All Things Financial Planning Blog


Scared of Investment Losses – You Should Be

There is a very simple way to approach investment decision making. To start with, begin by asking yourself some basic and preliminary questions such as what is the investment for (to buy a house, to fund a kid’s education, or is it to fund retirement and the like) and how long these investments will last ( for example, up to 40 – 50 years sometimes when one starts planning for retirement early).

Once these basic questions are answered then ask this $64 million dollar question of yourself: Over your planning time horizon, how much of this money are you willing to lose? For example if you are trying to accumulate $100,000 for a house, how much could you afford to lose and still not lose your bearings. What if it is a five-year plan and in the 4th year you lose 50% of your accumulated funds with only one more year to go. How would you feel? This is the critical question in any investment decision. Typically you will not hear an adviser talk in such terms.

When planners talk about conservative investing, they couch the same idea in terms of risk and return. In the language of these experts such measures are often quantitative and difficult to understand  for the average investor. While return on investments seems like a fairly straightforward concept (8% or 11% for example), risk is mentioned usually in terms of standard deviation, a statistical terminology difficult both to explain and to understand. Hence, most investors are pretty much in the dark when it comes down to making the decision itself since it is their sole responsibility. Thus, the investor is left with no other choice but to decide on whether the suggested investment return sounds attractive or not. On this track, the higher the return, the more attractive the investment seems. Further, planners may suggest that a return such as 8-10% is a conservative rate whereas 12-15% is aggressive. Hence if an 8-10% based investment is being suggested, the investor is likely to go with what she/he thinks is the most conservative decision, being the conservative investors they believe they are. (As an aside, there is a whole theory about investors being conservative and risk averse)

To unwind this basic mystery, simply ask the planner the likelihood of various amounts of losses in any single year including the last year of the investment. Could half your funds be wiped out in any year including the last year? What is the likelihood of such an event? What is the likelihood that it could be 25% in any given year? Suppose your planner shows how your $100,000 will grow to $150,000 in five years if you were to earnings the average rate of 8% per year for five years. Under such a scenario, what is the likelihood that you could lose half your accumulated funds in the last year and come out with a negative investment return even though you still earned that 8% average rate over the five years? As we know now such possibilities not only exist but are not uncommon either; as an extreme case in point consider the 2008-09 financial debacle. If your investment was maturing in 2009, the outcome would have been a lot worse.

This concern of loss is what should drive us in our investment decisions. Most planners are unable to explain this concept of loss aversion to their clients because they themselves are not adequately educated to understand the concept themselves. However, as mentioned before, the solution is simple. Now reconsider the example above of earning an average annual rate of 8% over 5 years. While it sounds conservative on the surface, it is actually quite aggressive. Earning 8% a year for five consecutive years (or averaging out over the five years to an 8% rate) is a very tall order. To do so, especially under most circumstances, one would actually be exposed to a large amount of loss in any given year.

Without getting into the details of how the standard deviation measurement of risk converts into the loss propensity and using very rough estimates, another way to view the 8% investment opportunity is to understand that in any year, you may not even earn a dollar (0%) and this could happen in each and every year. The likelihood of such an outcome is astonishingly high – about 25%. Thus, the investment decision is about whether you are willing to bet where the odds of loss is one to four (25%) every year for each of the five years. Of course the reverse is also true that in each of the years you have a 75% chance to  earn a positive return on your investment and the earning rate itself could be anywhere from zero to the highest rate imaginable. Further, there is a 12% chance that you could be actually losing 8% a year for each of the five years! In prolonged economic downturns, which are not so uncommon, such are the outcomes. Now ask yourself this question: If you were told about these odds of losses, would you still consider the 8% investment opportunity to be conservative? Hopefully not, especially when you feel unsettled about the existing economic state of affairs. Further, would you consider a 10% return to be attractive and conservative if you were rejecting a 15% investment and choosing the 10% one?

As discussed earlier, this idea of loss aversion is probably the most powerful tool in the investor’s bag. Once you understand the implications of loss from any investment decision, then the loss aversion approach to making this decision is a dimensional shift, something that can be easily understood and applied by all investors. Further, if most investors behaved similarly, collectively we would make the investment market a much safer place. Unfortunately for now, there are no known ways of educating all investors about this critical aspect since the tools that currently exist are all based on statistical concepts of risk and return which make little sense to most lay investors.

somnathBasuSomnath Basu
Thousand Oaks, CA

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Mental and Physical Well-Being for Boomers and Their Retirement Plans

A  Pew Research Center study[1] on the effects of financial stress on health finds 42.4% of respondents in a survey on the subject indicated that their health had been affect by financial problems. The study also found that 1 in 8 baby boomers were raising children, planning for retirement and at the same time caring for their elderly parents. This is the unfortunate reality for many baby boomers who face the implications of being a sandwich generation.

For boomers across the spectrum of age (born between 1945-64), financial stress has also contributed significantly to relational strife and has exacerbated many medical conditions. It has been linked to depression and sleep disorders and has been known to negatively affect the autoimmune and digestive system. For retirees who find themselves on a limited income with few options for augmenting that income the additional stress of financial problems has certainly  been detrimental to their mental, emotional and physical well being.  For such retirees who had an improper perception of their retirement needs the realization of the truth is definitely overwhelming. For others, who had thought they had planned ahead and were diligent, are now wrestling with guilt and remorse over their failure to provide for their retirement years. These individuals too are likely also facing fairly severe mental health conditions related to retirement security. Additionally these retirees will likely look back on the sacrifices they did make and feel these were in vain further exacerbating the state of their mental health. This in turn leads them also to resist reasonable advice because their fears make them more suspecting of any advice including the reasonable ones.

Two of the chief culprits have been the tendency of boomers (as a solace, all other generations suffer from these same problems though boomers have been most affected) to overestimate and have overconfidence about their financial knowledge and understanding of key financial concepts. Their lack of knowledge about overestimating themselves and being overconfident about their understanding of key financial concepts has proved to be detrimental to many a boomer’s health and well being in retirement. This is mainly due to these weaknesses leading them to not having enough funds for their retirement expense needs. A national collaborative strategy initiative on this problem has identified five action areas needed to help alleviate this problem –the need to educate consumers on the areas of financial policy, education, practice, research, and coordination. The reality is that when retirees are affected mentally, physically and emotionally (leading to overconfidence and over optimism), their financial decisions become faulty due to acting on their perceptions of retirement risk. This makes them tend to drastically under-estimate their retirement expenses. In such cases they experience or will experience significant reductions in their quality of retirement life. To ensure that expectations of retired life are realistic and risk perceptions are aligned to realistic and achievable goals are the first steps for boomers to ascend in order to improve the quality of their overall mental and physical health in retirement.

An objective of planning for retirement thus becomes the need to find some kinds of lifelong guaranteed pensions since it is well known and understood that retirees who have such luxuries are many times more satisfied in retirement than their peers. The more satisfied in retirement the better mental and financial well-being one has. The main thrust in achieving such a mental state is to understand the importance of a secure and assured income that arrives in the bank consistently every period (such as monthly or bi-weekly).  

Perception too plays a big role in mental health as does the security of regular income. However, those receiving Social Security as their regular income are known to be less satisfied than others. Studies show that Social Security benefits carry a “hand-out stigma” for those who rely on them for their well being. From the boomers perspective, living a simpler life but funding retirement from a disciplined pension fund approach (using 401(k) funds, IRAs, personal financial portfolios, etc.) ensures the chances that their mental and physical well-being in retirement will not be reduced in any way by their financial well-being. Now is the time for boomers to exact such a lifestyle and bring in a certain semblance of stability in the vision for the rest of their lives.


somnathBasuSomnath Basu
Thousand Oaks, CA


Jobs, Now

When a person works at a job for which he or she is overqualified, it is called underemployment. Being employed or even being underemployed beats being unemployed, any day. Since 2008, we have officially lost about 10 million jobs. These are people who have families and children to support. As a nation, our first priority is to try and figure out how we can get all (or most) of these people back to being productively or gainfully employed before we can start considering how and when our economy will recover. The actions that the government should consider the most are also those that resolve this situation the soonest.

Why so? Consider the fact that we have lost what these 10 million people produced. The only reason we are not seeing price increases because of this shortage of production is simply because these same people and others  are not spending or willing to spend at this point, and rightfully so. The upward spike in the personal savings rate since 2008 (from about 0% in 2006 to 6.4% today)  is a vocal if implicit  testimony to how scared most people are today about their economic well-being. These 10 million people have also lost their incomes and therefore their own abilities to consume as before. Their standards of living have declined significantly. The government does not receive the taxes from their income either and hence cannot plow it back into the economy. Everyone is losing here, all of us, because of this unemployment. That is why it is our priority, us common people, to figure out how to increase employment for those who need it badly to get out of their current dire straits and help our entire economy. Now is not the time to point fingers, expect government created economic miracles or to play politics for votes.

Here are a few possibilities to consider. If you are unemployed and there is no suitable jobs for you, you have to find something (and if necessary compete for it) that you can do. It could be jobs to maintain people’s homes and yards, or to clean pools and wash cars, or to drive buses, or to become a janitor, or to become a city bike courier. It could be whatever you can do best other than what you were trained for if jobs are that rare in your field.

Remember, under current conditions, being underemployed is always preferable to being unemployed. No task should be (and is not) too menial, too mindless. Look around: How much does it cost every time you need a plumber or an electrician or another trades person at home? Why so? Compete here for these jobs. That helps everyone by adding value to the economy. Production at home (fixing whatever you can) and outside (fixing stuff for others), vegetable gardening if you have a little land, sewing, raising chicken for eggs, whatever value you can produce, do so!  

Going abroad and trying your luck outside is another alternative. More and more Americans are seeking their new careers or fortunes in foreign land. Wherever, there are opportunities. In Brazil, Russia, India and China, of course. There are others like Canada, Australia or Vietnam. These economies have done much better than ours of late. Our skills could find greater value there. And why not? Foreigners have immigrated here through the centuries for similar opportunities as well. We are more experienced than all others on immigration – let’s use this experience to our advantage.

Our emigration should go hand in hand with reduced immigration domestically as well. Nothing will deter immigrants (legal or illegal) from moving than the lack of opportunities; just like the reverse is true for emigrants. If you know anyone overseas or have done anyone outside any favors, call them in now. Now is the time to ask them to help you find a job in their country. Absolutely no shame here either.

Another fact that we often forget – small businesses in our economy are also the largest employers of people. This is your time to support your local ‘Mom & Pop’ establishments whenever you can. For example sell any veggies you can grow in your local farmers’ markets and buy your needs from there as well. Now is the time for home-grown or small-scale production to organically spread and take a grassroots hold on employment, just like it has done many times before.

If you are so lucky to find a job, this time around, start with saving whatever you can. Your savings (investments) will not only generate jobs and help everyone else; it’ll help rebuild your assets. Only consumption spending impoverishes our futures including those of our children.

This time around, we need to work together to get out of this economic morass and stay out for a long time to come. The way out is by generating new jobs, vocations, opportunities. We need to accomplish this task any which way we can – and do so in a concerted effort. Only then can we begin to relax about our futures.

somnathBasuSomnath Basu
Thousand Oaks, CA


A Poe-tic Tale: Gurus of Marketing

Why is it so difficult to save? What is in spending today that cannot wait? Surprisingly, the answer in not so much a financial one but much more one that is sociological and psychological in nature. Much of the answers lie in how we, as a society, react to the titillations carried through media that cajole us to spend even in the face of distressing financial conditions while exhorting us mercilessly to do so during economic bubbles. Our spending on basic living needs is not the issue here. It is the add-ons, the options bundles, much like when we buy a car. The basic need of going from A to B as simply as possible fade when we consider issues of images (yellow Ferraris, superfast Vettes, 57 Mustangs, etc.), or comfort (plush leather, auto all) and all the other complex factors that go behind the “bundling options” decisions. Behind all these images are some very clever folks who subtly or not so subtly, intrude in our mind and link connections between our desired images and a product that seems to exclusively cater to it.

This realm of the study of the purchase decision process lies in the academic arena of consumer behavior and market research. Some very smart folks study how we make these spending decisions, in every possible combination. They study how kids get excited about various toys when they watch Sponge Bob or Barney on Nickelodeon and suggest their appeasement possibilities. They copiously study every buying habit of yours when you save oh-so-many dollars because you used your grocery’s preferred card(s). Of course your credit card company knows these already down to the details of what you charged $3.25 for on your card. The popular magazines and journals know exactly what type of people read their rag, down to the last details of the number of kids you have and whether you eat out more than five times a week. In turn, for most consumers, it is extremely difficult to resist such consumption spurring. Understanding our own personal financial health condition is somewhat akin to most people not wanting to conduct their own surgery and self-medication of their own appendicitis, no matter that drugstores may any day introduce do-it-yourself kits! In a nutshell, we are quite helpless.

Imagine you are parents of two or three kids and you both work. You come back home at the end of a long hard work day after picking up the kids from various activities and figure out the day’s dinner protocol. After that, tuck them in bed and sit in front of a TV to relax and enjoy your personal quality time a bit. This is your prime relaxation time. Your guards are finally down.  Of course, it also happens to be prime time TV for which corporations pay top $ to be in front of you. Wafting through the TV (or from the newspaper/magazines or radio for the snobbier) come through subtle and not so subtle images of a happier you skiing down some fine Colorado powder or on a Caribbean beach sipping umbrella-clad drinks. Pictures of yourself – a happy retired millionaire at 40 or so. And, you know what happy people do. Next morning the natural query is to enquire about credit possibilities on your home equity or credit card. What chance do we have to resist being like such beautiful people? Our present is all we know of our future and how can we step into this future without a happier now!

A friend once proposed this financial study to me. Call up a financial advisor, one you do not know, pls. Maybe someone from the yellow pages or from the local classifieds with lots of credentials after their name, preferably starting with a “C”, though any alphabet soup will do.  Ask them what you should do with the $200,000 you just inherited. Now watch for the effects of the underlying corporate marketing gurus to come through to you – fangs and all. 

Who can protect us from this onslaught? Not corporations, politicians, bureaucrats or government. Can things get worse? We’ll have to wait and see what kind of a mess we get into, or not, when the consumer protection act of the financial reform bill gets implemented and understood over time.

somnathBasuSomnath Basu
Thousand Oaks, CA


How Well Behaved Are Your Financial Decisions?

How well we make investment decisions depends in large part on how reasoned or emotional the decision was. The greater the emotional content the more likely will be the mistake. It is useful for all of us to understand the emotional pitfalls of financial decision-making.

An appropriately titled study by a financial psychologist Rashes, “Massively Confused Investors Making Conspicuously Ignorant Choices,” cites that the widespread phenomenon witnessed in the market, whereby several stocks with similar ticker symbols all went up in value when positive news was announced about any one of them. A case in point is the parallel movement between two entirely unrelated stocks, MCIC (ticker symbol for the telecommunications firm, MCI, bought by Worldcom in 1997), and MCI (ticker symbol for the Massmutual Corporate Investors fund). The acquisition of MCI, the telecommunications firm, in 1997-8 caused an upward movement in its stock (MCIC). That movement was also closely correlated with the upward movement in the stock of Massmutual Corporate Investors (MCI), whose ticker symbol was the same as the telecommunications company’s name. Rampant confusion of this sort strongly supports the notion that irrationality, not rationality, rules the financial markets. Another noted scientist, Malkiel suggests that when it comes to investing, people generally follow their emotions, not their reason, their hearts, not their minds.

This line of argument has been gaining credibility over the last decade or so, not only among behavioral finance experts, but also economists themselves, as well as stock market pundits and the population at large. There is a strong sense among all these groups that greed, exuberance, fear and herding behavior affect markets as much as or more than calculations of P/E ratios, profit projections, or market benchmarks. The bursting of the stock market bubbles of 2000 and 2008 only confirmed these long-held suspicions. As a result, widely used economic models based on rational investor behavior require some reevaluation and could be found to be unreliable at best and irrelevant at worst.

The following is only a partial list of the biases that may be induced in you if the financial decisions you make are based on emotion and not on reason. The list includes the bias name, a descriptive definition and an example of application error. Before closing that next trade you make, a good question to ask yourself is whether any of the biases from the list were included in your financial decision. If so, these decisions too need further evaluation.

Over-estimating the chances of correctly predicting the direction of price changes. 

Attribute good outcomes (i.e., gains) to your skill while attributing bad outcomes (i.e., losses) to your bad luck.

Pride and Regret:
Investors often over-estimate their powers of discerning stock winners from losers.

Investors (essentially, active traders) rapidly sell and buy back stocks, in order to capture expected gains. 

Selling your winning picks early and holding onto losers hoping they rebound. Studies show that doing the opposite can increase your annual returns by 3-4%.

Cognitive Dissonance
Suggests that investors experience an internal conflict when a belief or assumption of theirs is proven wrong.

It’s easier to remember your winning picks than your losing ones since the latter outcomes disagreed with your earlier beliefs.

Confirmation Bias
Suggests that they try to seek out information that will help confirm their existing views whether those views be right or wrong. 

When you hear someone agreeing with your investment decision, you feel that person is much more knowledgeable than one who disagrees with you.

A phenomenon whereby people stay within range of what they already know in making guesses or estimates about what they do not know. 

The Dow Jones Industrial Average (DJIA), which grew from a value of 41 in 1896 to 9,181 in 1998, does not include dividends. They then value the index in 1998, including dividends, at a whopping 652,230. When asked, investors estimate the value of the DJIA would be if dividends were included, all were way off the mark, keeping their answers close to its familiar value of 9,181. The highest guesses came in at under 30,000, less than 5% of the actual value.

Representativeness Heuristic
An over-reliance on familiar clues, such as past performance of a stock.

Most investors assume that the stock of a company with strong earnings will perform well and that the stock of a company with weak earnings will perform poorly. The law of large numbers suggests however that the exact opposite is much likelier to be true.

somnathBasuSomnath Basu
Thousand Oaks, CA


Going to Zero?

How have your investments done over the last three years? If you were to ask the myriad of people who are or even pose as professional financial advisors, they would generally say that it would depend on how well your portfolio was diversified.

By this jargon, they would mean how your money (in what proportions) was invested among various asset classes such as stocks, bonds, commodities, cash and the like. The more it was spread out around various asset classes, the safer they would have been.

To see how safe (or how risky) your portfolio was over the last few years, it’s useful to view how these asset classes themselves fared over this time period. That is what is shown in the next chart where the following asset class performances over the last few years are shown. The chart shows the performances of stocks (S&P 500 shown by the symbol ^GPSC, in red), bonds (symbol IEI, Barclay’s 3-7 Year Treasury Bond index etf, in light green), Commodities (DBC, Powershares etf, in dark green), Long dollar (UUP, Powershares long dollar ETF, in orange; this fund allows speculating on the dollar going up against a basket of important currencies;  whenever the world financial markets are in turmoil, this index generally goes up as investors around the world seek the “safe haven” status of the dollar. Alternately, note that this index value will also typically rise when the domestic economy is in a sound condition and both domestic and international investors favor the U.S. financial markets) and the short dollar (UDN, the Powershares inverse of UUP). Note that the “Cash” asset class has been left out and returns on cash (or money market funds) have been close to zero the whole time.

There are a few startling observations from this period. The first part that arrests the eye is how commodities performed over this time period. If your portfolio was heavy in this sector, you had a heck of a ride these last three years. If you had a lot of stocks as well, heck, your ride just got wilder. As can also be seen from the picture, healthy doses of bonds and currencies would have made your ride that much smoother.

On the other hand, what is additionally startling to observe is that we all started this period close to zero returns in the beginning of 2007 (around March 2007) and in June 2010, we are all converging back to zero returns. No matter how you were diversified, you either took a smooth ride (well diversified portfolio) from a zero return environment to a zero return environment or a wilder ride. That is why diversification is so important.

Another way to gauge your diversification benefit is to use a two-pronged system. The first is what I refer to as the “monthly statement effect.” When your monthly financial statements come in, you first observe the current month’s ending balance, then the previous month’s ending balance and then have a great day, a lousy day or an uneventful day. Depending on how good or bad (how volatile the ride) the monthly effect is, it may last for much more than just a day, maybe days.

The second piece is your age. As you grow older, you have to ask yourself how wild a ride can you tolerate at that point in your life. Hopefully, as you age, this tolerance level should show significant declines. If it does, you are then joining a rational investment group practicing a “lifecycle-investment hypothesis” style.

Finally, did anything do well during this time? Yes, and surprisingly from an asset class whose underlying asset is shaped too like a zero – mother earth and real estate. Having some real estate in your investment basket (another important diversification asset) would not only have smoothed your ride but would have made your financial life so much more pleasurable. Just take a look at this picture below (FRESX, an old Fidelity’s real estate index fund) which says it all.  Even in the darkest days of falling real estate markets of 2008, this fund produced a positive return. Of course many other real estate indexes lost their bottoms; thus finding these stable indexes in all asset classes are well worth their salt. That is, if it is time for you to diversify. 

somnathBasuSomnath Basu
Thousand Oaks, CA

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The Economics of Fear

An experiential learning of mammoth proportions occurred last Thursday in the financial markets. The absolute 10-minute freefall of the prices of stocks and bonds, without any pre-notification froze the hearts of many in the investment community. The possibility of a $1 trillion dollar loss had suddenly and unexpectedly turned real. It happened in a matter of minutes. This experience of panic, of the possibility of a severe economic degradation of life becoming immediately real, is like none other that most of us can ever remember experiencing. Even the 1987 crash happened over a large part of that Monday. Like then, this time too there is no known reason of why it happened, though attempts are being made to understand the cause(s). Whatever the reasons may be, it will not change the experience we had of the realization of the fear of a sudden and unexpectedly large loss.

Before going deeper into the experienced fear, it is useful to provide some analogies to the event. If the meltdown in the financial markets of 2008 was like an earthquake, then this was like a severe aftershock. It is also similar to going down one of those severe roller coaster freefalls that some may consider very undesirable. Alternately, what makes a 30-year old be mostly unconcerned about his/her lack of retirement savings while a 60-year old in the same poor condition is much more concerned. Obviously, the possibility of a lower quality of economic life is much more real for the elder than the younger. In such cases we would expect the fear of an economically degraded life to spur people to take preventive or remedial action.

To truly understand our responses to fear, we need to go deeper into our minds. According to psychologists and neurologists both, there are various segments within our mind. For example, one segment of our mind (the frontal lobe) is understood to process analytical tasks. Similarly, other parts of our brain (the older limbic system composed of mammalian and reptilian brains) react to and affect/control our emotions and fear. When we are faced with an immediate threat, this older system takes over control of our reactions and often drives us towards instinctive responses and will not, in general, make the analytically reasoned response. It is similar to learning about all the different ways we need to behave in the wild if we came across a bear. When people actually are faced by such a situation, they rarely remember all their learning and respond with their instincts. Those are the limbic responses. In other words, when threats are real, our emotional mechanisms will dominate our rational mind and we will react according to our older and longer existing nature.

Such was the effect of the financial freeform. In those 10 minutes the economic shock to our limbic system was the first of its kind, in terms of magnitude. While discussions are held about sudden unexpected losses, typically the impact of sudden huge losses in a very very short period of time is rarely thought of in very meaningful ways because the probability is so very low. This time, it did actually happen! We will bear some consequences which will begin playing themselves out slowly over this summer. For one, the investing nation will be much more circumspect about stocks and other volatile financial instruments. In a more technical way, our risk aversion as a nation will have suddenly increased. This will have an impact on both trading volume and security market prices and eventually on portfolio values. How younger investors will react is less known. Finally, there is one important lesson for us all and that is to find competent planners who can safely herald people in these times. It also is probably an important point to understand why the portfolios of older people should consider safety of principal first whilst the younger ones focus on growing their wealth.

somnathBasuSomnath Basu
Thousand Oaks, CA


Current Retirement Investment Options

There is heartening news for those of us in retirement or approaching it. There’s a new type of bond called the Build America Bond or BAB. The BAB, along with an older, but often ignored retirement investment, is viewed as positive developments for those saving for retirement. But before we jump into these investments, some background information is required.

When people in their early careers save, their primary objective should be that their money grows healthily. They generally should invest in stocks which provides for longer run growth. This phase of our financial life can be called the “Accumulation Phase.”

However, people in their mid- to end-careers (roughly between the ages of 40 – 65) start switching their objectives toward a more conservative future growth in their current savings, especially those associated with emergencies and retirement. This phase is usually identified as the “Preservation Phase” where individuals should begin switching their investments toward more fixed-income securities, such as bonds and bond funds. This idea of how reasonable people “should” behave is commonly known as the life-cycle hypothesis of investments.

Finally, people in retirement, those who are in the phase termed as the “Decumulation Phase,” should have a healthy dose of bond-type investments in their retirement portfolios.

Strange as it may be to some, this opinion about the investment life-cycle actually contains a lot of truth. If most people followed this basic rule, we would be better off this way than by any other method and especially in times like the recent financial tsunami that hit us.  Those hit especially hard were people between the ages of 55 and older who held unhealthy amounts of stocks in their portfolios. Following this simplified version of retirement investments is both easy and effective.

All we do as we age is reduce our stock investments and increase our bond investments. While such a strategy reduces the growth of our wealth it also protects us from large to calamitous losses.

Unfortunately, the last 10 years or so have not been good for bond investments because bond prices have been at or near all-time highs and their returns near all-time lows. The following picture shows the rates one would earn by investing in the government’s (highest safety) 10-Year Treasury Note. Many bonds and mortgages (and subsequently the respective funds) use the 10-Year rate as the benchmark rate.

10-year T-note Rates

As can easily be seen, these rates have come down steadily. A result has been the difficulty, of late, to find (the safer type) bond funds because they have been so expensive. However, one recent development in this field is worth mentioning: that is the emergence of a class of (stimulus-related) bonds known as the “Build America Bonds” or BABs, which for the first time in many years offers investors a very suitable entry to convert stocks into bonds. BABs, which were introduced in April 2009, are an innovative new tool for municipal financing created by the American Reinvestment and Recovery Act of 2009. BABs are taxable bonds for which the U.S. Treasury Department pays a maximum of 35 percent direct subsidy to the issuer to offset borrowing costs.

The second issue of note is that at this point, it is quite expensive to hold cash in money market type funds because of the dismal rates offered on very short-term products. An alternate that all investors should contemplate purchasing instead of CDs and money market deposits are a class of bonds, issued by the Government and known as Treasury Inflation Protected Securities, or TIPS. These investments sold directly by the government to you (at are excellent vehicles for holding funds as they guarantee that your money will hold its buying power over time and a bit more. TIPS are a great way to hold the capital you will need in the short term. The following picture shows the stability of the TIPS rate; a much safer and more stable investment opportunity than short term Bank CDs, recent money market funds, etc.

T.I.P.S. Rate

Build America Bonds (BAB):

The Build America Bonds program, created by the American Recovery and Reinvestment Act, allows state and local governments to obtain much-needed financing at lower borrowing costs for new capital projects such as construction of schools and hospitals, development of transportation infrastructure, and water and sewer upgrades, according to a recent U.S. Treasury Department press release. Under the Build America Bonds program, the Treasury Department makes a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the bonds.

Here’s how BABs work according to the Treasury Department: “The bonds, which allow a new direct federal payment subsidy, are taxable bonds issued by state and local governments that will give them access to the conventional corporate debt markets. At the election of the state and local governments, the Treasury Department will make a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the Build America Bonds. As a result of this federal subsidy payment, state and local governments will have lower net borrowing costs and be able to reach more sources of borrowing than with more traditional tax-exempt or tax credit bonds. For example, if a state or local government were to issue Build America Bonds at a 10 percent taxable interest rate, the Treasury Department would make a payment directly to the government of 3.5 percent of that interest, and the government’s net borrowing cost would thus be only 6.5 percent on a bond that actually pays 10 percent interest.”

According to the Treasury Department, Build America Bonds have had a very strong reception from both issuers and investors.  From the inception of the program in April 2009 to March 31, 2010, there have been 1,066 separate Build America Bonds issuances in 48 states for a total of more than $90 billion. Read more about BABs (PDF).

Now, till the general level of interest rates go back to their normal states, it will be difficult to find another opportunity such as this one. This is especially true of investments that are made to local governments through their taxable investments. Municipal bonds are typically considered less risky. Add to this the partial guarantee of the Govt. and you have the makings of a very safe Bond fund providing an average yield of nearly 6% for a medium term duration. There has been a dearth of such fixed income investments in the Bond markets for quite a while. Thus, for all people at or near retirement, an exploration and investigation of BABs is an absolute must.

somnathBasuSomnath Basu
Thousand Oaks, CA

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Prepared for Financial Emergencies

There is a heartening change that we are observing today, an event that is truly national in character. At the bottom of the financial abyss, we single-handedly turned around our personal savings for the first time in 12 years.  The chart (Dept. of Commerce publications data) below expresses this turnaround emphatically. 


It is the timing of this turnaround that is so heartening. The realization that this crisis may truly be worse than any other enabled us as a nation to halt this decline. We have our emergency “nest eggs” rebuilt again. Amazing still is that this feat was achieved with a determined effort to curtail our consumption levels to ensure that our emergency funds were rebuilt. Again, a similar chart expresses this aspect better.

What next then? With our emergency nest eggs rebuilt, we must now ponder the question as to continue to increase our savings or not. For seniors, the objective would be to ensure they did not outlive their funds. For those between 45-65, in general, retirement must loom somewhere, and retirement is sweet. Similarly, for those between 25-45, thoughts would turn towards families, home purchase and children’s education. All worthwhile savings objectives. Thus the central question is whether we should increase our current consumption or postpone consumption to attain our future objectives. Only time will tell whether we continue the trend of increasing savings and moderating consumption or whether we go back to drawing down on our savings to increase current consumption.

somnathBasuSomnath Basu
Thousand Oaks, CA

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Simplifying the Investment Decision: An Overview

There are three basic considerations in any investment decision.

The first is the understanding of the investment objective or why the investment is being made. While this may seem somewhat irrelevant at first (why would you be investing if you do not know what you are doing), combining investment objectives can pose problems downstream. For example, if you are saving for your retirement so that you can afford the retirement lifestyle you desire (the investment objective), your saving plan should not include any savings you are making for your children’s education (a separate investment objective). Compounding the two savings streams in one plan can very easily lead to one or both of the plans failing.  

The second consideration is the time horizon of the investment. As a rough guide, investments that need to mature in the next 5-7 years can be considered as short-term, 8-15 years as medium-term and the rest as long-term.

Finally, and probably the most important consideration of all is the importance you attach (priority) to achieving your investment objective. In other words, how safe and secure should your investments be.

For example, if you are 70 years old and considering how you should invest your retirement funds so that your expenses are covered say for the next 25 years, you do not want a large margin of error in how your investments turn out; you can ill afford to be broke when you are older and hence you want your investments to be as secure as possible.

On the other hand, if the investment is for a second home or a boat, for example, you may wish to engage in some risk taking, which may help in lowering your upfront investment needs. It is very important for any investor to clearly understand how much loss they can bear from any investment decision.

It is useful to express the investment framework described above as a simple decision matrix. Using the matrix (shown below) as a decision support system should clarify and simplify most investment decisions.

Investment Decision Scenarios


Investment Time Horizon

Short Term Medium Term Long Term



Very Safe 1 2 3
Moderately Safe 4 5 6
Very Risky 7 8 9

Understanding where in the matrix your decision falls is a very good first step of your decision. Both these elements (safety and time) will ultimately decide the kinds of financial instruments that will reside in your portfolio. We will examine the structure of each of the nine possible combinations shown in the matrix above.

Before doing so, let us start by examining the various investment alternatives (e.g. stocks, bonds, etc.) since they have an implicit connection with the two dimensions portrayed in our matrix.

Stocks are the most well known and popular form of financial investments. Stocks may be further segregated between large cap and small cap stocks, where the term “cap” is surrogate for the size of the underlying corporation or firm. Stocks may represent investments in both domestic and international companies. Within the international category, stocks may represent corporations registered in developed (safer) or emerging (riskier) markets. In terms of our matrix dimensions, stocks are best suited when the decision is of medium or long term.

In terms of safety, large cap (both domestic and international) stocks are the safest, while small cap and emerging market stocks are the most risky. The riskier the stock, the greater are the profit possibilities as are the chances of large losses.  

The second common type of investment is bonds. Generally, bonds are much safer than stocks, with the exception of a class of bonds known as high yield (or junk) bonds. Bonds are issued by companies, governments (domestic and international) and other agencies such as local governments (municipal bonds or “munis” which are especially desirable for those in high income tax rate categories) and quasi-government agencies such as Federal Home Loan Bank, Student Loan Administration, Agricultural Cooperative Banks, etc (collectively known as “Agency” bonds such as Ginnie/Fannie/Sallie Mae, Freddie Mac, etc.).

Government bonds are the safest, followed by agency and municipal bonds and then by bonds issues by corporations. Corporate bonds may be safe (which are assigned credit safety ratings such as AAA, AA, BBB, etc.) or risky (junk bonds with ratings such as BB, CCC, CC etc.).

Bonds can be used for all time horizons, their maturities ranging from 3 months to 30 years. Very short term bond and bond like instruments (with maturities of one year or less) are known as money market securities which are generally safer than most other investments.

Other types of investments include real estate (long term, risky), commodities (such as energy, basic building materials, precious metals, etc.) which are also risky and which may be used for both short-term and long-term purposes and provide a good hedge (counter balance) in an inflationary environment, and derivatives (options and futures) which are very risky and typically short term in nature. Derivatives are generally suggested for very sophisticated investors and are best left alone otherwise.

A very important feature about investments is that when various types of investments are bundled together in a portfolio, they help to reduce the riskiness of the investment decision without affecting the profits in a comparable way.

This basic aspect of mixing various kinds of investments (stocks, bonds, etc) to reduce risk is known as diversification and it is a “must” for any investment portfolio. It is a “must” because this technique of risk reduction is generally costless (unless you are paying a financial advisor to do this for you) and it is very worthwhile. All other methods of risk reduction have cost implications.

Armed with this nomenclature regarding various investment types we can now go about examining what the nine combination (Scenario) portfolios may look like for investment purposes. Starting with Scenario 1, if you wish to make a short-term decision that is very important to you and needs to be very safe, investments should be made in very short-term bonds (government or treasury bills) and other similar money market (short-term, safe) securities. International short-term bonds of developed countries may also be included. Such investment products are generally available through mutual funds or Exchange Traded Funds (ETFs). ETFs are just like mutual funds except that they are usually cheaper, much easier to buy and sell and may provide tax deferral benefits.

If your investment falls in the Scenario 2 category, include agency/municipal bonds as well as some domestic and international (developed country) large cap stocks. While for Scenario 3, smaller portions of small cap and emerging market stocks may be added proportionately while reducing some of the safer investments.

If your investment was a Scenario 4 type of investment, corporate large cap stocks (both domestic and international) could be added to agency or corporate (domestic and international) bonds. Before investing in stocks (in any Scenario) for this Scenario 4, a good question to ask is the following: how profitable were stock investments in the last 3-5 years? If the answer is “very profitable” then reduce the proportion of stocks as compared to bonds in the portfolio. If the last few years were not good, then it would be good to increase their comparable shares. The main reason for this “fine tuning” is that the fortunes of stocks (and many other types of investments) follow a cyclical pattern and the cycle is related to the general cycle of economic (GDP) growth and contraction.

It can be seen now how Scenarios 5 and 6 (as also 8 and 9) will follow a similar pattern as before, increasing proportionally in stocks (of all sizes, domestic/international), real estate, commodities, etc. Portfolios falling in these groups may also include some small cap and emerging market stocks as well as high yield or junk bonds. The proportion of these riskier investments would of course be higher for Scenario 6 over Scenario 5 (and Scenario 9 over 8).

For Scenario 7, the investment portfolio would typically resemble one that would be like an opposite of the portfolio in Scenario 1 and would include a greater proportion of large cap (domestic/international) stocks and a much smaller proportion of bonds. As we move towards Scenarios 8 and 9, the portfolios would be dominated by small cap and emerging market stocks as well as junk bonds.

In the discussion above, I have tried to generalize the investment decision in a simplifying way. While the discussion may have centered more on stocks and bonds, it is important to note that all portfolios must “diversify” the investment risks by expanding upon the various types of investment products contained in the portfolios. The very fact that a portfolio contains various types of investments will ensure that the portfolio will perform better than those which are not as well diversified. This will be so in spite of any one of the investment types underperforming at any point in time and the diversification benefit will be received consistently over long periods of time. A popular analogy to this diversification benefit is the common phrase of not putting all eggs in one basket.

The above approach to investment decision-making can be considered as a basic template that can be used universally. For those seeking greater sophistication and who have a foundation built on the above model, expert advice is strongly recommended.

somnathBasuSomnath Basu
Thousand Oaks, CA


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