their lives tend to be better investors. Those who are not assertive and do not see themselves in charge of their lives are overly cautious. But taking control has been at the forefront of many women's movements and lives and I believe they will continue to show a marked improvement in their investment selection and returns.
Unfortunately the brokerage companies are not helping women that
much. A March 1995 study of 300 brokers showed that women were being treated
as the lesser sex when it comes to getting the straight facts about investments.
The comments from the survey were
And though the sex of the brokers was not stated, I bet most were
males. This would "justify" the statistics in that the male ego "normally"
tends to focus on women as second rate people/investors.
I will note a specific comment however in regards to the offerings of "Women Only" Investment Courses. Many brokerage firms have women teaching these "special" orientation classes under the guise that women have different investment "needs". Mostly garbage. While I do admit that a woman broker may be more amenable to explaining things, after that the issue is not justified. Outside of the fact that there may be a picture of a man on a dollar bill, there's nothing else that is sexist about investing money (save for the fact that a woman needs to be more aggressive in earning money since they will live six years longer, on average, than a man.) What they really need is someone that is highly skilled in analyzing investments overall- be that a woman, man, small furry animal or green farm machine. However, since women brokers aren't taught anything of value in their initial training (same as men) and rarely get any additional education (same as men), discussing investments with an incompetent person doesn't make much sense no matter who it is.
In the end, the direct approach of explaining the risks and returns in detail- without all the psychological drama- universally works best.