Fed Drops Rates & Stocks Fall

The Federal Reserve dropped the federal funds rate by a quarter point to 2%, and dropped the discount rate to 2.25%. The Fed indicated that it was going to take a wait and see approach on further rate drops. The Fed is concerned that inflation may become an issue, regardless of the fact that it already is a problem for many Americans.

'Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.'

Here is how the stock market reacted to the Fed's statement:

Source: bigcharts.com

The market is addicted to the low interest rates that the Fed is doling out. Why else would the market fall on the news? This 'pause' was as widely expected as this interest rate drop.

Source:
'Fed Trims Rate to 2%, Signals Ready to Consider Pause', by Craig Torres, Bloomberg News
FOMC Press Release

Wealthy, Fat, Lazy...and 7-Star Hotels

This is what an massive inflow of petrodollars will do to a local population:

• If the oil price remains at about $100 a barrel, they will reap a cumulative windfall of almost $9 trillion by 2020;
• Almost a fifth of the UAE's native population suffers from diabetes;
• (A) McKinsey (study) reckons a quarter of native employees in Bahrain, Saudi Arabia and the UAE fail to show up for work;
• Burj al-Arab, the world's only seven-star hotel. Guests arrive by helicopter or Rolls-Royce, watch 42-inch plasma TV-screens in their rooms and choose from 13 pillows on which to lay their heads.

Another problem with all of the money coming into the Gulf region is inflation. The Saudis are dealing with an inflation rate of 8.7%, while Oman has an inflation rate 11.1%.

Most local currencies are pegged to the US dollar, which has dropped like a rock lately. This drop in dollars devalues there currency, requiring more local money to purchase goods not priced in dollars. The inflation rate is even hurting foreign workers who send money back to their home countries. Below is a great explanation on how inflation works:

'When an energy exporter converts its petrodollars at the central bank, domestic spending rises. But unless the local economy has a lot of slack, it cannot magically produce more goods and services to meet this fresh demand. Their price instead rises, relative to the price of things that can come in from overseas. According to a study by three IMF economists, a doubling of the oil price results eventually in a 50% rise in the price of non-tradable goods (such as housing), relative to tradables.'

This shows up as inflation. But the price rises should peter out once they have served two useful functions: diverting demand to goods from abroad, and increasing the supply of those goods and services that must be produced at home.'

Source:
'How to spend it', by The Economist

No Bottom For Home Prices Yet

Prices for existing homes, as measured by the S&P/Case-Shiller Home Price Indecies, continue to drop, with 17 of the 20 markets recording record declines. The 10-City index has dropped 13.6% while the 20-City index has dropped 12.4%.

“There is no sign of a bottom in the numbers. Prices of single family homes continue to drop across the nation. All 20 metro areas were in the red for the February-over-January reading. In addition, 19 of the 20 MSAs are still reporting negative annual returns. The monthly data show that every one of the MSAs has now declined every month since September 2007, marking six consecutive months. On top of that, the declines have remained steep with eight of the 20 MSAs and both composites reporting their single largest monthly decline in February." -David M. Blitzer, Chairman of the Index Committee at Standard & Poor's.

Las Vegas, Miami and Phoenix hasve suffered the most, with the YoY change in prices of atleast -20%. Charlotte NC is the only market to reamin positive with a YoY price change of 1.5%. However this market has experinced an increase in the drops in prices over the past three months.

Source:
'Steep Declines in Home Prices Continued in Feburary...', S&P/Case-Shiller Home Price Indices

Will Work for Oil

Interesting chart from thechartstore.com, via Jeffery Saut with Raymond James. It takes an average wage earner 6.8 hours of work to 'buy' a barrel of crude oil, almost a 300% increase from five years ago. Yet the Government sees little inflationary pressures on the average American.

Source: raymondjames.com

Source:
'Investment Strategy'. by Jeffery Saut, Raymond James

New Rise of Nationalism

The WSJ has an article in today's paper discussing the rise in nationalism, and the decline in globalism. Over the past several decades, it seemed that the 'nation' would be a reduced factor in world affairs, and that global commerce would be able to knock down all barriers to local markets. The biggest example of this push towards globalism was the creation and continued expansion of the European Union.

Now many countries are asserting control over market forces. Since 2004 Russia, Venezuela, Bolivia and Ecuador have nationalized once private oil companies. 80% of the worlds oil-reserves are control by state owned firms. Countries continue to throw up barriers on exports and institute price controls for food stuffs.

Countries are also throwing up barriers to investments, especially from sovereign wealth funds which total almost $3 trillion dollars. Some countries have identified critical industries which will be protected from foreign investment.

Even the Internet is coming under nationalist pressures. Many countries have asked ICANN to develop a way for them to use their own local alphabet instead of the Latin based one. While in one respect this makes it easier for the local population to use the Internet, it closes off users from other countries.

"The era of easy globalization is certainly over," Daniel Yergin, Pulitzer Prize-winning author.

Source:
'Rise of Nationalism Frays Global Ties', by Bob Davis, WSJ {$$$}

Investment Definitions - Part 2

More definitions for investors to be aware of. Most of your money is made when you buy a stock (or other type of investments), and using a limit or a stop order will help you purchase a stock at the price you want.

Limit Order - is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. When you place a market order, you can't control the price at which your order will be filled.

For example, if you want to buy the stock of a "hot" IPO that was initially offered at $9, but don't want to end up paying more than $20 for the stock, you can place a limit order to buy the stock at any price up to $20. By entering a limit order rather than a market order, you will not be caught buying the stock at $90 and then suffering immediate losses if the stock drops later in the day or the weeks ahead.

Remember that your limit order may never be executed because the market price may quickly surpass your limit before your order can be filled. But by using a limit order you also protect yourself from buying the stock at too high a price. Some firms may charge you more for executing a limit order than a market order.

Market Order - is an order to buy or sell a stock at the current market price. Unless you specify otherwise, your broker will enter your order as a market order.

The advantage of a market order is you are almost always guaranteed your order will be executed (as long as there are willing buyers and sellers). Depending on your firm’s commission structure, a market order may also be less expensive than a limit order.

The disadvantage is the price you pay when your order is executed may not always be the price you obtained from a real-time quote service or were quoted by your broker. This may be especially true in fast-moving markets where stock prices are more volatile. When you place an order "at the market," particularly for a large number of shares, there is a greater chance you will receive different prices for parts of the order.

Stop Order - is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the specified price is reached, your stop order becomes a market order.

The advantage of a stop order is you don't have to monitor how a stock is performing on a daily basis. The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. Also, once your stop price is reached, your stop order becomes a market order and the price you receive may be much different from the stop price, especially in a fast-moving market where stock prices can change rapidly. An investor can avoid the risk of a stop order not guaranteeing a specific price by placing a stop-limit order.

Buy Stop Order - investors typically use a stop order when buying stock to limit a loss or protect a profit on short sales. The order is entered at a stop price that is always above the current market price.

Sell Stop Order - a sell stop order helps investors to avoid further losses or to protect a profit that exists if a stock price continues to drop. A stop order to sell is always placed below the current market price.

Stop Limit Order - is an order to buy or sell a stock that combines the features of a stop order and a limit order. Once the stop price is reached, the stop-limit order becomes a limit order to buy or to sell at a specified price.

The benefit of a stop-limit order is that the investor can control the price at which the trade will get executed. But, as with all limit orders, a stop-limit order may never get filled if the stock's price never reaches the specified limit price. This may happen especially in fast-moving markets where prices fluctuate wildly.

See my earlier post with additional definitions.

Source:
'Orders', SEC.gov

World Food Prices

There has been a lot of news coverage, and here, and here, on the increase in the prices for food stuffs across the world. Just this week Wal-Mart, Sam's Club and Costco have put limits in place on how many bags of rice people can buy. Granted the limit is between four to ten bags, but the stores have experienced a run on rice.

This chart compares the futures price of oil (in green) to the futures price of rice, which have moved together over the past three months.

Source: wsj.com

This chart compares the futures price of oil (in green) to the futures price of wheat, which moved together through mid-march but have diverged since then.

Source:wsj.com

The charts above are not meant to be a true technical analysis between these prices, its is just interesting to see them moving in relation to each other.

As the world's population increases, expect to see the prices of food stuffs become a real problematic issue. Some countries are limited in the amount of food that they can grow internally due to climate, governmental policies or state of modernization. How will these countries react when it becomes increasingly expensive to feed their population.

How will the world react? Will countries with a small surplus of crops be willing to export to other countries in need? Will there be an increase in civil unrest and war between countries? Most wars have been started in order to increase a countries access to natural resources.

What are the investment opportunities out there? There will an increased demand for farming equipment, fertilizer, pesticides and seeds. Any one of these, which improves the efficiency of growing crops will be able to charge a premium.

Additional Reading/Listening:
'Soaring World Food Prices', National Public Radio series
'The Silent Tsunami', Economist

Source:
'Rice Shortage Roils San Francisco Stores, Markets, Food Banks', by Ryan Flinn, Bloomberg News

2007 Largest Exporter

From the WTO, via the Economist, Germany was the biggest exporter in 2007, shipping out $1.3 trillion dollars in goods. China and the US were second and third, with all three countires account for 25% of all world trade. On the downside, the US is the largest importer with close to $2.0 trillion in goods coming into the country.

Source:
'Shipping Out', by Econmoist.com

Some Good News, Sort Of....

The IRS will begin sending out the Economic Stimulus payments one week early. The plan is to get $50 billion dollars into the US economy by the end of May, with another $50 billion by the end of June. The money will be available just in time for summer vacations and gasoline prices at $4.00 a gallon.

Check out the stimulus payment calculator on this post.

Source:
'US to start sending tax rebates Monday:Paulson' , by David Lawder, Reuters

Are They Worth It?

The NY Times has a great interactive feature on executive compensation in relation to the company's stock price and change in net income.

The feature was part of a special report on executive pay, and how shareholders have been fighting to keep compensation in line by tying it into stock or company performance.

'The compensation research firm Equilar recently compiled data about chief executive pay at 200 companies that filed their proxies by March 28 and had revenues of at least $6.5 billion. (The data) shows that average compensation for chief executives who had held the job at least two years rose 5 percent in 2007, to $11.2 million. '

Source:
'A Brighter Spotlight, Yet the Pay Rises', by Claudia H Deutsch, NY Times
'Executive Pay: The Bottom Line for Those at the Top', NY Times

Middle Class Pinch

With the election season in full swing, the plight of the middle class America has taken center stage. The past decade has not been a great for the middle class in America with the continued loss of jobs, the technology stock crash, the mortgage bubble popping, inflation, lack of affordable health care and stagnant wages.

The American worker's salary has not kept up with the rising cost of living. Between 2000 and 2006, the average family's income dropped 4.0%, while inflation increased by 17%. What cost a dollar in 2000, would now cost $1.17. However if you look at the cost of some basic items that a family uses on a daily basis, these prices increased at a faster rate than the overall inflation rate. A pound of ground beef has increased in price by almost 40% while a gallon of gasoline has increased by almost 80%.

Below is a graphic from an article in the WSJ about the middle class, and specifically about their roll in deciding the Pennsylvania Democratic primary. This is an issue not just isolated to Pennsylvania, but across the states. 'In a recent Pew Research Center survey, 41% of respondents rated their lives as better than five years ago, and 31% said they were worse. That response is even glummer than in 1979, when, amid rising economic malaise, 25% of respondents to a similar survey rated their lives as worse.'

Expect to the politicos to focus on this through November.

Source:
'Trapped in the Middle', by Justin Lanhart and Kelly Evans, WSJ {$$$}

Today Is Tax Freedom Day

April 23 of 2008 is Tax Freedom Day. This means that it took Americans about four months of work to make enough money to pay their tax obligations (federal, state & local) for the year. We achieved freedom three days earlier than last year due to the economic slow down and the stimulus package.

From the report: 'Americans will work longer to pay for government (113 days) than they will for food, clothing and housing combined (108 days). In fact, Americans will work longer to afford federal taxes alone (74 days) than they will to afford housing (60 days). As a group, Americans will also work longer to pay state and local taxes than they will to pay for food.'

If the fact of having to work so long to pay taxes makes you mad then move to Mississippi, which reached freedom on April 7th. They have a combination of low personal income and low tax rates. Due to the progressive nature of the tax law, the more money you make the more you are taxed. The states with the longest wait for freedom are New York (May 5), New Jersey (May 7),and Connecticut (May8). These states have some of the highest personal incomes in the US, along with high state and local taxes.

Source:
'America Celebrates Tax Freedom Day', by Tax Foundation, taxfoundation.org
'Special Report No 160', by Gerald Prante and Sctoo A Hodge, Tax Foundation

Oil and Gas Prices - New Highs

Oil futures have hit a new all-time high, due to OPEC maintaining their production quota, an attack on an oil facility in Nigeria and an attack on a oil tanker in the Gulf of Aden. I am not sure that these events are really driving the oil market, per se. It seems that the market is looking for any reason to run oil higher. From a Bloomberg News story:

``The price seems to be rising inexorably towards $120,'' said Bill Farren-Price, director of energy at London-based Medley Global Advisors. ``OPEC has a very limited amount of spare capacity left and maybe they're trying to keep that in case there's actual physical disruption.''

Source: wsj.com

Granted oil supplies are limited and demand has/will increase due to growth in China and other countries, but it seems that oil and other commodities are getting ahead of themselves. As prices increase they will eventually reach a point that they will reduce demand and undercut their price support. Again from Bloomberg News, OPEC president Chakib Khlelil was quoted as saying the if OPEC nations increase their output, they 'will not find people to buy the increment.'

With the increase in oil prices, gasoline prices have also increased. For the week that ended on April 18th, a gallon of gas cost $3.4737, up 15.66 cents. Trilby Lundberg is quoted as saying, "(i)f crude oil prices do not retreat, then we will see somewhere between 10 cents to 30 cents rise in the retail price of gasoline, probably in the next few weeks,"

How much longer will the average US consumer be able to handle these price increases? What is left for them to cut back on?

Source:
'Oil Rises to $117 Record on Nigerian Supply Cuts, OPEC Stance' by Grant Smith, Bloomberg News
'Drivers paying record pump prices', by Chelsea Emery, Reuters News

Investment Definitions

A couple of definitions all investors should be aware of:

• Correlation - is the extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions. Correlation is measured on a scale of -1 to +1. Investments with a correlation of +.5 or more tend to rise and fall in value at the same time. Investments with a negative correlation of -.5 to -1 are more likely to gain or lose value in opposing cycles.

• Sharpe Ratio - used to compare the relationship of risk and reward in following different investment strategies, such as emphasizing growth or value investments, or in holding different combinations of investments. To figure the ratio, the risk-free return is subtracted from the average return of an investment portfolio over a period of time, and the result is divided by the standard deviation of the return. A strategy with a higher ratio is less risky than one with a lower ratio. This type of analysis, which is done using sophisticated computer programs, is named for William P. Sharpe, who won the Nobel Prize in economics in 1990.

• Beta - is a measure of an investment's relative volatility. The higher the beta, the more sharply the value of the investment can be expected to fluctuate in relation to a market index. For example, Standard & Poor's 500-stock Index (S&P 500) has a beta coefficient (or base) of 1. That means if the S&P 500 moves 2% in either direction, a stock with a beta of 1 would also move 2%. Under the same market conditions, however, a stock with a beta of 1.5 would move 3% (2% increase x 1.5 beta = 0.03, or 3%). But a stock with a beta lower than 1 would be expected to be more stable in price and move less. Betas as low as 0.5 and as high as 4 are fairly common, depending on the sector and size of the company. However, in recent years, there has been a lively debate about the validity of assigning and using a beta value as an accurate predictor of stock performance.

• Asset Allocation - is a strategy, advocated by modern portfolio theory, for reducing risk in your investment portfolio in order to maximize return. Specifically, asset allocation means dividing your assets among different broad categories of investments, called asset classes. Stock, bonds, and cash are examples of asset classes, as are real estate and derivatives such as options and futures contracts. Most financial services firms suggest particular asset allocations for specific groups of clients and fine-tune those allocations for individual investors. The asset allocation model — specifically the percentages of your investment principal allocated to each investment category you’re using — that’s appropriate for you at any given time depends on many factors, such as the goals you’re investing to achieve, how much time you have to invest, your tolerance for risk, the direction of interest rates, and the market outlook. Ideally, you adjust or rebalance your portfolio from time to time to bring the allocation back in line with the model you’ve selected. Or, you might realign your model as your financial goals, your time frame, or the market situation changes.

Source:
Glossary, Yahoo Finance

Stock or Industry Selection

A paper published by Jeffery A Busse and Qing Tong, of the Goizueta Business School at Emory University, explains that for consistent performance in a mutual fund its better to have a manager who can pick industry sectors than one who can pick stocks. The paper explains 'that industry selection contributes substantially to fund performance, accounting for roughly half of a fund's abnormal performance.' The paper states that this importance of industry selection is 'stable across time, with little year-to-year variation in the mean contribution across funds.'

The paper is based on analyzing almost 4,000 actively managed domestic mutual funds from 1980 to 2006. The researchers analyzed a manager's industry selection ability by setting up a hypothetical portfolio which replaced each stock in the fund with an index for that stock's industry. For example if a manager bought Johnson and Johnson, the researchers added an equal dollar amount of an index representing major drug manufacturers. If the hypothetical portfolio beat the market, the manager was showed to be good at industry selection. If the manager's stock picks outperformed the hypothetical portfolio, the manager was judged to be good at stock selection.

Based on the analysis, the researchers found that a manager's margin for beating the market was split almost evenly between stock selection and industry selection. However, over a longer period of time, industry selection was a skill that would most likely persist. The paper also found 'a negative relation between fund portfolio size and stock-selection skill'. This 'negative relation' was not present when comparing the size of a fund and industry selection. This fact probably explains why some large mutual funds preform quite well, while others suffer.

Below is a chart comparing Fidelity's Magellan Fund (market cap $38.40 billion) to American Funds Growth Fund of America ($165 billion). Between 1977 and 1990, the Magellan Fund, under the management of Peter Lynch, had an annualized returned of 29%. The fund ran into problems in the late 90's when the funds asset base swell to $100 billion dollars and ended up a 'closet' index fund. As the fund grew, the manager was unable to put that money to work effectively. Stock selection which had been the strong suit of the fund's new manager broke down under the weight of its asset base.

Source: bigcharts.com

On the other hand the Growth Fund of America, has an annualized return of 13% compared to 8.2% for the S&P 500 over the past 10 years. This fund has been successful due to its management structure and sector selection. Rather than relying on one manager, or even a team of in-house managers, it is managed by multiple management teams. This structure has allowed it to grow, while still preforming better than the market. Granted that at $165 billion, this fund will probably have a difficult time maintaining its returns, and will probably end up mimicking the returns of the market. (How large is too large?)

Below is a chart of Van Wagoner Emerging Growth Fund (market cap $15 million) compared to the Russell 2000. In the mid to late 1990s, the Emerging Growth Fund was returning 50% plus returns each quarter by investing in small-cap technology stocks. However, since 1995 the fund has an annualized return of -7.8%. You would have made more money leaving it under your mattress.

Source: bigcharts.com

The funds dismal returns are due to stock picking, and industry selection. The fund focused on small-cap stocks in the technology sector, not the best place to be since the Internet bubble popped in 2000.

Source:
'Mutual Fund Industry Selection and Persistence', By Jeffery A Busse and Qing Tong
'Picking the Forest or the Trees', by Mark Hulbert, NY Times

Dollar Cost Average or Lump Sum

Dollar cost averaging or lump sum, which is the best approach for an investor. The unequivocal answer is either one depending on your situation.

Basic Investment Strategies

Below is a brief explanation of the two investment strategies. Have also thrown in another strategy that is similar to dollar cost averaging.

Dollar Cost Averaging (DCA) is defined as the investment strategy of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. An example of this type of investing is to purchase $1,000 of shares each month to in a mutual fund for a total of $12,000 over a year.

Lump Sum Investing (LSI) is defined as the investment strategy of buying a particular investment at one time. An example of this type of investing is entering in an order to purchase $12,000 worth of shares at a single time. Typically additional purchases would not be made in a significant amount.

Value Averaging (VA) is defined as an investing strategy that works much like dollar cost averaging (DCA) in terms of steady monthly contributions, but differs in its approach to the amount of each monthly contribution. In value averaging, the investor sets a target growth rate or amount on his or her asset base or portfolio each month, and then adjusts the next month's contribution according to the relative gain or shortfall made on the original asset base. An example of this type of investing is to start by purchasing a set number of shares, and over a period of a time purchasing additional shares each month so that the account value equals $12,000. The number of shares would vary depending on the price of the shares. Months when the price is lower than the intital purchase price, more shares would be bought and the opposite when prices are higher.

Which Strategy Yields The Best Returns?

Using historical data to compare the DCA strategy to the LSI strategy, the LSI method returns higher results 2 out of 3 times. Here is a tool that allows you to test the two methods for each month of the year since 1950. LSI has the advantage since the overall trend of the stock market has been to increase in value year to year. In a rising stock market, DCA is hurt by the fact that with each purchase the cost basis of the shares increases while the LSI cost basis remains constant. Typically in a market that is in a down trend, the DCA strategy comes out ahead because with each purchase the cost basis is lowered.

Below is a chart from AllFinancialMatters.com, that compares DCA strategy to LSI strategy. The LSI strategy (account value) took $19,900 and invested in the Vanguard S&P 500 Index fund on January 2, 1990. The DCA strategy invested $100 at the begining of each month from January 2, 1990 to July 3, 2006, which works out to a total of $19,900 (199 months multipled by $100 each month).

Practical Advice

If you come into a large amount of money and want to invest it, you are better off putting it on all at one time. First is the evidence clearly shows that in most cases you will come out ahead by lump-sum investing. Secondly if you invest it all at one time, you will not be tempted to spend it.

Most of us cannot afford to take a large sum of money at one time and invest it, by default we have to dollar-cost average. An employee sponsered retirement plan (401K or 403B) is a perfect example of dollar-cost averaging. If this is the only way that you can afford to invest, this is your best option.

Source:
'Dollar Cost Averaging', Investopedia.com
'Value Averaging', Investopedia.com
'Dollar Cost Averaging v. Lump Sum Investing - Part II', by JLP, allfinancialmatters.com
'Lump Sum Beats Dollar-Cost Averaging' by Richard E. Williams, Ph.D., and Peter W. Bacon, DBA, CFP, Journal of Financial Planning

And These Guys Are In Charge?

Saw this on The Weekly Standard website:

Roll Call reports that the Members of Congress who are deciding how to address the depressed housing market and economic slowdown are among those who've lost the most. And one of the contenders for the title of biggest loser is John Kerry:

Congress’ uber-rich had the most at stake. Sen. John Kerry (D-Mass.), who married into the Heinz ketchup fortune, is near the top of Roll Call’s list, with as much as $2.9 million in potential banking stock losses. According to his 2007 disclosure form, Kerry owned at least $1 million apiece in insurer AIG, investment bank Morgan Stanley and mortgage issuer Washington Mutual, whose stock alone has lost 75 percent of its value during the past 15 months.

It's useful to remember that hundreds of Representatives have experienced losses direct and indirect as a result of the slowing economy. Few if any will recuse themselves from voting on legislation that may directly influence their net worth. And if you may have lacked faith in the wisdom of Congress to properly address the slump, check out this:

Cleta Mitchell, a lawyer who works with many GOP Members on their financial disclosure statements, suggested during a conversation about potential pitfalls in disclosing financial information that it's not surprising that nearly 10 percent of lawmakers may be out millions of dollars because of the current credit collapse.

“Frankly ... these people are economically illiterate,” she said.

Economically illiterate, those are fighting words.

Source:
'Kerry Loses Millions', by Michael Goldfarb, The Weekly Standard

Simple Investment Advice

There is a ton of information and advice out there on how to build wealth. It seems that some people try to attain wealth by developing a 'system' on how to be rich, then write a book on the 'system' and finally give seminars on how the 'system' works. A long the way there are plenty of opportunities for selling 'system' merchandise. The problem with this is that each 'system' needs a little different angle to make it stand out from all the other stuff out there. All of these different angles end up creating a lot of noise and confusion, when really most systems talk about the same basic things.

I guess if I were to write a book on how to build wealth I would write about these six pieces of advice. Eventually I will have to come up with a fancy buzz word, which would be trademarked, to describe my powerful wealth building system, but these things just seem like common sense.

Just think, I have already started you on your way to building your wealth. By finding this you just saved $9.99 plus tax for my book.

1. Start Now

The sooner you start to invest the better your long term returns will be due to the power of time (and compounding). Time is one of the best investment tools you will ever have. Below is a chart, from AG Edwards, that compares an early saver and a late saver. The early saver deposits $250 a month for 10 years for a total investment of $30,000, while the late saver waits 10 years and then begins to deposit $250 a month for 30 years for a total investment of $90,000. Assuming an 8% compounded return and ignoring taxes, at the end of 40 years the early saver has $88,000 more than the late saver. If the earlier saver continued to save $250 a month for the entire 40 years the difference between the two savers would be much greater.

Source: AGEdwards.com

Don't worry about the hottest stocks or sectors to be in. Don't worry about not having enough money to begin. Don't worry about being too young or too old. Don't worry about how much you need to save. Just start.

2. Compounding is Your Friend

Albert Einstein has been quoted as saying "The most powerful force in the universe is compound interest." In the case of investing in stocks and mutual funds you are really compounding your returns, but the idea is similar to compound interest. As you reinvest your dividends and capital gains distributions back into your stocks or mutual funds, this reinvestment generates additional earnings which grow year after year. Below is a chart, from Bankrate.com, showing that if at age 25 you started to put $100 per month into an account that returns 6% each year that you would have $200,145.

Source: Bankrate.com

The great thing about compounding is that the growth you get from reinvesting the dividends and capital gains distributions will start to outpace the return you get from your initial investment. Think of it as a small snowball rolling down a mountain. As the snowball rolls down the hill it picks up more and more snow, building in size. At the bottom of the mountain the snowball has grown in size to a massive one (a bit of an exaggeration but you get the idea). Eventually you reach a point where your money is working for you to create more money. This is the 'holy grail' for investors.

3. Your Only Average

You should just come out and say this 'I am not as good of an investor as I think I am'. Numerous studies have been performed showing that people tend to be overly optimistic when it comes to investment decisions. This over optimism leads people to sell their winning investments too soon and hold onto their losing investments too long. If you are able to take the emotion out of your investing, and accept that you are only average you will come out ahead of many others. From a NY Times article:

Stocks have been a great investment in the last 80 years, with an average return of about 10 percent a year. But have investors in the stock market done as well as stocks? Surprisingly, the answer is no. The average dollar invested in the stock market in those years has earned only about 8.6 percent a year.

The article references a paper published by Ilia D. Dichev, a University of Michigan accounting professor, that explains the difference due to investors buying patterns. The article provides an example:

To understand the difference between a stock’s return and an investor’s return, consider someone who buys 100 shares of a company at a price of $10 a share. A year later, the share price is up to $20, and the investor buys 100 more shares.

Alas, the investor’s luck has run out. By the end of the next year, the price has fallen back to $10 and the investor sells his 200 shares. A buy-and-hold investor who bought at $10, held the stock for two years, and then sold at $10 would have had a zero return.

But our friend who tried to time the market did much worse: over the two years, he invested $3,000 in the stock and ended up with only $2,000. Even though the stock broke even, the investor lost money because of bad timing: most of his money was invested right before the market fell.

To calculate a meaningful measure of the investor’s return, it is necessary to weight the yearly returns by the dollars invested during that year. When Mr. Dichev calculates the dollar-weighted returns on this stock according to his preferred method, our hypothetical investor’s average yearly return ends up being negative 26.8 percent, far below the zero return that the buy-and-hold investor would have received.

4. Invest for The Long Term / Invest Through All Markets

Shorter time periods in the stock market are very volatile, however the general trend for most stock markets has been in an upward direction. The market will fluctuate from day to day, month to month and year to year, the market can not be up making a new high everyday.

Source: yahoo.com

Above is a chart of the S&P 500 starting in 1950 through today, compared to the 10-year US Bond. Since 1950 there have been 12 bear markets with an average loss of -26%. Over the same period the S&P 500 has returned over 7,500%. During those 12 bear markets it probably seemed like the world was ending, however the market rebounded from these events. Granted markets do not go up all the time and there maybe periods of under performance, however being invested in the stock market is a great way to build wealth.

5. Keep It Simple, Be Lazy

There is no need to spend a lot of time developing a complex portfolio of stock, bond and mutual fund holdings. The easiest way to be invested in the market and to be diversified is to invest in a Life Style or Target Retirement fund. These types of funds are a one-stop-fund that invest in a basket of stock and bond mutual funds, shifting overtime from more stocks in the early years to more bonds as the 'target' age is reached. These funds will even re-balance as needed to maintain their asset allocations, all you would need to do is fund the investment. Granted these types of investments are not a lot of fun to talk about at a cocktail party, but in the long run they will save you time, effort and worry. Below is a chart comparing a very simple portfolio (Second Garder's Starter), a target retirement fund (T Rowe Price 2040 Fund) and the S&P 500.

	Portfolio	Equity %	1 Year Return (3)	3 Year Annualized Return (3)	5 Year Annualized Return (3)
	Second Grader's Starter (1)	90%	8.83%	12.31%	17.02%
	S&P 500 (1)	100%	5.49%	8.62%	12.83%
	T Rowe Price 2040 Fund (2)	91%	6.67%	10.31%	14.76%

1) Source: Morningstar Inc
2) Source: T Rowe Price
3) Returns as of 01/03/2008

For more information see my posts on being a lazy investor, part one and part two.

6. Make It Automatic

Sign up for an automatic investment plan. The most common of these plans is a 401K or other employee-sponsored retirement plan you might find at work. These plans work by automatically taking money from your pay check and investing them into your account. You don't even get a chance to spend the money. You are paying yourself first.

Another great thing about automatic investment plans is that you are dollar-cost averaging (DCA). Dollar cost averaging is a 'technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.'

There is some controversy about DCA and that it is nothing more than a marketing gimmick. Some studies have shown that over 'long periods, dollar-cost averaging almost always produces lower returns than investing lump sums in diversified portfolios, and almost never reduces risk meaningfully.' The studies are correct, if one were able to invest lump sums they would come out ahead, but who has a nice lump sum sitting around?

Probably the most important lesson to take away is that it takes discipline and commitment to build wealth. Very few people are lucky enough to win the lottery, to have developed and marketed a must-have gadget or worked hard starting their own company which has been bought out for millions of dollars. Most of us have the save and invest diligently, live within or means and let time help us out. But it is possible if you just start now.

Source:
'Sometimes the Stock Does Better Than the Investor That Buys the Stock',by Hal R Varian, New York Times
'Dollar-Cost Averaging', Investopedia.com
'The costly myth of dollar-cost averaging', by Timothy Middleton, MSNMoney.com

What A Decade

Seems that the period from 1998/1999 to today has been a terrible time to be either an employee or a stock investor.

Wages Down

The graph below is from a NY Times article talking about how many Americans did not get a head during the boom of the last decade. At the end of 2000 the median (or typical) American Family made about $61,000. At the end of 2007 the estimated median income was $60,500. These numbers are from the Census Bureau and have been adjusted for inflation via the NY Times article.

The article goes onto explain that, "(t)his has never happened before, at least not for as long as the government has been keeping records. In every other expansion since World War II, the buying power of most American families grew while the economy did.'

'More than anything else — more than even the war in Iraq — the stagnation of the great American middle-class machine explains the glum national mood today. As part of a poll that will be released Wednesday, the Pew Research Center asked people how they had done over the last five years. During that time, remember, the overall economy grew every year, often at a good pace."

"Yet most respondents said they had either been stuck in place or fallen backward. Pew says this is the most downbeat short-term assessment of personal progress in almost a half century of polling.'

The average American family has also been battered around by the end of the technology bubble in 2000 and the collapse of the housing market in 2006/2007. They have also had to deal with increases in food and gas prices making it hard to feed a family and fill up the car. No wonder the outlook is so downbeat.

Stocks Down

Below is a graph from a WSJ article talking about the stock markets lost decade. Since 1999, the S&P has returned just 1.3% a year over the past decade. This return takes into account inflation and dividends. You would have made more money by investing in the US Long-Term Treasury Bonds (7.68%) over the same period.

The article explains some of this under-performance due to after a period of "extraordinary returns, as we did from 1982 through 1999, then usually the next 10 years aren't very good," says Prof. Sylla. His research suggests that exceptional booms steal gains from the future. When the booms end, returns become subpar, so that average returns over the longer term fall back to the 7% norm. Economists call this "reversion to the mean," the idea that exceptional performance can't last forever.'

Don't look for a quick recovery either:

"We have to accept that this is no longer a nation of 4% real economic growth. This is a mature nation that no longer has a strong manufacturing base," says Steve Leuthold, chairman of Leuthold Weeden Research in Minneapolis. He believes that another bull market is on the horizon, perhaps following some additional stock declines. But that future bull market, he contends, could be followed by another bear market that could bring stocks back close to where they are today."

"Before another lengthy bull run can begin, stocks need to overcome two problems: the hangover from the high prices of the late 1990s, and the continuing effects of the exceptionally low interest rates instituted by the Federal Reserve in 2001 and again today. Those low interest rates helped push corporate profits higher, but also fueled borrowing excesses that led to today's economic problems."

Both articles are a good, if depressing, read.

Source:
'For Many, a Boom That Wasn’t', by David Leonhardt, NY Times
Stocks Tarnished By 'Lost Decade', E. S. Browning, WSJ {$$$}

Jonathan Clements is Retiring

Read in the WSJ that after 26 years as a journalist Jonathan Clements is retiring. He has decided to take his mom's advice and is getting a real job, although he doesn't go onto explain what that real job will be.

His last article asks "What is the reason for all this saving and investing?" He provides three key benefits.

1. If you have money, you don't have to worry about it. This isn't guaranteed. There are lots of rich folks who agonize constantly -- and needlessly -- about their finances. Still, if you save diligently, you should reach the point where money worries are relatively rare.

This feeling of financial serenity isn't, however, only for the wealthy. If you live beneath your means and invest prudently, you can achieve a sense of financial control long before you achieve full financial independence.

As I see it, this is yet another reason to follow my favorite investment strategy, which is to build a globally diversified portfolio of low-cost index funds.

If you are diversified, you don't have to fret about your wealth imploding because of a few disastrous stocks or a single rotten market. And if you buy index funds, you don't have to worry about badly lagging behind the market averages because you or your fund managers pick the wrong stocks.

2. Money can give you the freedom to pursue your passions. Ideally, you want to spend your days engaged in activities that you find absorbing and satisfying, that you feel you're good at -- and where you feel you're doing good.

Indeed, the happiest retirees are typically those who have a sense of purpose, whether it's volunteering for their pet cause, coaching a children's sports team, helping their church or returning to long-neglected studies. Retirement gives them a chance to pursue their passions without worrying about a paycheck.

But again, you don't need to be financially independent to have a sense of purpose. If you're young, you can pick a career that is close to your heart. If you're in your 40s and you have been saving for 15 or 20 years, maybe you can afford to swap into a new job that is less lucrative but more fulfilling.

3. Money can buy you time with friends and family. You don't just need a reason to get up in the morning. You also need somebody to come home to at night.

Studies have found that regularly seeing friends and family can provide a huge boost to happiness. Money helps in this regard, allowing you to go out to dinner with neighbors, travel to see old friends, take your family on vacation and go to the theater with your spouse. If you don't need to work or you only work part time, that will help further, giving you more hours to share with the folks you like best.

I have always enjoied reading Mr Clements articles. He has some keen observations on personal finance and how to build your wealth.

Source:
'Parting Shot: What I Learned From Writing 1,008 Columns' , by Jonathan Clements, WSJ {$$$}

Changing Jobs - Don't Forget Your 401K

Back in the 60's most people went to work for one compay and stayed with that company until they retired. Today the job market seems to be constantly changing. The U.S. Department of Labor figures show that the youngest baby boomers (ages 42–49) have, on average, held more than 10 different jobs during their careers.

Below is a chart From Charles Schwab listing the options you have when it comes to your 401K plan:

	Option	Pros	Cons
	Roll over to new employer's plan	Avoid early withdrawal penalties. Money continues to grow tax-deferred.	May have a limited number of investment choices May have limited ability to make exchanges among funds in your plan.
	Roll over to an IRA	Avoid early withdrawal penalties. Money continues to grow tax-deferred. Offers more options than employer plan.	Can't borrow against the assets. May have to pay an annual fee.
	Leave in former employer's plan	Avoid early withdrawal penalties. Money continues to grow tax-deferred. Retain the ability to roll over to an IRA or new employer's plan at a later date.	Can no longer contribute to former employer's plan. May have a limited number of investment choices. May have limited ability to make exchanges among funds in your plan.
	Take a cash distribution	Can provide cash when facing extraordinary financial difficulties.	If you are younger than age 59½, you'll face a 10% early withdrawal tax penalty and a 20% federal mandatory tax withholding. Money no longer grows tax-deferred. You may face goal short-fall risk—the risk that you won't have enough money for retirement.

Source:
'Managing Your Finances When Changing Jobs' , by Charles Schwab & Co., Inc.

Geographical Bias

Ran across this while reading the Numbers Guy blog over at blogs.wsj.com. Nicolas Kayser-Bril, a graduate student in media and economics, published a series of maps showing world news coverage for ten 'international' media organizations. The maps show the amount of coverage countries received from the media organization.

There are several problems with the data used to produced the maps, or cartograms. Most of the data was gathered by Mr. Kayser-Bril who went to the websites of the organizations and counted the number of times a country was mentioned in an article published in 2007. Some of the other problems with the data is the difficulty in determining the difference between country names and peoples name (i.e. Chad and Chad Johnson) and some countries have multiple ways of being identified (i.e. England, Great Britain). Even Mr. Kayser-Bril, acknowledges that the maps are not very accurate and were published as a blogger not as a researcher.

Below are some cartograms of The Economist, The New York Times and The Australian:

The Economist

New York Times

The Australian

A couple of totally unrelated points about this:

1. Think of Others - we tend to think of only those things that are immediately around us. Most of the news lately has been how terrible the US economy is, but what is happening with the rest of the world? Is it as bad as it is here?
2. Don't Accept Everything At Face Value - while there is probably a lot of truth behind the data Mr Kayser-Bril used to make these maps, there are enough problems with it that requires us think discount it. Enron!
3. Everything Is Local (this is a corollary to item #1.) - even though the world has shrunk, most people only care about what is immediately around them. Humans have short attention spans.

Source:
"Why It’s Hard to Map Media Coverage", by Carl Bialik
"Le monde dans les yeux d’un rédac chef, l’Américaine version", by Nicolas Kayser-Bril