Investing returns depend on timetable

While basking in the afterglow of a 50 percent rise in the stock market, the financial press reminded me that we are closing in on the worst decade ever for the S&P 500 going back to 1927.

After a 17 percent rise year-to-date, the results are basically flat for the 10-year period. Adjusting for 10 years of inflation, we have actually lost 33 percent.

We don’t need to mope around over this state of affairs, because there’s a solution. If a zero gain for the past 10 years is bothering us, we can just go back fourteen years. Thanks to a 347 percent compound gain from ‘95 to ‘99, our average annual rate of return suddenly becomes a compounded 7.5 percent over this longer period, so we can feel great with respect to whatever money we had invested as of 1995.

The balance of what we have contributed since that time has been dollar-cost averaged, which means that we were reducing the average cost of all our shares when the market was down in the early 2000’s and also in the most recent few years. The math on these regular deposits since 1995 indicates that their rate of return averages 4.6 percent.

Most of us investing in mutual funds have taken to heart the concept of reducing risk by putting together a mix of fund types. The positive results of so-called diversification have never been more compelling than they are right now.

The S&P 500 index is, indeed, flat for the past 11 years, but an equal mix of an S&P 500 index fund, a small company index fund, and an international index fund would have generated a combined rate of return equal to about 6 percent. To put this in dollar terms, 11 years of $1,000 annual contributions into just the S&P 500 Index would total $11,200 today — a $200 profit. The same $1,000 in the above-suggested diversified mix would be worth $15,800 — a $4,500 profit. When the world is otherwise flat, a 6 percent return is a nice reward for taking the time to diversify.

We can just forget about that giddy feeling we experienced in September of 2007, the stock market’s high water mark. Our account statements from then had us all calculating that we could retire five years earlier than whatever the original plan might have allowed. After swallowing some disappointment, however, we can see that results are not so bad. For those of us taking the long view, the stock market has been doing its job.

What we can look forward to is the extent to which the market has demonstrated higher than normal returns for the years following any of the past flat decades. While expected returns average 10 percent, the 10-year average after a flat 10-year period has trended toward 13 percent. Warren Buffett predicted back in 2005 that the market would earn an average annual return of 7 percent for the following 10 years. As far in the hole as we are today, an average of 7 percent for the entire period between 2005 and 2015 would require a major bump going forward over the next five years.

We can’t lose sight of the broader picture. The financial press can prompt us to view the world with blinders. We don’t like 10-year results? Try fourteen. We don’t like the S&P 500? Try some diversification to create the path of minimum regret. Adjusting our perspective can do wonders for our dispositions and fortitude at times like these.

TIP bonds could trap investors in bad bet

Don’t look now, but Treasury Inflation-Protected bonds (TIP’s) may be a trap for the unwary. They’re certainly good for the government, because the interest cost on TIP’s is half of what it takes to sell a regular fixed-rate, 10-year government bond.

Money has been flooding into this 10-year-old financial invention on the premise that future inflation will trigger a dollar amount increase in the bond’s principal. The increase will be a direct reflection of the cost-of-living increase.

For example, if you buy a $1,000 TIP and inflation turns out to be 10 percent in a year (remember the 1980’s?) then your bond’s capital value would be adjusted to $1,100. In the meantime, you would be receiving an interest payment equal to about 2% currently of the original $1,000 — about $20.

Right now, the interest rate on 10-year TIP’s is 1.8 percent and the interest rate on regular 10-year bonds is 3.6 percent. The “invisible hand” of economic forces is trying to show us something here. Collectively, everyone buying a 10-year, fixed-interest bond is assuming that today’s fixed interest rate of 3.6% is a fair deal. If 10-year bonds typically pay a rate that is 2 percent above the expected inflation rate, then inflation is expected, by today’s bond buyers, to average about 1.6% per year for the next 10 years.

Since TIP’s right now pay an interest rate of only 1.8 percent, this says that the inflation-rate assumption for TIPS is the difference between 1.8 percent and the 3.6 percent which the world of bond buyers considers a good value.

Confused? In other words, TIP’s investors will accept an interest rate of only 1.8 percent today because they know the government will increase the capital value of their bond by as much as the rate of inflation. This is where the other 1.8 percent comes from to bring the total to the 3.6 percent market rate for 10-year, fixed rate bonds. If the public thought that inflation was going to be a lot more, it would be quick to buy TIP’s that paid even less interest today. If today’s bond buyers are wrong, and inflation soars, the TIP’s buyers will make a lot of money. If we have deflation, they could actually lose money.

For us amateur, self-styled economists convinced that inflation will run rampant because of huge government debt, there is an alternative to TIP’s that will protect us if we’re wrong.

It would be short-term corporate bond funds with average bond maturities of about 2 years. Vanguard’s short-term corporate bond fund is now paying a yield of 2.8 percent. Short maturity means that if inflation comes on strong, new bonds rapidly added to replace those that reach maturity will be paying the higher inflation-driven interest rate. With a spike in interest rates, it would take about a year for the fund’s turnover to bring on enough bonds at the new higher rate to raise the average coupon to an acceptable level, but a year goes by pretty quickly. In the meantime, until that event does happen, we have an investment that can make better sense than a money market fund paying negative rates or TIP’s that currently amount to a gift to the government.

In my mind, TIP’s fall into the same category as Roth IRA’s and 401(k)’s. Both are tools invented by our government to improve immediate cash flow by saving money on today’s interest costs (TIP’s) or by generating tax revenue sooner (Roth.) The government, like the casino industry, has the odds stacked in its favor. There’s always the chance that we might win when using one of these new incentives, but the fates statistically rule against us. Government statisticians have figured this out.

Regulations help keep bankers honest

“Death panels” for institutions “too big to fail” sounds like a good idea to me.  The concept was voiced by Barney Frank in describing what Congress has in store for the financial services industry.   We should have remembered the last experiment with unfettered free markets when we deregulated the Savings and Loan industry.  Over 3,500 executives went to prison.  Fortune magazine ran a hilarious two-page spread with hundreds of tiny mug shots.

This time out, the problem is not so much criminal as just plain stupid.  When leverage limits were lifted in 2004, most financial institutions went right to the thirty to one limit of borrowed money for each dollar of cash.  Just a 3 percent gain (net over the cost of borrowed money) created a 100 percent profit.  Any executive not following that herd at the time would have lost his or her job.  While leverage works both ways, Wall Street’s “IBG” factor was at work.  “IBG” stands for, “I’ll be gone.” 

Fifty-year- old banking regulations spawned during the great depression helped to keep greed and stupidity at bay.  A ban against interstate banking and a prohibition against banks selling securities were both done for a reason.  Regional banks with limited footprints were largely kept in line by threat of embarrassment.  Community leaders running banks were more concerned with their long-term reputation than with the size of their annual bonus.  Allowing companies to combine several financial functions into a single organization, like AIG, meant that they could use the insurance arm’s credit rating to design hopelessly short-sighted investment products that pretended the 20% housing downturn of 1992 had never happened.

Moreover, the entire conglomerate was regulated by the government’s thrift industry regulators because tucked somewhere in the bowels of AIG was a thrift institution handling Christmas club savings accounts. 

An interview of former Treasury Secretary Henry Paulson by Todd Purdum in Vanity Fair sheds some light on where we will go from here and offers some reasons for optimism.   Our situation today would be much worse if it hadn’t been for the actions of a bird-watching, non-drinking, non-smoking, devout Christian Scientist and former Goldman Sachs Chairman who is still worth over $500 million after having given over $100 million to environmental causes.  By letting four major “too big to fail” institutions walk the plank, he managed to stabilize what was left of the world’s financial underpinnings.

 I still have an issue with companies that benefited from our AIG bailout, such as Goldman who received $12.5 billion, but solving that problem can be step two of the process.  We still have the power to sanction and tax.

What give me feelings of eternal hope are the comments Mr. Paulson made regarding Barney Frank with whom he worked closely during the crisis.  “This is the guy that’s got the intellect, he’s got the energy, he cares, he wants to legislate, knows how to legislate.  I wish he were a Republican and we all shared the same policy principles and you’d cut a wide swath.”

 I know that about Mr. Frank.  Forty-three years ago I used to be part of a standing-room-only crowd that would listen to his lectures on political science at Harvard for their sheer brilliance and entertainment value.  I wasn’t even taking his class. 

But if that wasn’t enough, Hank Paulson then goes on to sing the praises of Nancy Pelosi and her command performance during the meltdown.  “She was engaged, she was decisive, and she was really willing to just get involved with all her people on a hands-on basis.”  Bottom line: we have some competent people in Washington who are capable of engineering a “Back to the Future” chapter of our financial services sector.