How Your Children Can Win the Stock Market Game (2006-02-20)

How Your Children Can Win the Stock Market Game

(2006-02-20) by David John Marotta

Good things do come from France. Frenchman Antoine Deneriaz captured Olympic gold in the men’s downhill skiing event beating out favorites Austria’s Michael Walchhofer and America’s Bode Miller. Deneriaz skied last of the 53 competitors in the event but won the gold medal with a time of 1:48.80, beating second place winner Michael Walchhofer by 0.72 seconds.

The difference between gold and silver may seem infinitesimally small, but in the world of Olympic downhill skiing, hundredths of seconds dramatically separate the winners from the rest of the pack. Deneriaz’s 0.72-second margin of victory may seem razor-thin, but it marks the largest spread between gold and silver since the 1964 Olympics.

Winning means flying madly off jumps and yet staying in a tuck position to shave every millisecond off your time. It means coming back from a year long injury to risk your health to win a race. It means being determined to either win or break every bone in your body trying.

Your investments shouldn’t be like that.

Even if you have the risk profile of an Olympic skier that doesn’t mean you need to have a do or die investment portfolio. When it comes to money, every investor should avoid the three cardinal investment sins: fear, greed, and pride. Fear keeps you off the slopes, greed makes you ski faster than is safe, and pride makes you risk everything in order to get a place on the podium.

I’ve advised several teams of school children participating in mock investment competitions. Usually, the team whose imaginary portfolio does the best in three months wins. Three months in investing is like a minute and 48 seconds in downhill skiing.

To win a short-term investment contest you have to invest like a downhill skier. Bet everything on your one trip to the bottom in hopes of being elevated to the top. But, the strategy to win such a competition is almost exactly the opposite of a good investment philosophy in real life. In a mock investment competition you shouldn’t diversify. Diversifying your investment smoothes returns guaranteeing a return toward the middle of the pack. Instead, you want to put all your capital in one risky investment and hope for the best.

In the Olympics, no one remembers fourth place. In a school competition, few will remember the team that finishes second. A guaranteed finish in the top half isn’t a worthy goal. My advice to students who want to maximize their chances of winning the competition is to find a single volatile stock and invest everything in that one stock for the duration of the contest.

Your investments are real, and your financial goals are real. To meet your goals you don't need to beat the investment returns of everyone else. Instead, you want a decent return in order to retire comfortably and to ensure a cash flow which will support your standard of living.

Why risk breaking every bone in your body when you can snowplow your way safely to the end of the race and maintain your financial security? Instead of madly chasing the highest returns, diversify your portfolio, decrease the volatility of your investments, and avoid the possibility of a wipe out.

If our investment philosophy were modeled after a downhill skiing run, we would gladly take any of the returns received in the Olympics. But trying to be on the podium isn’t worth the additional risk. We’d rather get to the bottom of the hill in one piece with a decent return.

Let’s assume the skiers’ performance on the slopes corresponds to their stock market return. The US stock markets average about 10.5%, but they are inherently volatile and risky, like downhill skiing.

Imagine that Deneriaz’s 0.72-second margin gives him a return of 10.5%. Scott Macartney, the third-best American, finished 15th with a time only 1.88 seconds longer than Deneriaz. In stock market returns, this would be the equivalent of getting 98% of the possible return, or averaging 10.3%. Not bad.

Florentin-Daniel Nicolae, the skier who finished last in 53rd place, took only 12.13 seconds longer than Deneriaz. In stock market returns this is the equivalent of only getting 90% of the possible stock market returns or averaging 9.4%. I’d gladly take returns like those. If you can get 90% of market returns averages but make sure to finish safely you will get the gold even if it isn’t a medal.

While being a little more conservative will eliminate your chances of having the highest returns, diversifying will increase the likelihood of meeting your financial goals. In other words, you won’t finish with the best time, but you’ll have a much greater chance of finishing in one piece.

We advise our clients to reduce their exposure to unnecessary risk by investing in more than just US stocks. To diminish risk, we utilize multiple asset classes and invest globally, balancing between markets which do not move in sync with each other.

With the news that American skier Lindsey Kildow was hospitalized after a devastating fall on a downhill practice run, it appears yet another medal contender has suffered a punishing loss on the race to the bottom. Don’t let your investments do the same.

from http://www.emarotta.com/article.php?ID=167

The Guillotine of French Economic Freedom (2006-02-13)

The Guillotine of French Economic Freedom

(2006-02-13) by David John Marotta

The financial outlook for France is not promising. We can learn from their decline. The Heritage Foundation’s survey last year of 155 countries ranked France among the top-ten countries to lose the most economic freedom. The French people are paying the price. According to a study by T. Waning, economic freedom is to blame for France’s nightmarish unemployment rates brought into the public eye by angry youths protesting the lack of liberte, egalite, fraternite.

My wife and I just returned from a trip to Paris, dubbed the City of Light for the gas street lamps which lined boulevards as early as 1829 and also for its role in enlightenment thought. Paris is rich in art and history and our visit to the Louvre and Orsay museums were certainly the highlight of our visit.

Some Parisians fear a "museumification" of the city as the stringent architectural protection laws are embalming Paris as a relic for tourists. As a result, any real economic activity has fled to the more business-friendly suburbs. Although this is a benefit to tourists, tourism represents only a few percent of France’s Gross Domestic Product (GDP).

France is performing a delicate balancing act of having the world’s fifth largest economy while maintaining dismal GDP growth numbers of 0.9% in 2003, 2.0% in 2004 and 1.5% in 2005. Although its economy is second in Europe after Germany, unemployment rates of 23% among its young people and a burgeoning national deficit cause concern.

It is impossible to discuss France’s economic problems without addressing the role of the State. The Republic was founded on grand socialistic notions of heavy government involvement in daily life. Government programs are still seen as the remedy to all social ills.

At the Louvre we saw the Code of Hammurabi dating from the 18th century BC. At seven and a half feet tall, the stele represents one of the first set of rules by a sovereign authority. It would take over 300 massive steles to hold the French labor laws, the weight of which is tied around the neck of struggling French companies.

Although the French gave us the word 'entrepreneur,' it’s a wonder the term isn’t obsolete in French. Opportunities for growth are stifled by their bureaucracy and are over-regulated in the name of equality. A 2004 World Bank study reported it took the average entrepreneur 53 days to start a business in France compared to the US average of 4 days.

According to the Heritage Index of Economic Freedom, government intervention in the economy is largely to blame for the ten-year downtrend in economic freedom in France. The presence of the State is inescapable. The education and healthcare systems are run by the state. And state-owned monopolies control energy, transportation, and the telecommunications industries.

With 22 regions, 96 departments, and 36,000 municipalities, the French government employs one in four workers and consumes nearly a quarter of the GDP each year. To fund their dirigiste economy, the French pay some of highest taxes in all of Europe, surrendering 55% of their wages to income and social security taxes.

Increased regulation in the economy usually results in diminished productivity and profitability. When it comes to investing, we don’t recommend investing in countries with declining economic freedom.

The recent success of some French companies can be attributed to their production and sales in foreign countries. But France is carrying so much domestic baggage they have underperformed the international index averaging only 2.25% annually the past five years.

In a twenty-year study from 1984-2004 comparing total annualized index returns the French index returns lagged well behind Hong Kong and the US. Coincidentally Hong Kong and the US also ranked 1st and 12th in economic freedom, respectively. France ranked 44th in economic freedom.

We don’t recommend investing specifically in France. Of the EU options, we would advise investing in the United Kingdom, Sweden, Germany, Austria or even Italy so that your investment returns can pay for your visits to Paris.

from http://www.emarotta.com/article.php?ID=166

Compute Your Net Worth Once A Year (2006-02-06)

Compute Your Net Worth Once A Year

(2006-02-06) by David John Marotta

Belated Happy New Year! Now that the confetti has been swept up and your head is a little clearer, how do things look? Specifically, now that you are a year closer to retirement, are you on track to meet your goals? Have you measured? What gets measured is more likely to be accomplished. Computing your net worth once a year is the first and most important step toward financial security.

Net worth is a snapshot of how much money would be left if everything you owned were converted into cash and all your debts were paid off. Your net worth is computed by creating four smaller lists.

Liquid assets: An asset is something that you own that is worth significant value. A liquid asset is something that can be sold in a matter of days. Include all of the following types of investments: personal bank accounts (checking, savings, money market), certificates of deposit, bonds, mutual funds, stocks, and exchange traded funds. Use values as of 12/31 of the previous year so that all of your amounts will be on the same day.

Non-liquid assets: Non-liquid assets are those things that you own that cannot be quickly and easily sold without penalty. In this category include the value of your retirement accounts (IRAs, 401ks, 403bs, Keoghs, Profit Sharing Plans, and Pension Plans). Also include any real estate investments including the market value of your home. In the Charlottesville area using the assessed value is an easy indicator of the market value of your home.

Other non-liquid assets can include business interests such as proprietorships, partnerships, or company stock in a company that is not publicly traded. Include the cash value of any life insurance that is not term insurance. Some people include personal property such as jewelry, collectibles, cars, and boats in this category. While these often have a high retail value, their true worth is often a small fraction of their initial cost. I recommend not including personal property.

Immediate Liabilities: Now list what you owe to creditors. These are called liabilities and are also divided into immediate liabilities and long-term debt. Immediate liabilities include credit card debt, car loans, student loans, and any other loan, bill or debt that must be paid within two years.

Long Term Debt: The last category lists long-term debts. For most people this is primarily their home mortgage, but may include other real estate or business loans.

The first time you gather all of this information will be the most challenging, but in subsequent years it becomes much easier. By keeping a record of your net worth each year, you have a valuable tool for financial planning.

Now compute three additional values: Your Total Assets by adding your Liquid Assets and Non-Liquid Assets. Your Total Liabilities by adding your Immediate Liabilities and Long Term Debt. And finally, determine your Net Worth by simply subtracting your Total Liabilities from your Total Assets.

Now that you have computed your Net Worth, you can use these numbers to compute other values useful for reaching your financial goals.

Your Emergency Reserve (Liquid Assets minus Immediate Liabilities) should be at least half of your annual income. Any amount more than this can be invested more aggressively for appreciation. Your Debt Load ratio (Total Liabilities divided by Total Assets) should be under 35%, with your home mortgage comprising the majority of your debt. If you are aggressively trying to pay off your mortgage instead of aggressively trying to save and invest, your efforts are laudable, but mistaken. The quickest path to wealth includes having a home mortgage that could be paid off, but choosing not to in order to take advantage of the tax benefits. The rich wisely leverage and invest.

The most important use of a net worth statement is to measure your progress toward retirement. In order to retire at age 72 and have sufficient funds to maintain your standard of living you need about twenty times your annual spending.

Take your net worth and divide by your annual take home pay. This is how many times your annual standard of living you have amassed in savings. If you are under 40, the number is probably less than five. That’s ok; it is supposed to be.

Progress toward retirement is not a linear function. To those of you wondering if the math you studied in high school is useful, the following equation was determined by quadratic regression. It estimates how much of your current net worth you should have saved given your age. This gives you a benchmark for determining if you are on track to retire by age 72.

Take your age and divide by 166. Then subtract fifteen hundredths (0.15). Finally, multiply the result by your age. The resulting number should be between zero and twenty. That number is how many times your current annual income you should be worth.

Pull out your calculator and follow an example. If you are 45 years old then forty-five divided by 166 equals 0.2711. Subtract 0.15 to get 0.1211. Then multiply by 45 again. The result is 5.45. By age forty-five you should be worth about five and a half times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but this is a good approximation of your progress. Here is a table that shows by what age you should have saved different multiples of your annual spending.

Age	Annual Spending Saved	Age	Annual Spending Saved
30	1	57	11
35	2	59	12
38	3	61	13
42	4	63	14
44	5	64	15
47	6	66	16
49	7	68	17
51	8	69	18
53	9	70	19
55	10	72	20

If your net worth is a higher: Congratulations! You are on the path to retiring earlier than 72! For every 0.5 you are over, you could consider retiring about a year earlier. Conversely, for every 0.5 you are under your age’s benchmark you may have to work an additional year beyond 72.

Between the ages of 40 and 60 your net worth should increase by one unit of your annual spending every two years. That means that your current net worth divided by your take home pay should be one unit greater than it was two years ago. Alternately, if you are between 40 and 60, your net worth should have increased this year by half of your take home pay.

This is because money makes money, and by the time you are in your 40’s you should have enough investments to be earning about half of your annual spending each year. The compounded growth of your investments does the lion’s share of the work while you only need to contribute 15% of your current earnings. If you save 15% of your take home pay between age 20 and age 72 you should have sufficient savings in retirement. This is despite the fact that you will have saved less than 7 years worth of pay and many of those years will have been at a lower rate of pay. How much you save and invest is the primary determination of your financial future.

Want to retire younger? Try lowering your standard of living. In retirement, most people spend about 70% of the gross salary they earned while they were working. If you can live off 50% of your take home pay, you don’t need as much savings to maintain that lower lifestyle.

Need to catch up? Save more than the 15% of your take home pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30 you should be worth 1.4 times your annual income. What should you do if you are only worth 1.1 times your annual income? Normally, to stay on track you need to save 15% of your income each year. In order to catch up you need an additional 0.3 times your annual income. One option would be to save an additional 10% of your income for three years. If saving 25% of your income is too much, try saving 20% (an additional 5%) for six years.

All of financial planning begins with a clear understanding of your net worth. We have a template in PDF format on our website (www.emarotta.com) that you can use to help you compute and keep track of your net worth each year. Contact us or visit our website to receive a free copy.

from http://www.emarotta.com/article.php?ID=165