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Wednesday, March 21, 2012

Individual Investing ... Stocks, Bonds and Cash ... A Contrarian's Approach

While working, people planning for their retirement years traditionally are encouraged to buy a blend of stocks and bonds, aka a balanced fund, to assure sufficient funds upon reaching retirement.

The standard mix is 60% stocks and 40% bonds, or something similar thereto. As they approach retirement, these same people are encouraged to own a higher percentage of bonds and a lower percentage of stocks.

Even though this investing methodology is pretty much universally recommended by financial advisors today, I think that's bad advice.

And what about those people who have already reached retirement age and have money to invest, including perhaps money in a 401(k) or IRA plan? What should their investment mix be?

As with all good questions, the correct answer is--that depends. In other words, how many assets does the person have, how much debt, how knowledgeable is the person about investing, and how much trouble does he have sleeping at night?

With those caveats, let's try to help the person, whatever age he may be, to understand the need for planning and knowing and acting.

Undoubtedly you have never heard of the acronym PEGIT. I know that because I made it up-- all by myself.

Using PEGIT helps me when I attempt to simplify something which otherwise can be quite complex. So here goes.

P stands for planning, E for education, G for gifting, I for investing and T for taxes.

The biggest benefit from planning (P) isn't the plan but the planning process itself. It should be iterative and kept up to date. After all, things change during a lifetime.

And the planning process should begin prior to graduation from high school. It should end only when we're no longer able to do the mental work. In other words, start early and keep going throughout life.

But what if you're over 18 and less than 90, but haven't begun the habit of planning? Start now.

Educating (E) ourselves about financial affairs is essential. The more money we earn, the more "experts" will want to "help" us invest or spend that money. Self help is preceded by knowledge.

Get to know at least the basics about this financial stuff. You'll be glad you did. Besides, investing is both interesting and fulfilling.

Gifting (G) means how much we're able to, as well as the amount we want to, give to others, whether that be cash, the church, tuition, a car, investment funds, charity or a bequest at the end of the road.

Investing (I) decisions are something we need to take very seriously throughout life. Getting an education is investing, buying a house is investing, taking out a student loan is investing, setting aside funds for retirement is investing and so forth.

Taxation (T) is something to be avoided but not evaded. We should pay what we owe and no more than that. Unless, of course, we wish to make a "gift" to government, which we always have the right to do.

Let's review I today.

With respect to investing, most financial advisors are quick to tell us to invest in a mix of stocks and bonds. They also advise that cash is trash when interest rates are low, as is the case today.

Let's focus on a 65 year old with 25 years to live. He has $100 and plans to spend $4 of that $100 annually. And if possible, he'd like to leave all, or at least most, of that $100 in inflation adjusted terms to his heirs when his time is up. That's his plan.

Here's what I would do financially if it were me with respect to the mix between bonds, stocks and cash.

I'd invest zero in bonds. If rates stay low, bonds won't earn enough to provide any real inflation adjusted income over time. If rates rise, bonds will become worth even less than they are today. Either way, with bonds I lose if rates stay the same or rise.

Let's keep enough cash to assure ourselves that we can pay $4 annually from the $100 starting point. And a sufficient amount to sleep well at night, too. Of course, that brings us back to E. The more we know about investing and markets, the better we'll sleep.

For now we'll keep $8 in cash or two years' worth of spending. That leaves $92 for stocks.

{Here's a similar but more belt-and-suspenders investing and spending approach. If you're a light sleeper, then keep between $20 and $30 in cash, representing about 5 to 7.5 years of spending needs.

With the $80 or $70 invested in stocks, you should realize ~$2.40 or ~$2.10 in dividends annually, which in turn can be used to replenish part of the cash used each year. At some point in the not distant future, the $80 or $70 will grow back to the original total amount of $100. Then, or even before then, you can always rack up and shoot over, as you hopefully will have already been doing. The big and basic idea is to avoid bonds and the outsized risks associated therewith.}

Back to the main story. Stocks and some cash are the best approach over time. Not bonds.

We'll invest by buying stocks in blue chip companies that have a solid track record of paying dividends and increasing those dividend payments over time. Companies like Pfizer, Merck, McDonald's, Wal-Mart, GE, Boeing, Microsoft, Intel, Pepsi, Coke, Whirlpool, Exxon, JP Morgan and Wells Fargo are a few that come to mind.

We'll plan to earn cash dividends of 3%-4% on those initial investments. Thus, the $92 will initially pay us more than $3 annually. We'll also plan for that annual amount of dividends to grow to at least $4 within eight years.

Hence, we'll use $1 from the $8 original cash stash and $3 from the dividends to pay ourselves at least $4 in each of the first eight years. Thereafter we'll have dividends sufficient to meet our cash needs.

Even more important, our $92 will likely have grown to more than $150 and perhaps as much as doubled by then. And we'll thereby have some considerable remaining assets left at the end of our line, whenever that may be.

But why no bonds? Because bonds become less valuable as rates rise. And rates will be higher ten years from now than they are today. They'll even be higher in one year.

Here's an example. If we buy a bond which pays 2% with our $100, then we receive $2 annually. If rates increase to a more normal 4% within a few short years, a bond purchased then for $50 would yield that same $2. What was worth $100 now becomes worth only $50.

That's what happens when interest rates rise over time. And it's just the opposite of what happened the past 30 years. Thus, since rates won't be lower ten years from now, I'd rather stay in cash and take advantage of the increase in rates over the coming years.

Summing Up

Here's the point of this common sense contrarian approach. Bonds will be riskier than stocks during the coming decades. And at best bond returns will have trouble matching inflation. Cash can do that, so why bother with bonds? They're too risky for me.

Besides, there's no real reward to be had by owning bonds because in a period of increasing interest rates, holding cash is preferable to bonds.

Rates will be rising in the future, even though during the past 30 years they declined. As a result, today too many (almost all) investment advisors are living in that conventional but dangerous past world of investing advice.

In 1980 rates were as high as 15% and inflation was high as well. Now they're as low as 3% and inflation is low, too. That's quite a drop. So it's obvious that in the future, rates will be higher than today, barring deflation.

And even if we have deflation ahead of us, which I don't expect, cash will be king.

But if we have higher inflation, which I do expect, at least cash will keep its purchasing power compared to bonds.

This may seem confusing. That's why E is so important to each of us as we pursue PEGIT continuously. And it's an 18 to 90 exercise, so there's plenty of time to get that E, whenever we begin.

We'll keep trying to achieve clarity on stocks, bonds and cash in future posts.

Getting to a basic level of knowledge of I is well worth the effort, especially since the financial 'experts' are advising just the opposite approach these days.

As the old saying foes, with all thy getting, get understanding.

Thanks. Bob.

2 comments:

  1. A very good post indeed. It's a shame about some of the responses. I have to admit that the way how tides work is just fascinating. Basically the same cycle is repeated over and over

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  2. There are lots of options to consider, one of which is bonds. Each investor has to consider those options and the potential risks involved, because all investments do come with some risks. You can learn details about bonds at http://www.mutualfundstore.com/bonds. If that's the way you decide to go, then good luck! I think we'll all need a bit of that.

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