While reading The Investment Zoo by Stephen Jarislowski recently, I noticed one interesting phrase he brings up repeatedly: if your investments double in 7 years, half your portfolio will be built in the last 7 years of growth. He likes to throw around 10-15% returns while I base my plans on a 5% real return (14 years to double), but it’s still a valuable perspective to keep in mind.
This is what’s really going on with the old compound interest math trick where you compare someone who invests for 10 years only, starting now, against someone who waits 10 years and then invests until they retire but ends up with less. The difference happens at the end because the first person gets another 10 years of growth which means another doubling or more.
When you’re starting to invest this is important because every year you wait counts. The gains might be slow at first, but if you invest for 40 years with doubling every 7 years the first 33 years will only account for half of your portfolio. As strange as it might sound it’s the expected first step (or first 33 steps) to the end result. On the other hand, when you’re getting closer to living off your portfolio this is important because letting it grow a bit longer can have a big impact in the right conditions. Even if you stop investing but keep earning enough income to cover spending you might double the investment income you get later.
This is just the power of steady compounding. Higher returns that don’t last can’t compare to repeated doubling of your portfolio. In fact any rate of return may not be meaningful to a lifetime income plan unless you can get it consistently for 20-40 years with little extra effort. Buy and hold fits that; chasing a growth stock and knowing you have to get out before it dies in the next 3-5 years and then find another growth stock doesn’t.
In other words, the length of time you are invested is sometimes more important than the amount you invest or the rate of return you get. As usual with sound investments, it’s hard to impress people by going around saying “I’ll be in this investment for over 40 years!” instead of “I made over 40% on this!”. But even those of us who know that we should take advantage of compound interest can easily forget the full value it gives us.
My plan is a bit different since I want to invest heavily and shorten the time until the portfolio income can pay our expenses. This relies less on compound growth over time, but any additional, unplanned growth from waiting longer will be that much more valuable as a result.
The other day I came across another article reminding us of how retiring baby boomers are sure to be selling stocks for a long time to come, possibly driving prices down. I scanned it quickly to see if it had any actual new evidence but apart from mentioning a Federal Reserve study it was the same as usual.
What if the worst comes to pass and the stock market actually declines for 20 to 30 years, or crashes and stays flat for that long? That would be a big win for me! To clarify that, I don’t plan to hold anything back from my investments and may be taking income periodically from my portfolio well before 30 years from now. So it’s not just that it would be a better price to buy at. But this could still be a good thing. Why is that?
Imagine a broad market index with a dividend yield over 5%. Imagine that you get paid in cash every month for holding hundreds of stocks without having to analyze them. Not only that, but you can re-invest it (when you aren’t taking the income) to buy more of the same stocks with the same dividend, giving you compounding income that you can see every month. I would imagine the earnings yield would still be well above the dividends, which would lead to good appreciation potential once buyers overpowered sellers again. This sounds like a dream, being able to really invest and not “send out distress signals and scan the horizon for Ben Bernanke”, as another article this week put it.
There are a number of reliable sources pointing out the potential downward pressures of the boomer effect, although there are many others who point to reasons it may not affect the market. Two of the main reasons given are that with long retirements and large portfolios baby boomers will be keeping their stocks for a long time and even leaving some as inheritances, while at the same time growing young investor classes in emerging markets will be buying more of our assets. The first reason does make sense and many could slow down their spending if they can’t all sell their stocks at once. The second reason will likely take longer to play out than some people expect, but could eventually be a force.
The market could go down, which would be good, and it could go up, which would be good. The news reports, focused on repeating the experience of 1985-2000 without thinking about why it happened, often ignore a lot of real opportunities. Eventually they will report on what’s successful in the new market 20 years after it happens. I’m not saying that investing in stocks can’t fail. If they stay at their current levels for 30 years that might be the worst outcome. But as long as the business environment continues to improve there is a lot of potential regardless of where the market mood swings may go in 30 days or 30 years.
In addition to my regular allocations to equities and bonds, I recently opened an alternative investment in a Mortgage Investment Corporation. For those who aren’t aware, like me until a year ago, an MIC is a class of Canadian corporation similar to an REIT that issues mortgages instead of owning property. This one deals in short-term high-interest loans, with some being special situations like construction rather than just people with bad credit. Currently my investment is just a small amount to keep track of where things go and see if it becomes a better opportunity in the future.
I heard about this last year, and I found it interesting that it’s got good returns (currently at their low point due to declining interest rates) but not everyone is likely to invest in it. The stock market is very accessible to investments from anyone, which shows with frequent overpricing and wild swings (ok, a thinly traded market would probably swing even more wildly). As much as I still believe in the stock market and will use it as a foundation for my portfolio, I’m keeping my eyes open for alternative investments that are less accessible or align with my skills.
This definitely qualifies as being less accessible since you have to find it, research it, and then jump through a few hoops to invest, probably all on your own (not many financial advisers will risk their reputation on something like this). The MIC I chose is not publicly traded although some are. Of course it’s possible that institutional investors could jump in but even they face a risk to their reputation with less popular asset classes and they might come in at a size that takes them to a different part of the market. At the high end this would be banks and the major national lenders issuing mortgages with highly competitive rates but at the low end there are a lot of little-known companies and less intense competition.
I believe this particular MIC has good management and a good spot in the market. It’s fairly small but gets good returns. Since I constantly study management for my own business I’m betting that I can see some of the risks and traps of poor management, although I also know it’s harder to see at a distance.
I don’t see this becoming a significant part of my portfolio, because it is risky and illiquid. But it could boost returns a bit and make things interesting. Now I just need to figure out how to classify it in my asset allocation…
Once again Warren Buffet has managed to draw a large number of comments that he’s past his prime. This time it’s not for staying away from the latest hot investment though – it’s for his tax policy ideas. He’s not known for policy skills and we should be cautious about taking him as an expert on everything, but his view of tax incentives is probably a lot closer to the mark than most of his current critics such as Peter Foster and Jack Mintz in the National Post.
Mintz’s article mentions that higher taxes will reduce the incentives for businesses and entrepreneurs to invest. As a business owner, I find this logic to be backwards. Many small business owners will spend more because they know they get a tax deduction. Like with capital gains taxes, you can keep the full amount invested in increasing your future income or you can take some as profit and pay taxes every year. If their marginal tax rate goes down, that means they’re giving up more personal income by investing and spending. It’s different for large capital investments which must be financed from taxable profits (or a tax-deductible loan) and then amortized over time, but those eventually lead to tax deductions which will be worth more if the taxes are higher.
The other side of incentives is that people take on risk to earn a certain amount for themselves, which will be reduced by taxes. This does seem right on the surface. You don’t quit your job and start a business just to fund national defense. But we’re talking about different things here. As Mintz points out, in the US the taxes are low in the average income range (in Canada I believe they’re a bit higher). An entrepreneur can earn an average or above average income without paying a lot of taxes. While this may not make them super-wealthy, the process comes with many personal benefits so even an above-average income can be enough incentive to take some risks.
The place where taxes might discourage a few entrepreneurs is when they want to go from 0 to deca-millionaire in under 10 years. Having that goal is fine, but it’s the type of thing that can also attract the wrong type of activity. You never want to do business with someone who’s only in it for the money because that just don’t cover everything involved. And from a government perspective they likely won’t contribute to society as much. Many countries that have encouraged investment have taken a big hit when another country adopts a slightly more favorable policy and the hot money goes there instead.
With taxes as low as they are now, a small increase would lead to a reaction closer to “oh well” than “oh shit”. As I write this I’m listening to Exile on Main Street, which was apparently named for the Rolling Stones’ decision to leave England and its (at the time) 90% marginal tax rate. Apart from being close to the highest tax rate that’s possible, that gives us a benchmark for when taxes are a disincentive – and we are nowhere near that in North America.
That’s not all though. The traditional economic theory of tax incentives is based on precise calculations – if someone can only make $400,000 instead of $500,000 they won’t take the risk. Some people may be close enough to say that, but business involves risks that can be much larger than the actual outcome so that kind of precision can be hard to find. You might end up getting $500,000 but you could have had anything from a loss of $1m to a profit of $3m. If the tax effect is smaller than the fundamental risk, it won’t have the incentive effect that economic logic seems to dictate.
Based on logic alone there are many reasons why a reasonable increase in taxes wouldn’t choke off business activity. If you go into behavioral economics (investments with a return for the business owner’s ego or risks taken on instinct rather than calculation) there are countless other examples of decisions that would not be impacted by a small increase in taxes.
I’m all for incentives to invest and I don’t see Canada being in quite the same hole that the US is, but we need to recognize that everyone has to play a productive role in keeping a functioning economy whether it means cutting loopholes or increasing tax rates. I’m currently in the middle of reading The Next Convergence, which rightly points out that in recent times developing countries increasingly seem to be coming up with more productive economic policies than the most advanced ones.
As I mentioned recently, I’m against a broad increase in the CPP because any such move is likely to be based on unsustainable assumptions and only benefit those retiring now. However there is one specific exception that I would support. People sometimes mention that the original “pension at 65” model was established when few people lived that long. With today’s lifespan that might work out to a pension starting somewhere between 100 and 110 years of age.
While that kind of increase in the retirement age would cause devastating riots, most financial planning has to account for a large uncertainty in longevity. You could die the year after you retire, or you could be spending your investment income for 35 years. As if that’s not bad enough, most financial planner consider “conservative” estimates to be safe if you run out of assets between 95 and 100. The lucky few who live past that run into the unlucky portion of the plan.
The CPP does take baby steps in the right direction by increasing payouts if you don’t take it until you’re 70, but there is still a massive gap here. Those who live past 100 using today’s financial planning could be thrown back to the age before retirement was an option, even if they prepared well and paid their own way before that. Most will be able to get support from family in addition to the minimal amounts they get from the government, but there is still a risk that could be fixed by the government at a much lower cost than giving everyone at 35-year retirement.
While this makes a lot more sense than many pension proposals out there now, there are two problems with it. The first comes back to my reason for avoiding CPP increases. Since this benefit would be over 70 years away for me, there is too much political risk. I wouldn’t be able to plan for this until getting much closer. The second is that this is really insurance against a low-risk event. It would make sense for insurance companies to sell this at a reasonable cost and they do, in the form of annuities.
Annuities have some variation, with lower payouts when interest rates are low. Despite this they are a tool to plan for the risk of living too long, although they probably aren’t used as much as they should be. But maybe economies of scale could apply here (unlike the CPP’s investment returns) if the government provided some form of consistent insurance against living too long. Who knows – one small step in the right direction might actually encourage people to take another.
Today Intelligent Speculator comments on how ratings agencies are under siege, and John Kay points out that loans to governments are different because no one tells a government what to do. Demanding repayment from other countries can and has led to wars. If you look at it that way, S&P may be going to war with the US! (maybe they’re hoping for those defense budget cuts)
Kay brings up good points about citizens not wanting to be responsible for some of their government’s actions. Some things are being done at a large enough scale to have a significant impact, and could lead more people refusing to support the decision. Foreign creditors are probably less likely to be repaid than a country’s own citizens too because they have less influence. When times are good it doesn’t matter, but if something goes wrong they will be the first ones overboard. That’s a good thing to keep in mind if you’re thinking of holding bonds outside your own country.
As for the rating agencies, they are always compromised. Since the rating is bought by the borrower they always have a conflict of interest, and it’s hard to imagine any structure that involves payment from someone else and keeps well-run rating agencies. For large corporations it might be possible for investors to sponsor the research but that would likely reduce coverage a lot. And anyone who pays for research like that probably wants to keep the advantage to themselves.
In theory the rating has value due to the agency’s good reputation and that should come from accurate ratings, but that still leaves a lot of pressure since any individual “mistake” probably doesn’t have a great impact. In the end it’s hard to get perfect information from outside; if you need to know you need to look at the objective facts yourself.
Last week I had the good fortune of spending a few hours with a well-respected (but not widely-known) economist at a time when there was a lot of news to discuss. The insights were a great counterpoint to the news and a reminder that when everyone else is calling for the end of the world it might be a good time to buy. My impressions were that stock valuations are already fairly high, but in spite of all the negative news there are signs of strength that may sustain further growth.
A focus of the discussion was on the US economy since it drives most North American markets. All is not well, but the headlines are missing a lot of useful information. A few interesting points were:
- Corporate balance sheets are much stronger. In 2007 they were over-leveraged, but now they have built up so much cash that everyone is wondering when they will act. This gives them options and security, and lessens the chances of another crash.
- Capital goods spending is accelerating rapidly and even getting close to past peaks. Businesses are investing their cash.
- Job creation is picking up in businesses. Even if the US government has its hands tied (or cut off), job growth seems to be going at a sustainable rate. In fact the latest US numbers were positive in spite of shrinking government jobs.
- Consumer spending is reviving. Major purchases may have been delayed in the bad years but eventually they do come through.
- Even the housing market may have its day soon. There is still a large inventory of unsold homes, but like someone who has been out of work for a few years those are getting to the point where they aren’t even in the regular market anymore. New home construction is picking up and if it continues it could give a boost to the economy.
- The US dollar is weak. This may have positive effects for exports.
- Credit is getting much easier to obtain. Large corporations can rely on bond markets and other mechanisms, but small businesses have been held back by tight bank lending until recently.
- The market frequently swings on monthly reports, but the economy doesn’t change direction every month. High-frequency data is noise.
Another good point he made was that most economists and market commentators have one view that they stick to. If it’s happening now they talk about how they were right all along. If it’s not happening now they talk about how it will happen soon. It’s rare to find someone who can actually switch between different positions depending on what the indicators point to.
Is this information we can trade on? As the efficient-marketers will tell you, everyone knows this. But they may be focused on other news that grabs more headlines. This isn’t all you need to know but it just shows again how markets can overreact to bad news and give you opportunities. This week may well give even better buying opportunities if you need to increase your stock allocations.