All Things Financial Planning Blog


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What is Really Driving Your Financial Decisions?


A brain scan was taken just before an individual placed a stock trade. Another brain scan was taken just before someone was given a hit of cocaine. In both cases, the brain was flaring up in anticipation of a gain, and the scans were virtually indistinguishable.

Contrary to what we like to believe, decisions are made with the right side of our brains. This statement is controversial because we generally believe that we are rational people and make most decisions after an objective evaluation.

With respect to our financial decisions, this is even more controversial because as soon as we hear the word “finance,” our left brain springs into action. We have conditioned ourselves to believe that finance and mathematics are inextricably linked, and therefore, we make our financial decisions based on rational thought. In reality, we frequently make decisions before we are consciously aware of them and then attempt to rationalize them before we act. We must not confuse this with rational thought.

The left side of our brain tells us the two scenarios outlined above are different, but our right brain can not tell the difference. The left brain tells us that drugs are bad, and making money is good. The right brain simply knows is that we are about to benefit from something.

One of the things that makes us human is the ability to engage in rational thought. Unfortunately, this often results in bouts of overconfidence in our ability to control our emotions.

The brain scans above outline this phenomenon perfectly. Through rational thought, we have the ability to control our urges by recognizing the inherent danger in certain situations. However, we often neglect to acknowledge that danger when it applies to money (or we greatly underweight it), as we are conditioned to believe we ought to pursue more of it.

We must also recognize the overpowering nature of our emotions in reverse. Rational thought would not have led to so many people’s decision to bail out of the market (or not rebalance their portfolios) in 2009. Rational thought would have prevented millions of homeowners from purchasing homes with little or no money down. Rational thought would result in everyone spending less than they earn and planning more for the inevitable uncertainties in life.

We can not change how we are biologically wired, but we can make consistently better decisions by simply acknowledging how and where they are actually made. Like the deterioration of our bodies as a result of cocaine, the pursuit of short-term financial gain can set us up for long-term financial ruin. We insulate ourselves from the dangers of drugs through avoidance. It would serve us well to do more of the same in our financial lives.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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The Reality of Compound Returns


Albert Einstein was reportedly quoted as stating that compound interest is the most powerful force in the universe. However, compound interest is also one of the most misunderstood, misrepresented and most destructive forces as well…even in the professional realm.

As the euphoria of “DOW 13,000!!!” takes hold of the investment world, the talking heads are, once again, bantering about whether it is safe to invest again. As I wrote in this blog just over a year ago, that is absolutely the wrong question to ask. Ultimately, your behavior and ability to stick to an investment philosophy will have a far greater impact on your investment success than the actual strategy or investments themselves.

Ultimately, successful investing depends on your ability to participate in the “miracle of compounding”. You can scour the internet for days and find endless examples such as the following:

Tom and Mary are saving for retirement.

  1. Tom begins saving $5,000 per year at age 25 and continues to do for 10 years. At age 35, Tom stops and never saves a penny again.
  2. Mary waits until age 35 to begin saving, but then saves $5,000 per year until she reaches age 65.

Assuming they each earn 8% per year, here is how the scenario breaks down:

 

Total Savings

Age 65 Balance

Tom

$50,000

$787,176

Mary

$150,000

$611,729

The critical take-away is to start early because the longer you allow your money to compound, the more significant the impact it will have.

Now, here’s the cold, hard reality about compound returns:

Negative returns have a far greater impact on investment performance than positive returns

Consider the following scenarios:

 

Period 1

Period 2

Average Return

Actual Return

Portfolio A

+10%

-10%

0%

-1%

Portfolio B

+50%

-50%

0%

-25%

 

On the surface, based on the average annual return, it appears that both portfolios end up in the same place, despite taking very different roads to get there. However, the end result is astonishingly different.

If Portfolio A starts with $100 and earns a 10% return, you end up with $110. If you then lose 10% the next year, you actually lose $11 (not $10), leaving you with $99. When you apply the same math to Portfolio B, your end result will be $75.

Circling back to the assumption of 8% returns from Tom and Mary above, if Tom earned 20% in year one, followed by -12% in year two, the average of those two returns is 8%, but the actual return experienced by Tom plummets to 5.6%.

And just to drive things home further, assume Tom earns 50% in year one and -34% in year two. The two year simple average is +8%, but the actual return is -1%. It is possible to have a positive average return, but negative results.

So what does this look like in the real world?

I recently came across a video produced by a large investment advisory company that provided a classic example that even professional investors misunderstand how compounding actually works.

In this case, the fund manager only produced “alpha” for his clients in 9 of the 18 years since he launched his fund. In other words, he beat the index only half of the time. Further, if one were to calculate the average alpha produced during those 18 years, it would be negative. Therefore, the folks in the video concluded he actually produced negative alpha for his clients over that period.

In reality, people who actually invested in this fund for that period would have made 50% more money (or 50% more alpha) than if they had invested in the index. The exercise of comparing year-to-year performance against an index is extremely counter-productive.

To restate these facts again, the fund only beat its benchmark 50% of years, yet produced a total return 50% greater. The explanation of this paradox is quite simple. This fund avoided large losses. It outperformed the benchmark when it was down, and underperformed when it was up.

None of this is meant as an indictment of folks who index or the indexing philosophy. In fact, due to investors pouring out of the fund while it was lagging in the tech boom (and just before the 2000 – 2002 crash), index investors likely fared better than this fund’s investors…an indictment of poor investor behavior.

When investors like Warren Buffett explain that rule #1 in investing is to not lose money (and rule #2 is to never forget rule #1), this is one of the concepts they have in mind. They do not mean that your portfolio should never decline in value, but jumping out of an underperforming fund (or stock, or index) into something else at the wrong time will land you on the wrong side of the compound interest formula.

The US stock market continues to be one of the greatest wealth building machines ever created, but the extent of your participation is entirely dependent on which side of the compounding equation you fall.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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Get Off the Roller Coaster


The past 12 months perfectly captured the proverbial roller coaster of the stock market. It went up and down, it zigged and it zagged, and it ultimately came to rest very close to where it started. Each time we started to climb out of a valley, we experienced something to get excited about – a nuclear meltdown, civil wars, the US debt fiasco, Occupy Everywhere, the Greece/Euro threat.

The media likes to portray investing as if it were a game. Pundits blabber on TV about (insert investing guru here) making a “play” on ABC Company by loading up on shares on X date and talking about whether it “worked” several weeks or months later. And particularly during this time of year, comparisons showing winners and losers from the past year are everywhere. Furthermore, every Tom, Dick and Harry is casting their predictions for the year ahead.

As you know by now, I am a big fan of  Carl Richards (www.behaviorgap.com). Carl has made a name for himself by having an uncanny ability to capture the complex paradigms of finance in a series of elegantly simple sketches.

One of my favorite sketches by Carl is shown to the right. Nearly everyone who glances at the image will agree with the general message, but the reality of how we experience this paradox is not that simple.

Consider the following: “the neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine.” In the book, Your Money and Your Brain, Jason Zweig shares brain scan images from a Harvard Medical School study that clearly show the exact same location of the brain flaring up during each experience!

The rational part of our brain (which processes these very words and the logic behind it) recognizes that there is a big difference between financial gain and getting high, which makes this very difficult to comprehend. However, the limbic part of our brain (which experiences emotion and feeling) is literally incapable of processing logic. These parts of our brain are physically divided and engaged in an eternal tug of war whether we like it or not.

Investing is not a game, it is not an amusement park ride, and it is not gambling. As such, as soon as we begin to feel the same emotions with our investments as we experience while playing games, riding amusement park rides, or gambling, we may as well cash in our chips.

Many investors often believe they have special information about a particular company, industry or the economy that will yield significant gains in the market. They may have even achieved financial gain through the same type of thinking in the past. But the reality is this: logic would tell you that thousands, perhaps millions, of other people have already had access to that information or have thought of the same thing you so strongly believe. So what part of your brain is really talking to you?

The stock market is merely comprised of thousands of businesses. This is incredibly difficult to fathom in the rent-a-stock world we live in, but it is unquestionably true.

People own businesses because it provides an income stream and/or an opportunity to sell the company for financial gain in the future. Ultimately, the amount of gain realized depends on the price paid for it, but you can only sell it for the price someone else is willing to pay. Every business goes through good times and bad, but serves a specified purpose in the business owner’s life. Great business owners rarely attempt to shoot the lights out because they recognize that doing so introduces an enormous amount of risk to their current and future well-being. And they certainly do not care what they could sell their company for on a minute by minute basis.

Our portfolios are a collection of businesses. As such, we ought to run them more like businesses. We ought to recognize that they are going to go through cycles. Good businesses do not expect the capital they invest back into the company to yield immediate results. Sometimes it takes years to pay off. There are going to be good years mixed in with bad years, but over time, good businesses will succeed. As Warren Buffett has stated, “time is the friend of a wonderful business, the enemy of the mediocre.”

We need to focus on making good business decisions with our money. When we make investment decisions based on what worked well in the prior year, it is not logic talking. A quick way to go bankrupt in retail is to load up on 2011’s hottest holiday item in anticipation of selling them all during the 2012 holiday season.

When we “invest” in a stock with the belief it will double in value overnight, it is not logic talking. You have either done extensive research and determined the stock price is below true value, or you are subscribing to the greater fool theory with the hope that someone will come along later and pay you more. Even if the former is true, great investors will tell you it may take years for the market to reflect reality…it rarely happens overnight. But like gravity pulls everything back to Earth, valuation will ultimately pull market prices toward equilibrium. Like a great business exercises patience waiting for an investment to pay off, sometimes we need to exercise greater patience with our portfolios.

The future is uncertain and loaded with risks. The experience of a roller coaster is riveting because it packages the uncertainty of what is coming around the next corner and the anticipation of another high into a brief series of twists and turns. However, because of countless safety measures, we can jump on the ride feeling confident that we will end up where we started. In financial markets, those safety measures do not exist, so get off the ride and get down to business.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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This Holiday Season, Ignore the Relatives


‘Tis the season to gather and celebrate with friends and family. Each year, old traditions are remembered and new traditions are made. We reconnect with those we see often and long-lost relatives alike. Reliability has become an evasive event in the busy world we live in today. In the craziness and uncertainty of our day-to-day lives, we take solace in the certainty that some of these events provide.

In some families, it is a holiday tradition to attend church or temple together. In others, it is a certainty that Grandma will play the piano while everyone sings along. And in others, it is a virtual certainty that everyone will get their year’s worth of invaluable wisdom from that goofy brother-in-law that goes by “Blaze”.

Celebrating with relatives is a wonderful thing, but this time of year, we must all be more conscious of the unrelenting human desire to compare ourselves and our decisions to the people and things around us. The relatives you ought to ignore are not people, but perceptions.

In his book, Predictably Irrational, author Dan Ariely describes that “humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly” and later “we not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable – and avoid comparing things that cannot be compared easily.”

In other words, we often use completely irrelevant benchmarks to gauge our success and make decisions. We make comparisons about the car we drive or clothes we wear relative to our siblings. We draw comparisons about how our children act relative to the neighbors. We decide how much to spend on our holiday shopping after we figure out how much our friends or family members are going to spend on theirs.

None of these comparisons make any rational sense. However, it is far easier to take a shortcut and follow something easily comparable than it is to really figure out what makes sense in our own lives. After all, these comparisons provide a simple, concrete (but irrelevant) answer, while the question about how things fit into our own lives seems far more abstract.

People often share that they refinanced their mortgage at 4% while their brother got 3.75%. The interest rate provides a simple comparison for people, but misses the big picture. Digging a touch deeper, we find out that their brother paid closing costs and they didn’t. The monthly savings of that 0.25% difference would finally cover the closing costs after 10 years, while they only want to stay in the home for 5. Indeed, the rate is lower, but will end up costing them more.

No where in the world is relative benchmarking more prevalent and more irrelevant than the investment realm. How you perform against the S&P 500 has no bearing on your financial well-being. I am guessing almost everyone reading this beat the S&P 500 in 2008. I am also going to surmise that each one of you didn’t feel very good about that. Earning returns of -30% when the market is at -37% hardly provides a reason to celebrate.

If you own a business, you most certainly understand the cyclical nature of being a business owner. Your revenue goes up and down, your profits rise and fall, and the value of your business goes along with it. However, you choose to continue running it because of the lifestyle it provides for you. In fact, the goal of most business owners is to run the business in a way that allows them to live the life they want. It provides a nice income stream, job security and the hope of a nice payout when they sell.

A large minority of business owners really run their business to maximize returns at all times. Those that do are often hung out to dry when things get rough. We ought to consider our portfolios as our own small business. After all, our portfolios are literally comprised of ownership in thousands of very real, functioning businesses you can touch and feel. If we strive to maximize gains at all times, we are inevitably going to get burned. The business (portfolio) performance of the bicycle shop guy down the street has no relevance to that of your bakery.

Your portfolio is (or should be) designed to provide you with the lifestyle you want to live. In most cases, that does not result in a blind effort to maximize returns. Comparing it to an arbitrary benchmark (especially in short time periods) tells you nothing about whether it is going to allow you to achieve your life goals.

As it pertains to holiday spending, your holiday budget should reflect your own budget, not that of your relatives. Your relatives are trying to accomplish very different things in life than you are. As these comparisons begin to creep into your mind, ask yourself if they are relevant.

Invariably, year-end often provides a time for reflection on the past year and an opportunity to look forward toward the year ahead. In reality, it simply marks another day on the calendar. Our lives do not follow a calendar – they do not start over on January 1. Yet we somehow find ways to take comfort in the opportunity to start over again, to try new resolutions or to retry those we set the year prior. Year-end provides that certainty we strive for, so take comfort in that and your family traditions, and set a goal to ignore those irrelevant relatives you drag around with you in your day-to-day life.

In my extended family, we celebrate together with an appetizer contest that has become exceptionally competitive in recent years. Despite the herculean efforts of many of my cousins, aunts and uncles to garner votes for their dish, we all know full well that the newest member of our family wins every year. It is a certainty that the husband of my recently married cousin will magically procure enough votes to win the 2011 prize. Congrats in advance, Jim!

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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Mirror, Mirror…


Occupy Wall Street is creating a great deal of buzz around the globe, and it is a remarkably fascinating movement to witness. No matter what side of the proverbial fence you reside on, this movement is drawing a great deal of attention to several issues our country’s leaders have long ignored.

Opponents argue that there is no leadership, no direction and no central reason for its existence. And while proponents may have had no consensus rationale for participating in the first place, they are beginning to realize that the true underlying issue is that they believe their future has been compromised in one form or another.

It is unfortunate that it often requires devastating pain and suffering to draw attention back to issues that we turned a blind eye to in the past. While the Wall Street movement is drawing some attention to our macroeconomic and political issues, we ought to pause individually to consider the personal financial decisions we, collectively, have turned a blind eye toward the last several years.

While our political leaders and the big, bad banks had plenty of involvement in the financial crisis of the past several years, consumers played an equally vital role. While it is unpopular to state this, much of the angst and turmoil “caused by the financial crisis” is really the result of poor (or a complete lack of) planning.

Before we cast stones, let’s take an honest assessment of our personal situations and the decisions we have made to ensure that we have built an adequate moat around our financial lives.

We talk often about creating a margin of safety in your financial life. This concept is derived from Benjamin Graham’s book, The Intelligent Investor. It merely means that when making investment decisions, one ought to ensure that they are buying a company at a price well below its real value. This concept is equally important in our ongoing financial decisions.

As an example, consider how many people purchased a home that stretched their budget to the max (or beyond the max!). The banks’ role in this process was knowingly allowing people to purchase more home than they could afford. However, the purchasers of these homes were equally responsible for allowing their eyes to get bigger than their stomachs. In the pursuit of bigger and nicer, we forgot to consider what happens when things do not go as planned.

Most households manage their cash flow pretty effectively until a “surprise” expense throws them off. Another “surprise” expense pops-up the next month, and then two more arise in month three. This creates a cascading snowball effect and results in a death spiral it is extremely difficult to recover from. What makes these scenarios worse, however, is that the “surprise” expenses often come in the form of car repairs, health care costs, a broken furnace, etc., which are really not surprises at all. The timing is unknown, but the expense itself can be reasonably anticipated.

The alternative to the death spiral is something like a job loss. Without question, a job loss is a far more financially devastating event, and far more difficult to prepare for. However, these are precisely the reason financial planners insist on their clients maintaining substantial cash reserves, or emergency funds. When a financial expert jumps on CNN or Fox News and tells everyone to maintain reserves of 3 -6 months of living expenses, they have situations like this in mind. For many folks, the idea of establishing and funding an adequate cash reserve was deemed unnecessary or far-fetched. In reality, if you can’t afford to build a cash reserve with your current cash flow situation, you are living beyond your means with no margin of safety.

Bruce Berkowitz of Fairholme Capital Management has famously discussed his methodology for protecting himself and his investors: kill the company. “We spend a lot of time thinking about what could go wrong with a company, whether it’s a recession, stagflation, zooming interest rates, or a dirty bomb going off.”

Consumers could gain a lot of ground on their financial security by simply practicing this with their ongoing financial decisions. In your personal space, the company is your household’s finances. Instead of focusing on what could go right, focus on what could go wrong, and make sure you are adequately protected against it.

Cash reserves are critically important in this regard. Adequate life and disability insurance will protect against the loss of the breadwinner’s earnings. Be realistic about your job security and forward-looking earnings. Do not over-commit to future expenses. Save consistently and with purpose. If you realistically have a hard time “killing the company”, you can probably afford that bigger house or car. However, if this exercise highlights significant exposures in your financial life, or a relatively likely event will lead to financial ruin, you must have the discipline to walk away.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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Medicare Open Enrollment Changes for 2011


As we approach the final quarter of 2011, folks enrolled in Medicare prescription drug plans ought to be prepared for some changes to the open enrollment period.

First and foremost, the period in which you are allowed to change plans has moved up to the period beginning October 15, 2011 and ending December 7, 2011. In previous years, this period ran from November 15 through December 31. The last application you submit in 2011 before the December 7 deadline will be the plan that becomes active on January 1, 2012. In other words, if you submit an application on November 30, but change your mind the following week, you may still submit another application before December 7. The second application will trump the first.

Unfortunately, marketing activities from Medicare providers can not begin until October 1, leaving a shorter window of time to evaluate options and make decisions in 2012. This not only means that companies can not begin marketing their products to you until October 1, but also means that agents and advisors are not made aware of plan changes and new offerings until the marketing period begins.

One of the more controversial issues surrounding Medicare and prescription drug plan involves the so-called “donut hole”. This gap in coverage has changed slightly in 2012 and will begin after you and the insurer have paid $2,930 for covered drugs and continues until you have spent $4,700. In 2012, there will be some continued relief in the form of discounts in that gap. Brand name drugs will become available at a 50% discount, while generics will receive a 14% discount.

As you are considering your options, there are several factors you want to ensure that you are paying attention to:
– Your current formulary, including the tiers your drugs are placed in
– Co-pays for brand names and prescription drugs
– Deductibles
– Make sure that your pharmacy is an in-network provider
– Alternative options, such as mail-order, that may reduce your costs
– Pay particular attention to your total out-of-pocket costs rather than focusing on premiums

With an earlier enrollment period beginning in just over a month, it is important to begin planning and organizing your information now to ensure you can make a smart decision in the weeks ahead.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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Standard and Poors is Right (in Principle), but Wrong (Again)


In an attempt to regain any tiny bit of legitimacy that still remains at Standard & Poors (S&P), the rating agency sent shockwaves across the globe last Friday evening by downgrading the United States from AAA to AA+.

What does this mean? First of all, it means that AA+ is now the gold standard for S&P ratings. Second, people will panic and make some bad decisions. Third, a lot of companies, countries and agencies are going to have to be downgraded as well. Fourth, the other rating agencies have not changed anything and have not downgraded the US (and one of them, Moody’s, gives their reasons here). Finally, right or wrong, S&P is going to be mocked and ridiculed to no avail, however, they have no one to blame but themselves for their quality of work over the past several years.

If you are invested in a diversified portfolio, you are not going to be impacted as much as the nightly news is indicating, nor are you going to be impacted like the overall market is being impacted. In 2003, Howard Marks wrote that “there is a time when it’s essential that we beat the market, and that’s in bad times.” Marks’ statement speaks to understanding the mathematics of compounding. Take the following example:

Period 1

Period 2

Average Return

Actual Return

-10%

+10%

0%

-1%

-50%

+50%

0%

-25%

The top portfolio experiences a decline of 10%, followed by a gain of 10%. If you simply take the average of the two, you get 0%. However, the reality is that when you start with $100 and your value declines 10%, you are left with $90. A 10% return the following year on the remaining $90 is only $9, leaving you with $99, or a loss of 1%.

As the amount of decline drops, as it does in the second portfolio, it gets harder and harder to get back to even. After a 10% drop, an investor must earn just over 11% to get back to the starting point. However, after a loss of 50%, one must earn a return of 100% on the remaining portfolio to break even.

As Warren Buffett states, “be fearful when others are greedy and greedy when others are fearful.” We all recognize that buying low and selling high is an important element of successful investing. However, it is incredibly difficult to act on this simple advice when there is blood in the streets and it seems like there is no end in sight. At present, political “leaders” are pointing fingers at each other in the US and abroad, the media is spreading fear, and the S&P decision over the weekend only fuels the fires.

Turbulent times underscore the importance of planning. Turbulent times are the reason that you ought to maintain enough of a cash reserve to cover your portfolio income needs for three years. As painful as it may seem to hold substantial sums of cash in savings accounts earning nothing, at least you know it is going to be there when you need it.

In response to the US debt downgrade, investors worldwide sold stocks over the weekend and bought more US Treasury debt. No, this is not a typo, as you all witnessed through Monday (when this article was submitted for review).

When a rating agency downgrades your debt, it means that they think it is less likely to be paid. However, instead of selling that debt, investors were actually going out and buying more of that debt at a higher price this week. They are selling their holdings in companies that are minimally (if at all) impacted by this downgrade and buying the debt of the very country that just got downgraded. This means that either (a) the market believes that S&P ratings have no credibility whatsoever, or (b) investors are simply panicking. Our guess is that both elements are factors today. As Burton Malkiel (author of A Random Walk Down Wall Street) wrote in Monday morning’s Wall Street Journal, This is not the market meltdown of 2008 all over again. And panic selling of U.S. common stocks will prove to be a very inappropriate response.” One must rely on process and discipline to guide investment decisions rather than reacting based on emotion. Periods like the one we are currently going through are precisely why.

If we remove emotion from the equation, this phenomenon makes no rational sense. If the downgrade is valid, people should have been selling treasuries instead of buying them. The purchase of this debt actually bid up the price and drove down the yield, which literally translates to a willingness for investors to pay a higher price to invest in something that has been deemed riskier now than it was last week.

Benjamin Graham stated that “in the short-term, the stock market is a voting machine. In the long-term, it is a weighing machine.” Our Sharpie-wielding friend, Carl Richards of www.behaviorgap.com, created a simple sketch years ago to echo this sentiment:

This decision by S&P to downgrade the US comes on the heels of our country’s elected “leaders” waiting until the final hour to raise our debt ceiling, and neither side willing to compromise at all. Not surprisingly, these “leaders” on both sides of the political spectrum immediately started kicking and screaming as loudly as they could that the other party is to blame. The irony here is that Standard & Poor’s actually made it clear that they took the political landscape into consideration during their analysis, so the immediate aftermath and mudslinging had to be pretty amusing to for them to sit back and watch.

Let’s not kid ourselves, we have a big debt problem in the United States, and our problems pale in comparison to those of our friends overseas. We all got drunk on prosperity over the last few decades and it is now time to start paying the bills. While it is causing some short-term pain, this proverbial “shot across the bow” may be exactly what our elected “leaders” need to start taking our country’s financial health seriously.

Within minutes of S&P’s announcement, the US Treasury Department pointed out a $2 trillion mistake on the part of S&P in their analysis, which they fully acknowledged and merely shrugged at. $2 million is a blip on the radar, $2 billion is notable, but $2 trillion? That is downright absurd and reprehensible for a company of S&P’s stature and responsibility. In recent years, the term “trillion” has been thrown around in a fairly ho-hum manner, however, to put that term in perspective, click here. We are talking about a huge number here!

Credit ratings issued by Standard & Poor’s are supposed to represent probability of the first dollar of default. The US is not going to default on its debt. We are not like Greece and Italy, who gave up their sovereign currencies to adopt the Euro. We can literally print $14.5 trillion tomorrow if we wanted to and pay off all of our debts immediately. Greece and Italy can’t print Euros. In reality, printing that much money would be a terrible decision for the US to make, but it is possible to avoid default.

If the United States of America is “only” a AA+ rating, then AA+ ought to be the new benchmark. We are actually seeing that transition in real-time this morning, as S&P has already downgraded dozens of institutions and agencies today. Warren Buffett went on record over the weekend stating that if it were possible to do so in the current rating system, he would actually upgrade the US to AAAA, which doesn’t exist.

While the $2 trillion mistake is clearly an egregious error, let’s also not forget that Standard & Poors is the same group that:

  • Rated boatloads of subprime debt as ‘AAA’, playing an enormous role in fueling the fire that resulted in the 2008 financial crisis.
  • Had Bear Stearns’ debt rated as A+ all the way into November 2007, and ultimately decreased their debt to BBB in March 2008 after the company requested emergency relief.
  • They had Lehman Brothers, as a company, rated ‘A’ the week they went under, and reaffirmed its ‘AAA’ rating on some of their securities just three days before it went under.
  • Merrill Lynch and Morgan Stanley were rated ‘A’ and ‘A+’, respectively the week they had to be bailed out.
  • Had an ‘A-’ rating for Iceland in September of 2008 when the country was forced to guarantee all bank deposits after its currency plunged.

Nobel Laureate, Paul Krugman, said in the New York Times, “There is no reason to take Friday’s downgrade of America seriously. These are the last people whose judgment we should trust.” Here is a comical sketch of the S&P rating model from Barry Ritholtz:

Right or wrong, S&P kicked up a storm, but they have not told us anything we didn’t already know!

We have been spoiled with a tremendous bull market the last 2.5 years. While it certainly does not feel good, a correction such as the one we are experiencing is not a surprise, nor is it abnormal. In the first half of 2010, for example, many people have already forgotten that the market experienced a 17% decline (which is still greater than the current downturn), yet finished the year ahead by double-digits!

We can control the process of investing, but we can’t control markets, herds, rating agencies, or politicians. Turn off your TV’s and get out and enjoy the summer while it lasts.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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Approximately Right vs. Precisely Wrong


The second president of the United States, John Adams, made a prediction years ago in a letter to his wife:

“The second day of July, 1776, will be the most memorable epoch in the history of America. I am apt to believe that it will be celebrated by succeeding generations as the great anniversary festival…It ought to be solemnized with pomp and parade, with shows, games, sports, guns, bonfires and illuminations, from one end of this continent to the other, from this time forward forever more.”

Make no mistake about it, John Adams painted an incredibly accurate picture of what was to come! This past month, a mere 235 years later, our nation celebrated its great anniversary festival by hosting parties, parades and fireworks with our neighbors, family and friends.

But depending on your viewpoint, one could also argue that John Adams was wrong. After all, we celebrate our nation’s independence on the fourth of July, not the second!

In hindsight, it seems ridiculous to claim that Adamswas wrong. In the moment, however, it is easy to get distracted by details that have little relevance to our financial well-being. We easily become critical of ourselves and envious of others, resulting in us completely missing the big picture.

In our personal financial lives, this dynamic manifests itself in a wide variety of ways, but is typically a function of focusing too much on short-term results. Your neighbor got a 4.0% rate on their mortgage, while you refinanced at 4.25%. Your brother-in-law bought Apple stock 6 years ago, as you maintained a balanced portfolio. And your friend saved 15% on her car insurance.

On the surface, it may seem like you are doing something wrong, missing out, or getting bad advice. The big picture may paint a very different picture. Your neighbor is planning on staying in their home forever and was willing to incur higher closing costs to obtain that rate, while you are planning on moving within 5 years. Your brother-in-law also bought a handful of other stocks that didn’t fare so well (and neglects to mention that when bragging about Apple). And your friend elected to reduce her liability limits to obtain the lower rate.

Proper financial planning revolves around all areas of your financial life working in tandem to support the life you want to live. If you take on additional risk (whether it is in your portfolio, borrowing more money, or the result of reducing liability limits) as a result of focusing too heavily on the short-term, you jeopardize all of the things you have accomplished to date.

People frequently confuse precision with accuracy in their financial lives. They believe that the more precise they can get with calculations, the more details they can uncover, and emphasizing cost rather than value is the key to financial success. However, looking back years from now, you will recognize that all along, you would have been far better off maintaining a focus on being approximately right, than risking that you could be precisely wrong.

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN


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The “Margin of Safety”* Concept Applied to Financial Planning


“The intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong – as even the best analyses will be at least some of the time. The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.” – Jason Zweig, Wall Street Journal columnist and author, Your Money and Your Brain.

Over the last several years, we are experiencing record foreclosures on homes across the country. One could argue (and very convincingly, I might add) that lenders should have never allowed people to obtain the mortgages they did leading up to this mess. However, home buyers are every bit as responsible for choosing to acquire an asset (and more importantly, a liability) that provided no “margin of safety” in their financial life.

The conclusion these folks arrived at – that they could afford these homes – was undeniably based on a wide range of assumptions. To name a few, these assumptions included (a) home prices will always increase, (b) tax rates will remain the same, (c) they will not lose their job or have to take a pay cut, and (d) that they will not experience any unexpected or “surprise” expenses like medical costs, home or car repairs, etc. With no margin of safety in place to buffer against even one of these assumptions being incorrect, many people were caught sitting far out on an extended tree limb and had no chance of hanging on against the storm that quickly formed on the horizon.

With respect to its origins in investing, a basic description of the margin of safety principle is that it implies that there is a favorable difference between the price paid for an investment and its actual value – a buffer. So important is this concept, in fact, that virtually any time Warren Buffett is asked how investors can become better investors, he refers them to Chapter 20 in The Intelligent Investor (Benjamin Graham), aptly titled: “Margin of Safety” as the Central Concept of Investment.

In a recent white paper, The Seven Immutable Laws of Investing, James Montier argues that “valuation is the closest thing to the law of gravity that we have in finance…the objective of investment (in general) is not to buy at a fair value, but to purchase with a margin of safety.” In other words, buying stock of a great company (or index) does not always mean it will be a great investment – the price you pay for it matters! The purchase of stock will be a great investment at one price, a satisfactory investment at another, and a bad investment at another.

For example, if you have done your homework and believe a share of stock is worth $30 and you pay $30 for it, you may, indeed, get a fair return. However, if your analysis and assumptions prove to be wrong and the stock turns out to be worth only $25, you have no buffer to insulate you against loss. Conversely, if you “always insist on a margin of safety” (Montier’s rule #1) and refuse to buy it for anything greater than, say, $20, you still yield a satisfactory (although less than expected) result.

In his book, Graham points out that the importance of the margin of safety has far less to do with maximizing return and far more to do with insulating oneself against the effects of a miscalculation, or more likely, incorrect assumptions. In the early 2000’s, people were buying tech companies – even the good ones – at impossibly high prices (no margin of safety), and the result was portfolio devastation.

This same principle holds true in financial planning.

Our investing and financial decisions are heavily based on the conscious and unconscious assumptions we have used to reach our conclusions. Let’s face it, whether you are forecasting the weather, speculating on the direction of the price of gold, or trying to predict who is going to win the NHL’s Stanley Cup this year, you must use a wide range of assumptions to draw your conclusion…and therein lies the problem with forecasting.

One of my favorite economists, John Kenneth Galbraith, said that “the only function of economic forecasting is to make astrology look respectable.” Our opinions are entirely based on the assumptions used and our often skewed biases (most Boston Bruins fans, for example, predict they will win the Cup, while most Vancouver Canucks fans believe the same of their squad), which exemplifies the necessity to create a buffer against ourselves.

To illustrate the sensitivity of assumptions in our financial lives, we are constantly making decisions today that have a far greater impact than most of us realize down the road. Unfortunately, we have no way of knowing the result of those decisions until 20 or 30 years down the road.

To illustrate this conundrum, consider this: the difference between earning 8% per year on a $100,000 portfolio over 30 years and 6% on that same portfolio is a whopping $525,000! In percentage terms, that seemingly small 2% annual difference is a reduction in principal of 57% for the entire period!

Think about that for a moment – instinctively, we would immediately want to pin the blame solely on poor investment performance, but in reality, that difference may be the result of a wide variety things completely out of your control, such as a less favorable economic environment than the past 30 years, adverse changes to the tax code, a prolonged period of high inflation, currency debasement, wars, political revolution, and a variety of other things we can’t possibly foresee in the year 2011. A minor tweak to any of these variables can completely change the outcome of the model and result in the need for a permanent lifestyle adjustment.

“Always insist on a margin of safety.” This phrase is not meant to restrain you from living your life to the fullest today, but is meant to encourage you to be fully honest with yourself when assessing how much house you can really afford, how much you can afford to spend on a new car, and how secure you are in your current job. It is meant to encourage you to consider the possibility that your assumptions may be wrong, and more importantly, to realistically assess the risks to your financial life if that happens to be the case. It is much easier to adjust your lifestyle upward than it is to retreat to a lifestyle you have already moved forward from.

As true as it is when investing, it is far better to be approximately right than precisely wrong in your financial planning decisions as well.

* The phrase “margin of safety” was coined by Benjamin Graham and David Dodd in their 1934 book, Security Analysis, and further emphasized by Graham in his 1976 book, The Intelligent Investor (updated in 2003), which Warren Buffett has called “by far the best book on investing ever written.”

Joe PitzlJoe Pitzl, CFP®
Director of Financial Planning
Intelligent Financial Strategies, LLC
Edina, MN

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