Warren Ward Associates

Ten Years After

My Christmas present from my niece Deb was a book of recollections by various people who attended the 1969 Woodstock music festival. One recurring theme was that attendees had no idea what the event would eventually become. That was certainly true for me and my girlfriend (now wife). We went in order to hear her (then) favorite band but I have a much clearer memory of an outstanding performance by the British blues band whose name provides the title for today’s article.

A look back at an iconic occurrence like Woodstock or other historical event provides a chance to obtain insights that simply weren’t available as it unfolded. Ten years into the new millennium, I think it might be instructive to reflect on parts of the past decade. Perhaps we can learn something that could help us prepare for the future.

The year 2000 brought the end of the dot.com stock bubble. In the late 90’s, immense amounts of money were raised through Initial Public Offerings (IPOs), which allowed individuals to invest in new  tech companies. Unfortunately, that money was raised in support of a very few really good ideas. Among those enterprises which burned through their cash and disappeared were Webvan, Boo and Etoys (all ending in .com). Some of the successful companies include Google, Amazon and The Learning Company. Since many millions of dollars were lost, it seems that predicting the winners wasn’t as easy as people hoped. Because of the long odds against making money in IPOs, we continue to suggest that our clients avoid them.

Of course, 2001 was the year of the World Trade Center disaster, something so out of the realm of possibility that no one could have planned for it. Yet, the reason most of us maintain at least some insurance coverage is that we find it prudent to anticipate that something might go wrong, without having to know exactly what that might turn out to be. Fire, flood or terrorist attack, insurance is almost always available and we believe regular insurance reviews are simply part of good planning.

In 2001, actual US government spending was about $1.9 trillion. For 2011, it is expected to be about $3.8 trillion. This doubling is due, at least in part, to the cost of the beefed-up Department of Homeland Security and the various wars in which we are engaged. Such spending requires that the US borrow money, building up deficits. These have been with us for years but few elected officials are courageous enough to face them and make the difficult decisions required to reduce or end them. Since most politicians seem primarily interested in getting reelected, I doubt if deficit spending will be dealt with anytime soon.

I have seen recent articles which declare the first ten years of the 00’s to be the “lost decade” for investors since the S&P 500 ended 2009 about where it began 2000. That has certainly made things difficult for many investors, although some of our asset management clients have done better. We recently completed a review for the couple who have been our clients longest. They actually did quite well from 2001 (when we began managing their money) through 2009. Although we are not allowed to advertise our results, they prove, at least to us, that asset allocation does its job of providing a hedge against the unexpected.

Past Secretary of Defense Donald Rumsfeld and I have little in common but I do appreciate his bringing a little known concept from game theory (one of my interests) into the public eye. At a press conference in 2002, he made this statement: “ ...There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. These are things we do not know we don’t know.” This is a slightly obscure but extremely valuable insight, one which is critical to the financial planning process. Whether planning for peoples’ lives or structuring their investment accounts, we always consider the “known unknowns” such as interest rate changes and adjustments in relative currency values. We know those are going to change and try to plan for them, even though we have no way to know just how they will change. To do a truly effective job for our clients, we must also attempt to plan for the “unknown unknowns”, those unpredictable events like floods, earthquakes, terrorist incidents and recessions. It is our intention to be able to report to our clients in 2020 that we have helped them successfully navigate past both of these types of risk.

Money for Nothing

My articles tend to be at least somewhat topical, often attempting to answer a question from the headlines or being asked by our clients. Today’s deals with interest rates, as have several in the past. I am readdressing the topic because current rates may tempt investors to take risks they don’t understand in order to earn a little extra income.

The title of this article was borrowed from a Mark Knopfler song describing that fact that he loves playing music so much that he feels as if he’s able to make his living doing something he’d willingly do free. That’s a very rare situation indeed. Most individuals and institutions earn their income for doing at least some amount of work. Considering risk and reward instead of work and pay, people can be thought of as earning their money by accepting a range of risks. Quite appropriately, the safest investments pay the lowest rates. Towards the end of 2009, treasury bills moved to a negative interest rate, as buyers overwhelmed sellers and paid more than face value to get those extremely safe bonds into their portfolios by year-end.

With rates sitting near historical lows, we are again hearing about investment strategies that promise to deliver above-market rates of return while assuming little or no additional risk. Of course, this is virtually impossible to achieve. We only need to look 18 months into the past at the government agency-backed bonds which were popularly deemed failsafe, at least until banks began to close.

In my 2006 article The Quest for Yield, I described some interest-paying investments I thought made sense for that time and others that didn’t. Toward the end of that article, I pointed out that our recommendations change over time, as well as being tailored to each individual client’s situation. As an update to those comments, here are some thoughts for your consideration.

We do not recommend these investments for anyone today:

Fixed annuities   These CD-like investments are sold by insurance agents. Typically, the first year rate is guaranteed (and usually enticing) but subsequent year’s rates often are not. Since there is usually a multi-year period during which a penalty for early withdrawal is in effect, we are not comfortable having future interest rates governed by a company’s generosity.

Bond mutual funds   Open-end bond funds have provided good performance over the past 18 months and we see many of them being sold to investors on that basis. Unfortunately, if the falling rates which helped past performance are replaced by rising rates, investors will face loss of principal value instead of experiencing growth. We would stay away.

Reverse Convertible Notes  These are another class of “manufactured” investments like the mortgage-backed bonds which got our economy into so much trouble in 2008. These are also extremely complex. While forecasting the income stream is fairly easy, determining the amount of principal which will be returned is quite difficult. Please avoid these too.

We believe these investments are currently worthy of consideration:

Dividend-paying stocks   Although stocks can certainly be risky and are always subject to fluctuation in value, over the long-term they have been a sound investment. In addition, they are the only investment of which we’re aware that offers the potential for a rising income stream. Like any stock investment, these must be chosen carefully but this can be a very rewarding approach.

Floating-rate funds   Each of these is backed by the loans which businesses take out to meet their day-to-day cash flow needs. Typically, these loans are very short term (almost always less than a year) and rates are readjusted at the end of each term. This makes them a reasonable choice should interest rates rise. We feel that whatever additional risk comes from investing in these smaller businesses is offset by the large number of companies in each portfolio and the higher rates they are charged.

There have been times, and probably will be again, when we recommend both annuities and bond mutual funds, although I doubt we’ll ever become comfortable with Reverse Convertibles. Likewise, the time may come when we don’t think dividend paying stocks or floating rate funds make sense. We always offer investing advice in the context of individual situations, considering the current economy. We don't believe there is any practical way to “set and forget” an investment portfolio.

Getting back to the author of today’s title, in addition to receiving “money for nothing”, Knopfler’s song goes on to extol the value of being famous when it comes to meeting women. He describes them as a side-benefit which accrues “for free”. As rock stars and sports figures are constantly re-learning, nothing in life is truly free, whether an improved social life or higher interest rates.

Beware of Greeks bearing...

The Dow Jones Industrial Average briefly fell below 10,000 in February of 2010. Most commentators blamed the drop on the potential default by the Greek government on its “sovereign debt”, i.e. its government bonds. A bit later, Germany (and more reluctantly, France) committed to help their economically weaker Euro-zone neighbor and global markets rebounded.

Higher interest rates are the price issuers pay for falling credit quality. Investors apparently assumed that any additional risk with Greece’s bonds was being compensated for through higher interest rates. This situation is quite similar to the credit bubble which caused the current US recession. In our case, unusually high rates of return were offered on what were described as investment grade bonds but in neither case did the rating agencies do a good job of assessing risk. Donald MacKenzie, Ph.D. from the University of Edinburgh has published an interesting paper in which he considers the recent credit crisis as a problem in Sociology. Here’s a chart excerpted from it (page 92 of PDF), comparing the anticipated bond default rates in the US mortgage financing market with the actual results. As you can see, the best estimate the agencies made was off by a factor of more than 10, the worst by a factor of over 300.

The rating agencies provided little or no warning of Greece’s credit problems although they did scurry to downgrade those bonds after the bad news came out. Speaking strictly for myself, I’d prefer that a rating agency be ahead of the curve, not behind it. However, these agencies are paid by the issuers of the bonds, so perhaps we shouldn’t be surprised that they tend to be a bit generous in their ratings.

In the fall of 2009, you could look anywhere in the financial press and find an article about the weakness of the dollar and the idea that it might lose its status as the world’s reserve currency. That concept ran counter to our thinking at Warren Ward Associates. We believe that currencies, just like market sectors, tend to move within ranges. With that in mind, it was our expectation that the dollar would strengthen again and that its position as the world’s favorite currency was never in serious jeopardy. Based on that premise, we oriented our clients’ portfolios to prepare for that outcome and were rewarded for doing so.

Did we anticipate the problems in the Greek bond market? No, we absolutely did not. However we did anticipate that something would happen and we find that most somethings can be hedged against.

According to Virgil’s Aeneid, a huge hollow horse was employed by the Greeks to sneak 30 soldiers into the city of Troy. Perhaps its best known line, uttered when the horse was discovered outside the city’s gates, is: “I fear Greeks, even those bearing gifts”. Lower quality bonds can be a gift when an investor understands the underlying credit situation and is fairly compensated for assuming the additional risk. However, being blindsided by a wholesale misreading of the risks or an issuer who simply does not tell the truth, affirms the need for diversification regardless of the asset category.

Pollywogs and Shellbacks

As far back as the early 1800’s, sailors who crossed the equator for the first time were “initiated into the court of King Neptune” via a ceremony that typically involved at least one of head-shaving, fish-kissing and the eating of raw eggs. It seems like a lot of trouble to go to, celebrating the crossing of a “line” which separates one bit of ocean from an identical one a few feet away. Fortunately, the hazing aspect of the ritual has generally fallen out of favor in recent times, although equatorial crossings continue to be acknowledged in most navies and by many cruise lines.

We also have what are basically meaningless “lines” in the investment world. Recent headlines about the Dow Jones Industrial Average crossing through 10,000 (either way) make it seem as if either those thirty stocks or the number ten thousand have unusual significance.

When Charles Dow created the index in 1896, he felt that charting the fortunes of twelve large industrial companies might be an appropriate way to gauge the overall health of an economy just coming into its own. Later, various editors of the publications he founded made substitutions and additions to the list. It is now comprised of thirty large companies, some clearly industrial (Caterpillar) and others not so much (Walt Disney). Since first moving above the 10,000 mark in March of 1999, the DJIA has re-crossed it a couple of dozen times as the markets lost and gained strength. In early 2010, after flirting with 10,000 for a couple of days, the average dropped back through on February 4th, earning headlines across the country. It moved above 10,000 again the very next day only to close below it again the next. By the time you read this, it will likely have settled comfortably on one side of 10,000 or the other.

Although I am a professional money manager, it’s quite rare when the Dow’s day-to-day movements are of particular interest to me, even those relating to a line on a chart. With many thousands of stocks and dozens of financial indicators to choose from, the widely reported movement of a group of 30 stocks seems unlikely to be a source of significant information.

One of the most challenging aspects of investing is knowing what data may safely be “filtered-out”. Media pundits, both print and electronic, often stress the importance of line crossings and almost always have an explanation for such movements. Absent a world-changing event such as 9-11, Warren Ward Associates believes that it’s practically impossible to assign a particular reason to any specific market movement. However, we do believe that markets tend to move in broad cycles, so regression analysis is at the heart of our investment approach. We attempt to invest more in those sectors which have not done as well as we expected and reduce investments in those which seem to have done better. This asset allocation tends to protect our clients from the worst of market corrections while allowing them to ride along in better markets. One way to look at our approach is that we make money for our clients by not losing it to significant market pull backs, whatever their cause.

People who have not previously crossed the equator are called pollywogs, graduating to shellback status following the initiation ceremony. No such clear definition exists in the world of financial planning and investments. Virtually anyone is allowed to use the words “financial planner” or “financial advisor” to describe themselves. Obviously, we believe that individuals earning the CFA (for investment analysis) or CFP (for an individualized approach) should be among those you consider, should you ever decide to cede day-to-day control of your own investments.

Lessons In Solitaire and Life

A few years ago, I wrote an article titled Lessons in Poker and Life. Its basic theme was that people should never bet more than they can afford to lose, whether in the context of investing (especially in “sure things”) or while playing cards.

Re-reading that article got me thinking about the computer version of Solitaire which has been part of Windows since 1990. It was originally included in order to help people become comfortable using a mouse to open programs, save files, etc.

Now, after fifteen years of mousing, I use the game to allow my mind a chance to freewheel while I’m writing an article or thinking about a problem. Even considering the casual circumstances under which I play, I prefer to win rather than lose, so I’ve worked out some strategies which seem to improve my scores. Regular readers may not be surprised that I think some of them may also have application to financial planning, so I’ll be commenting on both.

In addition to sharing my strategies, I’d also like use this article to thank the father of a grade school friend for his still-heeded advice. The Wards were not great game players but Glen Grosbach helped me understand that, if I wanted to win, I should devise and follow a strategy instead of just playing randomly.

Here then, are some strategies to consider for Solitaire and life:

• Play in order, removing cards from the lower stacks on the left in order to open spaces for kings as soon as possible.

Planning works best when steps are identified and prioritized, so issues may be addressed as efficiently as possible.

• Don't move too quickly. A move doesn’t have to be taken just because it’s available. For example, waiting might reveal a later play from the deck which would uncover an ace, allowing you to start a new foundation.

Waiting to make a decision allows more time to gather and consider information, hopefully leading to a better result. Of course, sometimes you must act but don’t be overly hasty; contemplation may reveal a better option.

• Pay attention. There might be a move you’re overlooking.

Our lives are so busy that it’s tempting to simply assume that everything’s OK. Be sure to pause every once in a while to see if there’s an option which might have been overlooked. Even the most thorough plan should be subject to modification after time but especially if the situation changes.

• Know the rules. Did you know that pulling a card down from the deck before placing it on a foundation gives you additional points?

Knowing the rules is much more important in life than in a game, especially in the case of personal finances. Be sure you understand exactly what’s involved before taking a roll-over, cashing-out an insurance policy or obtaining a mortgage.

• Sometimes it makes sense to take a step backwards. Windows Solitaire allows you to pull a card back into the game from one of the foundations. That might allow you play a card from the deck, uncovering just the card you need to win.

Many of life’s decisions are irrevocable but it never hurts to review things to see if an option remains. For example, did you know it’s possible to begin taking Social Security payments, then stop and get a chance to do so again with a higher payment? The rules are tricky but even situations which appear to be final can sometimes be modified, either through negotiation or careful attention to the rules.

That’s pretty much everything I know about playing Solitaire but you may be sure Warren Ward Associates has additional resources related to investments and financial planning. We are always glad to answer questions and look forward to helping our clients and friends.