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The truth about “diversification.” September 26, 2011

Posted by shaferfinancial in Finance, Uncategorized.
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In my mind, diversification is fools gold. It looks good, all shiny and glittery, but in reality is worthless as a financial concept. First of all in its original form, it really means diversifying asset classes. That is if one asset class is doing badly it is less likely that 2 are doing badly and even less likely that three are doing badly, etc. But most people are only invested in equities or equities and bonds. Two asset classes are better than one, but that is hardly real diversification.

Most financial planners apply it to equities. On that you reach the vast majority of risk reduction owning 20 stocks. But most planners suggest owning a variety of mutual funds that might hold hundreds of stocks in each one.

What is wrong with this you might ask?

Well that leads us to the point most financial planners don’t understand or won’t explain to you. The way diversification works is it lowers overall variance. Meaning that owning one stock the total variance in any given year might be -100% [total loss] to let’s say 1000%. So a total variance of 1100%. Owning more than one lowers the risk of total loss. It also lowers the ability of choosing that home run stock. So lets say the possibilities are from -60% to 150% or a total variance of 210%. But here is the part they don’t tell you. It also lowers expected return. Diversification costs! Many people might say it is worth the cost to not have a total loss of funds. OK, but why diversify stocks to the point of owning hundreds or even thousands? Why not diversify asset classes?

But the bottom line is always how does all this theory do in the real world. And here is where it really fails. In the real world there always comes a time that the principal is needed. And this risk is rarely explained to folks. If you need the money within a few years before or after a major negative event you might never make up your losses. That is because you are spending the capital and therefore need a lot of time to make it up. Time you probably won’t have.

Mutual funds, the major financial tool most people have been told to depend upon are possibly the worst investment vehicle for retirement income because they don’t produce income. Bottom line is you have to sell the asset to get anything out of them. Selling into a down market is the worst thing you can possible do. All that diversification did not protect you one iota from the real risk.

So next time some financial expert starts talking about diversification ask them about what happens when a market downturn occurs during your retirement years and you have to draw down your account significantly. Or ask him what happens if you retire into a 10 year period like the last 10 years. And then go find out about dividend producing stocks or an EIUL or investment real estate all of which solve the issue in their own way.

3 Reasons for Having an EIUL be a part of your RETIREMENT STRATEGY April 29, 2011

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There are three big questions that no financial planner can answer for you. These are what I call the “Holy Trinity” of retirement problems. Because no-one can really answer these questions, they are rarely talked about in polite company. Here they are:

How much income will I have to live on?
How long will I live?
What are the tax rates going to be?

Wealthy people who were living on their wealth were once called coupon-clippers because they got their regular income from owning bonds that paid a fixed interest rate. Those days are mostly gone, because corporate bonds are callable and if you are living off of interest from treasuries or certificate of deposits then you are starving today. Most people have been sold on the idea of mutual fund ownership as a way to retirement income. But this is possibly the worst idea imaginable because mutual funds have high variability. That means they go down, as well as up in value [sometimes 50%!]. How can you plan an income stream using a product that has such high ups and downs? You really can’t [note all the arguments over how much of your mutual fund value to use each year of retirement].

Reason #1 to own an EIUL…..
It doesn’t have the variability of mutual funds and the cash value never goes negative.

Most people save for retirement unevenly, little if any until age 35-40 then acutely after age 50 when that retirement is staring down at you. The truth is 20% of 40 year old men will die before retirement [13% of 40 year old women]. On the other end 16% of those men will be alive at age 90 with 26% of those women alive and kicking at age 90. Fully a third of 40 year olds will have the problem of dying early or living an extremely long life.

Reason #2 to own an EIUL….
If you die early [before you have completed your retirement plan] the life insurance proceeds will finish your retirement plan for your spouse and family and if you live a long life not having to pay taxes on your income will stretch your retirement income out as long as possible.

Common practice is to defer taxes to your retirement years. But no one knows what the tax rate will be in those years. With the government running huge deficits, there is a high likelihood that taxes will be a bigger factor in the future. But the bottom line is no one knows.

Reason #3 to own an EIUL
Taking out income, TAX FREE, is not only a way to pump up your in-the-pocket retirement income, but a way to eliminate a huge uncertainty [risk] in your retirement planning.

Which would you rather be? Joe or John January 15, 2010

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Joe and John are twin brothers.  Both financially astute.  Both made identical money in the same industry.  However, at age 45  Joe made some different decisions than John.

They are now 67 years old and in good health.

Joe’s retirement  looks like this:

5 paid for rental homes with a total of $5K in net monthly rental income. At the peak of RE values these houses were worth $1.5M, but now are worth $900K.

$1.5M of cash value in an EIUL.

Dividend producing stock that once had a value of $600,000 but now is worth $450,000 but produces $2K/month in dividends.

Social Security: $1500/month

John’s retirement looks like this:

A 401k with a current value of $2M but was once worth $2.8M.  Inside the 401K is a well balanced group of mutual funds.  He always maxed out his 401K inputs.

Social Security: $1500/month

So which one do you prefer?

Let’s look at income.

Joe’s annual income looks like this:

$60K from real estate rental income partially offset by depreciation allowances that allows a net income after taxes of $55K

He is currently taking $100K from his EIUL tax free

$24K from dividends on his stock which is $20,600 after the 15% tax.

$18K from social security which is about $16K after taxes

For a total of $191,600

John retirement income looks like this:

He is using the 4% withdrawal rule for his 401K so this year he currently took $80,000 but had to pay the income tax rate of 25% so his net was$60,000

Net social security after taxes of $13,500

John’s retirement income was $73,500 this year.

Again, whose retirement would you rather have?

Saving for Retirement May 20, 2008

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If there is one place that there is much misinformation, it is in how much you need to save for retirement.  The mutual fund industry has spent much time and effort to propagandize to folks why they can accomplish this using mutual funds.  The truth is much different.  Now there is one caveat before I go into the numbers.  If you are fortunate to have a defined benefit pension, then you can make it work by putting monthly money aside into a mutual fund inside a IRA/401K wrapper.  Even better if you also qualify for social security.  But, if you really want to accumulate enough to have a comfortable retirement then pay attention.  If you don’t have a defined benefit pension, then it is critical that you understand the following.

Mutual funds have been sold as a safe/low risk investment.  And that is truthful.  But the rule of finance is that the lower the risk the lower the potential rate of return.  Now we know that individuals that purchase mutual funds average 2.5%-4% rate of return.  But for the point of this exercise lets assume a 8% rate of return (the average mutual fund return).

Now here is my rule of thumb.  In order to build enough wealth to have a comfortable retirement you must get 15% rate of return from you investments.  Let me show you why.

Lets say you put away $300/month until your retirement in 25 years.  Let’s also assume you never fail to put this money away.  If you get a 8% return on investment, you would have $285,308 after those 25 years.  This can produce $22,800 of taxable income per year assuming that same 8%.  Not bad.  That puts you in the top quarter of net worth for folks in the United States.  However, you haven’t accounted for inflation. Taking official inflation statistics, which I believe seriously understates inflation, that $285,308 has the buying power of $142,654 or $11,400 year.  But that is on day one of retirement.  The average person will live another 20-25 years.  So by the time you die that $285,308 will only have $71,327 of buying power or $5,700/year.

Now let’s run the numbers with 15%.  Same deal, $300/month for 25 years.  Now you have $973,059 and using 8% of it each year you would have $77,844/year.  But the buying power would only be $38,922 when you retire and $19,461 at likely death.

Now that is more like it!  But you say how can I get 15% without risk?  You can’t.  But you can get 15% assuming less but a different type of risk than you have with mutual funds. 

First, can you spot the risk of investing in mutual funds?  Well it is the very real risk of running out of money before you die.  In fact, 90% of retired folks are financially dependant on the government or family/friends before they die.  Remember mutual funds have been sold to the public for 2 generations and that strategy has been pushed for just as long.  So that risk is extremely high.

Here is the less risky way.

1. Find a stock that has returned over 15% for over 40 years.

2. Use leverage.  If you leverage an investment three to one you only have to have that asset return 5% to get that 15% return.

For regular readers you now should know the answers.  There is only one stock that has returned over 15% for 40+ years.  Berkshire Hathaway.  In fact it has returned over 21% for 43 years.  Over 18% for the last 10 years. I put my bet on Warren Buffett the driving force behind Berkshire Hathaway.

Finally, investment real estate, properly structured in growth areas have historically returned over 6%.  You can leverage this with mortgages.  And you get all the tax advantages of real estate.

Your choice on the risk.  Bet on two things that have proven to give superior returns over the last two generations, or bet on mutual funds which have proven to given inferior returns over the last two generations.


       ***** As always, this post in only the musings of a clearly deranged individual that happens to be good at math.  He has no license to sell securities nor real estate and any advice should be considered for amusement purposes, not expert advice that ones gets from a licensed individual.**** 

Retirement Strategies REdux: Old School v. My Way April 21, 2008

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Mary and Joe are typical folks, they have about twenty years to retirement with two kids fast approaching needing money to attend college.  Joe has been fortunate and has had the same job for over 15 years, while Mary works part-time for a local business and still does the majority of taking care of the kids.  They have accumulated around $100,000 in a 401K and owe $100,000 on a home that is worth $300,000 by aggressively paying off the mortgage and owning the home for 15 years.  Their emergency fund is meager at $8,000.  They know they need to figure out a way to get more money for retirement, but frankly, are at a loss how.  They make an appointment with John, the financial planner.  Mary pulls up in a 7 year old Honda minivan and waits for her husband.  Joe running a few minutes late pulls up in a 4 year old Chrysler 300.  Joe parks next to a new Lexus and admires it as they go into the office.  John meets them at the door and acknowledges Joe looking at the Lexus and mentions he has just leased it a few weeks ago.  Joe is impressed.

John, takes all their information and runs the numbers.  He looks them in the eye and delivers the bad news.  At their present rate they will not have enough to retire on.  They need to do something now!  Mary and Joe are a little embarassed about their situation, but they thought they were doing the right thing, paying off their mortgage and putting 8% of Joe’s salary in to the 401K.  Frankly, Mary knows because the wives talk about this, that they are better off than most of their friends.  So she is a little peeved at John’s rather cavalier attitude toward their retirement savings.  Then John throws in the kicker.  He can help them achieve success.  He starts to talk about asset allocation mentioning that they have all their money in one mutual fund.  He pulls out a prospectus that is for an international mutual fund that returned 28% last year.  Joe is impresses as he knows his fund returned a meager 3% last year.  Then Joe pulls out another prospectus for a Precious Metals Mutual Fund that returned 85% last year.  Joe is fully impressed now.  John suggests he take control of the $100,000 in the 401K to manage it.  He tells the couple to keep up the good work paying off the mortgage, but they need to put away more, much more if they want to retire comfortably.  John also suggests they need some life insurance so he suggests a $250,000 10 year term insurance which he says is dirt cheap now.  Joe and Mary look at each other with the same thought.  They are already pretty thrifty, but there goes the one night a week they eat out together and maybe Mary could work more hours after all the kids are old enough that they don’t need Mary to be there when they get home from school.  But, if that is what they need to do, then they will figure it out.

On the way home Joe is sold but Mary has some doubt about John.  She remembers reading “The Millionaire Next Door” in her book club a few years back, so she is not impressed with John’s car.  Her intuition also tells her that the returns that he showed them for those two funds were a little high, they must be risky she thought.  She thinks  they should talk to someone else.

Can you spot the mistakes?

1.  The assumption that leasing a nice car means that you know what you are doing financially is incorrect and probably the exact opposite.

2.  Mutual funds as a class underperform the market and specialized mutual funds have even more variability which means that those two mutual funds will probably underperform for many years to come to make up for their amazing performance last year.

3.  They use little leverage on their finances and are decreasing it by paying off their mortgage.

4. The majority of their net worth is home equity which gets a 0% rate of return.

5.  Suggesting to a frugal couple that they need to be more frugal is like throwing gasoline onto a fire.  They drive older cars, eat out only once a week and work 1 1/2 jobs between them while caring for two kids.  Life shouldn’t be this onerous for this couple.

My Way:

Move their 401K money to a discount brokerage account and buy $100,000 of Berkshire Hathaway B’s.  Warren Buffett’s returns 21% over 43 years and 18% over  the last 10 years.

Re-finance their home with a $250,000 mortgage now available at 5.75%.  This gives them $150,000 cash.

Take $25,000 and purchase a $200,000 duplex in Dallas, Texas that is cash  flow positive (See my Friend Jeff www.bawldguy.com for details)

Purchase a $450,000 equity index life insurance contract.  Fund it with $25,000 year for five payments.

Reduce the 401K amount to the 3% company match to cover the extra expense of the larger mortgage.

Place the $100,000 left over into a money market fund or high paying savings account to act as an emergency fund and reserve fund for the real estate.

As each year goes by make the $25,000 life insurance premium payment. 

Taxable income goes down as the mortgage interest goes up substantially and the real estate investment throws off tax advantages.

Let’s look down the road five years.  The real estate investment has a cash flow of +$3,000, +$3,000, +$4,000, +$5,000, +$6,000 as rent could be increased.  This $21,000 is held as reserves for deferred maintenance and is not counted for assets.  College aid was applied for the kids and this amount was not counted!

The insurance contract has a cash surrender value of $110,000 since the front loaded fee’s have been paid.  But this works as the couple’s emergency fund available to them with no tax consequences.  The big positive is that this is not counted toward income or assets for college aid.  So they have moved over $100,000 off the college aid books allowing the kids to qualify for more aid.

The Brokerage 401K is worth $228,776 with Warren Buffett continuing the 18% he got the last decade.

The duplex is worth $250,000 getting slightly less than 5% return. They have around $80,000 in equity.

Their home is worth $380,000 getting the same 5% return.  They have over $150,000 is equity.

Their taxes have gone down due to the mortgage interest deduction and the investment real estate.

Their passive income from the real estate is 500/month.

Their kids received large amounts of student aid for college.

They have a emergency fund/reserves over $130,000 so they sleep well at night.

The costs to do this was $5,000 for the refinance, $5,000 to buy the duplex, $12 to buy the stock, and the commission and fee’s for the insurance contract.

There are no ongoing fee’s (other than the insurance contract) payable to a financial planner.

No reduction in life style needed.  In fact as the couples net worth rose, they started to take a nice vacation once a year and Mary will stop working  as soon as the kids are out of college.

Old School V. My Way:  You make the choice!

PS  I used conservative numbers all the way through my way!

PSS  As usual this should not be construed as financial advice with respect to any particular stock or any general investment advice that might come under the auspice of the SEC.  It is only the ramblings of a derelect and a individual that does not have a license to issue stock or mutual fund or real estate advice.  Please see an “expert” for all tax issues.