Thursday, January 31, 2008

Retirement Planning and the Spoiler

Retirement Planning and the Spoiler

Some people just itch to ruin the ending. Perhaps they are giving instructions for video game play “Look for snake juice”, “Get magic glow”, or my favorite “Bring the Princess out of the Poor Quarter” give new players an unfair advantage and frustrated players the courage to brave on. Some folks stick to sporting events focusing on saved stuff on your Tivo, often blurting out scores before you have had a chance to stop them.

Currently the blog, Real Clear Politics is calling Texas Congressman Ron Paul the spoiler in the Republican Presidential race. Most of you know Ralph Nader as the classic Democratic spoiler, garnishing votes that reside on the extreme left.

The most common scene of the spoil is movies (“Chigurh leaves the house and makes sure there’s no blood on his boots”). Movie reviewers walk a fine line, hoping to give you enough information about the film that will serve to make the reader a more educated filmgoer and do so by expressing their opinion about the work. Good or bad, a reviewer never tries to spoil the ending but as Nathan Lee, film critic for the Village Voice, readers should focus on specifics.

He writes, "It’s silly to insist that the critic never spoil. In practice, spoilers can be irresponsible, motivated by laziness, vindictiveness or snark, but if the ambition to inform the reader outweighs the need to protect them, then spoilers are warranted on principle. The integrity of the critic doesn’t revolve around whether or not they’re willing to spoil, but why they chose to do so.

One mustn't criticize other people on grounds where he can't stand perpendicular himself.

- Mark Twain “A Connecticut Yankee in King Arthur's Court”

"Our obsession with spoilers has a diminishing effect, reducing popular criticism to a kind of glorified consumer reporting and the audience to babies. People outraged by spoilers should avoid all reviews before going to the movies or reading the book they’ve waited so long for, because the fact is all criticism spoils, no matter how scrupulous."

But retirement planning is the true realm of the spoiler and I probably take as much pleasure in it as Mr. Lee. It is why I do it and like every good investment book, the when and how are what makes most people make the purchase.

So far the conversation has concerned itself with the numerous roadblocks in the way of an easy retirement plan. From kids to parents to your own disposition, to the way the industry courts you and leads you on to the role the government has in maintaining economic growth. Collecting taxes – enough to finance what they do without pushing any debt burden onto future generations – who, may just rebel if they find out how much of their tax dollars is funding a portion of our retirement years and we may still have to work to the composition of that defined contribution plan.

The spoiler: To get where you want to go, you need to start early. If you have not, you will need to account for those missteps and false starts and if you are close to the end of the road, you will need to account for not only when you began the journey but also how far you have come.

Most of us have come a nice distance but worry about how much road is still ahead. At this point in the book, we examine the only thing that will make your portfolio perform better than it has and at the same time, could injure what you have accomplished. It is the risk and reward. It is volatility.

Wednesday, January 30, 2008

Retirement Planning and Observation

You will always be able to find two views. One comes from industry insiders who will be willing to signal the end of an era and the glorious advent of another. The other comes from the observer’s point of view, which is never given a voice, or more often than not, simply misunderstood.

Percy Hutchison, the late poetry editor of The New York Times once offered the following criticism: ““From one end of the book to the other there is not an idea that can vitally affect the mind; there is not a word that can arouse emotion. Hence, unpleasant as it is to record such a conclusion, the very remarkable work of Wallace Stevens cannot endure.” The comment was made about Mr. Stevens book Harmonium and was added because of a quote that was used in the book to illustrate a point.

Mr. Stevens suggested that, “accuracy of observation is the equivalent of accuracy of thinking.” And while Mr. Hutchison described poetry as “"stunts" in which rhythms, vowels and consonants were substituted for musical notes”, his work has endured. But that is not why he was given quote space in the book.

Stevens is not often the poet that comes to mind when greatness is discussed. And I’ll admit, he is not among my favorites. But the following piece, ripped from the heart of his work titled “Of Modern Poetry” offers a suggestion about what we hear and how we should think about the message that is being delivered.

“And, like an insatiable actor, slowly and
With meditation, speak words that in the ear,
In the delicatest ear of the mind, repeat,
Exactly, that which it wants to hear, at the sound
Of which, an invisible audience listens”

I offer harsh criticism for those who offer opinions about why pension plans (defined benefit plans) have fallen to the wayside in favor of the more corporate friendly defined contribution plan. I don’t believe that the majority of people who participate in them – and this may be a direct reflection on those that still do not – relish in the thought that making the kinds of decisions necessary so far in advance of actually having to use them.

And when folks like John Brennan, Vanguard chairman and CEO suggest that the “era of defined benefit plans is drawing to a close”, I wince. The original idea behind defined benefit plans was to encourage loyalty. And the fact that corporations rarely if ever, nurture the kind of commitment from their employees that pension plans once offered has made it easier to shift the burden of retirement to the worker.

That doesn’t make it better. It simply makes one believe that what is directly in front of you, what is presented to you as the best option, is not always as it seems.

J. Hillis Miller writes of Steven’s work Sunday Morning: “If the natural activity of the mind is to make unreal representations, these are still representations of the material world. So, in "Sunday Morning," the lady's experience of the dissolution of the gods leaves her living in a world of exquisite particulars, the physical realities of the new world: "Deer walk upon our mountains, and the quail / Whistle about us their spontaneous cries; / Sweet berries ripen in the wilderness."

And as much as I am loath to admit it, the defined contribution plan is here to stay, a physical reality of the new world.

Friday, January 25, 2008

Retirement Planning and the Social Science of C.W. Mills

Discussing C. Wright Mills is often controversial, always enlightening and somehow necessary. Including a quote from this distinguished social scientist was a risk worth taking. Even discussing social science with retirement planning can be a stroll through a minefield.

Mills, who was born in Texas (1916-1962), delved into topics that many in his field of thought considered out-of-bounds. He was gifted at separating smaller personal troubles from the much larger and more prominent public issues of his day.

Consider this: “When, in a city of 100,000, only one man is unemployed, that is his personal trouble, and for its relief we properly look to the character of the man, his skills, and his immediate opportunities. But when in a nation of 50 million employees, 15 million men are unemployed, that is an issue, and we may not hope to find its solution within the range of opportunities open to any one individual. (Mills 1959: 9)”

He was a radical. He interviewed Castro. He denounced American Imperialism. He attacked intellectuals for knowing enough to change the course of history but refusing to do so. He believed that knowledge could change the course of society and much of what he wrote (beautifully), read with great passion and has been accused of criticizing the same traits he exhibited. According to the Encyclopedia for Informal Education, “He was said to disguise his faults by admitting to even worse faults.”

He was, as his biographer Irving Louis Horowitz wrote in his profile of Mills titled American Utopian, “However much those who knew him firsthand differed about the quality of his work, they were unanimous about his personality.”

Mills did not address the topic of retirement planning specifically but instead sought to have a more open, well-discussed opportunity to choose. That is not present in our current retirement system.

Pension were, at there founding, a way of keeping workers with skill when their human capital, the cost of what they had to offer a fledgling enterprise by rewarding them in their later years with a degree of financial satisfaction. Focus on growing the business and we will focus on taking care of you in you golden years.

While that did not present choice, at least as we often define it, it did allow us to develop relationships with our families, grow intellectually if we so chose to do and give back to society when we had the opportunity. With the advent of self-directed retirements, we were given choices – that few understood and many still do not – and told that by doing so, our participation in the defined contribution plans would allow us to have much richer lives.

But that is not the way it worked out. Mills, who lived far in advance of this change in retirement thinking and worker contribution, would have been appalled. His many confrontations with the power of stratification in American society over the life of the individual would have gained new strength. His focus on the distinct levels of difference between who runs the country and who provides the labor would have risen to a boil. He was confrontational and by examining the stress of workers within the labor movement, in the situation of the middle class, in the elite strata of society, within the discipline or sociology or in his own personal life--there was a search for some path to achieve "the all-around growth of every member of society."

The following four notes come from Mills’ book “The Power Elite” published by Oxford Press in 1956. Keep in mind several things as you read them. One, even though you are permitted to choose, there are boundaries already placed around you retirement choices and they were not open for discussion. Secondly, the cost of those choices was not democratically considered with the input of the largest group – the actual investor – who is almost completely ignored in the process of picking which plan administrator, is best for the whole. You have to accept the plans offered by your employer – if they offer any at all, limit your contributions based on legislation and exercise the so-called portability of many plans that often comes without good instruction on how to best create an alternative plan when the worker leaves her or his current employer.

Mills writes:

“I. In the democratic society of publics it was assumed, with John Locke, that the individual conscience was the ultimate seat of judgment and hence the final court of appeal. But this principle was challenged-as E. H. Carr has put it-when Rousseau 'for the first time thought in terms of the sovereignty of the whole people, and faced the issue of mass democracy.'

“II. In the democratic society of publics it was assumed that among the individuals who composed it there was a natural and peaceful harmony of interests. But this essentially conservative doctrine gave way to the Utilitarian doctrine that such a harmony of interests had first to be created by reform before it could work, and later to the Marxian doctrine of class struggle, which surely was then, and certainly is now, closer to reality than any assumed harmony of interests.

“III. In the democratic society of publics it was assumed that before public action would be taken, there would be rational discussion between individuals which would determine the action and that, accordingly, the public opinion that resulted would be the infallible voice of reason. But this has been challenged not only (1) by the assumed need for experts to decide delicate and intricate issues, but (2) by the discovery-as by Freud-of the irrationality of the man in the street, and (3) by the discovery- as by Marx-of the socially conditioned nature of what was once assumed to be autonomous reason.

“IV. In the democratic society of publics it was assumed that after determining what is true and right and just, the public would act accordingly or see that its representatives did so. In the long run, public opinion will not only be right, but public opinion will prevail. This assumption has been upset by the great gap now existing between the underlying population and those who make decisions in its name, decisions of enormous consequence which the public often does not even know are being made until well after the fact.”

Thursday, January 24, 2008

Retirement Planning and the Whaling Industry

I begin chapter 15 with a story of Nantucket. While for many, the first thing that comes to mind are those bawdy limericks, the village in Massachusetts was once the third largest city in the state behind Salem and Boston.

Whaling was an important source of income for the city and as the video below shows, allowed the world to see after dark. Whale oil was a superior product. The quest for the riches it would provide to those willing to take the risk was often paid for with the lives of the men (and sometimes women disguised as men) who boarded the ships. But when the hunt was successful, everyone was entitled to a lay.

A lay was a fraction of the proceeds of the catch. In Nantucket, the average whaler would receive 1/175 of the proceeds. The Merriam-Webster Dictionary, in an entry dated 1590, describes the nouns as “terms of sale or employment : price b: share of profit (as on a whaling voyage) paid in lieu of wages”.

Elmo P. Hohman wrote an article for the “The Quarterly Journal of Economics” (Vol. 40, No. 4 Aug., 1926) titled “Wages, Risk, and Profits in the Whaling Industry” where he described the method of payment as singular to the whaling industry.

He wrote: “The whaleman was not paid by the day, week or month, nor was he allowed a certain sum for every barrel of oil or for every pound of bone captured. Instead, his earning consisted of a specified fraction share known as a lay, of the total net proceeds of a voyage.” The amount was determined by the skill and efficiency of the person hired.

This sort of partnership is at the heart of your retirement plan. Because of the structure of many defined contribution plans (your 401(k) is a defined contribution plan – you are responsible for making the deposits into the account for your future rather than receiving a set amount from a pension – a defined benefit plan). You are in it as a group, using a single captain – also known as, at least for the sake of this example, the mutual fund manager running your investment) to steer you towards profitability. In turn, each of the participants it entitled to his or her share depending on the amount they have invested.

This so-called partnership in the enterprise, according to John Randolph, who wrote The Story of the New England Whalers in 1909, this also extended to anyone involved in the ship including the boatbuilders, the blacksmiths and the coopers. Each man was working for himself and hoping that the captain was able to give them an adequate return for their efforts.

This may have been the first instance where “past performance, while not a guarantee of future success” was used as a guide to determine which vessel was the best one to sign on to.

I write in the book that like investing, “the seas can get rough, the catch can be nimble and sometimes scarce and worst of all, the world can be awfully unpredictable.”

Tuesday, January 22, 2008

Retirement Planning and the Rebalance

(Author’s note: This topic will be discussed at length in the book I am currently working on, Mutual Funds for the Utterly Confused, scheduled for a January 2009 publication. You can look for updates on the book at Mutual Funds – Explained as it is written and edited.)

There are some really smart people out there asking some really intelligent questions. Jie (Jay) Cai is one of them. He is currently Assistant Professor at Drexel University in the Department of Finance at the LeBow College of Business in Philadelphia, Pennsylvania. The work he does, while often academic, touches on some of the thoughts that the average investor might have in the course of making decisions about whether to invest in this fund or that one.

The subject of rebalancing comes up often. As investors age, they are often advised to rebalance their individual portfolios to avoid unnecessary risk or exposure for a market that might be too volatile – a suggestion seems better suited for another era. If the argument for retirement savings is based on the fact, as we discuss in the book, that we have not saved enough, then why are we acting as if we did and rebalancing our portfolios.

Mr. Cai along with another very bright fellow, Todd Houge (The University of Iowa, Henry B. Tippie College of Business, Department of Finance) took a long look at the effects of rebalancing inside an index. What they discovered might be considered enlightening.

Before we move on too far, just a brief reminder of what an index does. It is meant to extract a certain group of stocks from the market because of some type of criteria. The S&P 500, an index that is managed by the Standard and Poors Company, keeps track of the largest 500 companies based on market capitalization (or worth – shares outstanding multiplied by the price of those shares). Numerous companies do this to help investor get an idea of how the market is performing based upon just such a grouping. Only the Dow Jones Industrial Average is price-weighted.

Cai and Houge focused their efforts on the index most commonly used to track smaller sized companies, the Russell 2000. Unlike the S&P 500, which actually has 500 companies in its index and among them, the best performing rarely get removed; a small-cap index does not carry the whole of the small-cap universe. They simply can’t.

The reason is simple. Many of the companies in this type of index are too small, rarely traded and considered illiquid. If the Russell 2000 suddenly shifted its balance, all of the funds that track that index would need to purchase the new shares of the latest addition while selling the shares of the latest deletion. This could have not only a negative effect on the share price, but would, in some cases punish the funds who need to buy those companies but are unable to find an adequate amount of shares in the marketplace.

But suppose you didn’t sell the shares of the companies kicked to the proverbial curb. According to the two men, “a value-weighted portfolio of index deletions return an average of 1.52% per month compared to only 0.87% for non-new issue index additions.” This continues for the next five years although the gap does narrow somewhat.

More so in the next book than this one, I talk about how and why actively managed mutual funds choose a certain index. Some are actually trying to mimic the index while some are trading the same companies held within the index. It would be hardly fair to compare a small-cap growth fund with the largest names on Wall Street.

Here’s the problem. Index funds have their place in a retirement portfolio and, it is not inside your retirement account. (Buy the book to find out why. If you already own the book, you know why.) Actively managed funds that look to compare themselves to an index, do so to attract investors to their performance. Trouble is, too many actively managed funds do not practice a buy and hold strategy.

What Cai and Houge discovered suggests that if fund managers do try and mimic an index, they may be leaving money on the table so to speak. If they continued to hold the deleted stocks from the index, they would do better than if they had tried to follow the index too closely.

And how can you follow the Russell 2000 too closely. The index, according to the authors of the paper changes on a certain day each year and unlike many of the other indexes is not based on some “proprietary selection process.” In choosing the Russell 2000 to track, they stumbled onto an index that changes shape often and sometimes in a huge way.

“Russell replaces an average of 457 firms or nearly 23% of the index holdings each year. The annual turnover ranges,” they wrote “from a low of 309 companies in 1980 to a high of 690 companies in 2000. Since delisted securities are not replaced between reconstitution dates, the number of additions always exceeds the number of deletions.”

The person focused on retirement planning can draw two conclusions from this. First, not all indexes are created equal, necessarily do as you would suspect and might be more active than you would imagine.

The second is much simpler. Indexes often bill themselves as safe havens for investors and some might be safer than others, but the performance numbers they use in their sale material might not be as good as an actively managed fund that acts passively. Turnover may become the key statistic in determining the overall long-term strength of a mutual fund.

You can read the full paper, titled “Index Rebalancing and Long-Term Portfolio Performance” here or download the PDF

Saturday, January 19, 2008

Retirement Planning and Déjà Vu

When I mention the word déjà vu at the beginning of Part Four: The Investment, I, like many people who have been surveyed about the event recall something pleasant, a sense of having already seen – which is what the French word translates into, a dream. Most people think nothing of it, but that wasn’t always so.

There was time in the not-so-distant past when such activity was associated with front lobe epilepsy and relegated to the world of the paranormal. Déjà vu was said to occur right before a patient would seize so you can imagine how it was easy is was for early researchers to make the association. Although we know much more about what goes on the brain than they did in the early 1800’s, the exact cause of why it happens has not been fully explained.

French scientist Emile Boirac, is credited with first coining the word déjà vu to describe the event even though literature has made numerous attempts. St. Augustine, even though he wrote about it in the early fifth century, named it "falsae memoriae" and further citing the Pythagoreans as observers a thousand years prior. They believed it was the transmigration of souls.

Sir Walter Scott, Proust and Tolstoy noted it with Dickens (in David Copperfield: “We have all some experience of a feeling, that comes over us occasionally, of what we are saying and doing having been said and done before, in a remote time – of our having been surrounded, dim ages ago, by the same faces, objects, and circumstances – of our knowing perfectly what will be said next, as if we suddenly remember it!") introducing a form of it called déjà vécu.

Theories, as they often do, seeking to explain why it happens run the gamut from revisited memories implanted on the brain at birth to the sufferers being most likely to be strongly political or even religious zealots.

Travel may have an influence on the memory, giving the brain too much information at once and randomly filing away those memories for some time in the future, often when you least expect it. The brain, wired much the way a computer’s hard drive is, stores everything, dreams, good or bad, pleasant or anxious, memories, short-term and long, and emotions, often transferred during sleep between two known physical areas: the hippocampus and amygdala.

Emile Boirac was a French psychological researcher and president of the University of Genoble and Dijon University. Not only was Boirac credited with the naming of déjà vu, he also helped define ESP. His long out-of-print book L’Avenir des Sciences Psychiques explains how it all works, in French and even makes a stab at explaining clairvoyance, magnetism and spiritualism. You can read it here

Arthur Funkhouser broke Déjà vu into three different variations, déjà vécu (through sight), déjà visté (via some precognitive dream), and déjà senti (scent, taste or a certain feeling).

In the book however, these memory triggers, whatever they may actually be can be used to help you with retirement planning.

Retirement planning actually requires you to look in many different directions at once. You need to take into consideration all that has happened, all that could occur in the near future and make some educated decision about how it will all turn out in the future. No easy task for most of us.

What this boils down to is all about location. With all of those forces at play, you need to know exactly where you stand. You cannot change what has happened. But the next step should take into account where you have been. And unlike all of those disclaimers that accompany investment opportunities – “past performance is no guarantee of future results”, everything you did will determine where you will end up.

We will always be haunted by the investment choices we make but our past performance should make us more confident –even if you haven’t even begun to save enough for retirement – that the future will be much better.

Friday, January 18, 2008

Retirement Planning and Control Theory

Control theory, as it applies to math reads like this: The mathematical study of how to manipulate the parameters affecting the behavior of a system to produce the desired or optimal outcome. As it applies to you and me, it means getting the most out of what we have to work with.

In math, the calculations involved in understanding control theory, as Eduardo D. Sontag suggested in his book “Mathematical Control Theory: Deterministic Finite Dimensional Systems” is “geared toward an audience of mathematically mature undergraduate and graduate students”. Mr. Sontag is a professor at Rutgers University.

In our quest to plan of retirement, some of the principles used to determine control theory are also necessary for what we are attempting to do. Every retirement plan should seek to have optimal control, be subject to dynamic feedback, and be observable and stable.

I mention Orville and Wilbur Wright in the book with good reason. These two early aviators, while often being credited with being the first ones to fly, actually were not. Instead, they sought to give flight some measure of control.

Otto Lilienthal and Octave Chanute were the ones who designed the wings that allowed flight to happen. The ability of these designs, giving man the opportunity to defy gravity and fly, or glide worked to stimulate the two brother’s imaginations. Lilienthal died during a flight when his craft crashed in 1896. Both men had been able to achieve short flights of thirty seconds.

Otto Lilienthal

Octave Chanute

But those short flights were usually straight and somewhat level. The Wright brothers believed that flight needed to be more than simply elevation over a period of time. And as history tells us, the control they developed for the wings (actually two sets of wings) allowed the pilot to do more than just sit there. The two sets of wings were necessary to allow for wing warping and an elevator in the front of the craft allowed the pilot to make adjustments for pitch, or angle. This created a three-axis control.

Retirement planning, especially for those of us who are just beyond our youth, becomes incredibly difficult. While there are numerous influences that seem to act as a roadblock, one of the greatest problems middle-aged investor face is diversity.

A good plan is the sum of its parts. One by one, you need to gain control over your life, which is why the book methodically looks at not only who you are but who around you is influencing your decisions. While every one of us hails from different socioeconomic places, differs in race and ethnicity, has perhaps chosen a different career, we are all on the same path.

Gaining control is essential in creating diversity in your investments. Without it, you may fall behind.

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Thursday, January 17, 2008

Retirement Planning and Dennis Connor

Numerous people turn to books written by the highly successful among us trying to mine some keys to what makes them what they are, try to understand how they achieved what they have succeeded in doing and perhaps, take what they might be able to tell us and apply it to our daily struggles. This does not always mean, that just because you read one winner’s book, that you can become a winner as well. Emulation is no easy feat.

I threw a quote from renowned skipper and yachtsman Dennis Conner in the book as we begin the section on investing as an “Early Bird”, a title I give to the investor just beginning her or his journey. Mr. Conner won the America’s Cup four times, first in 1974, then again in 1980, 1987 and finally in 1988.

Now this race, won by Americans – super wealthy Americans I might add – for 132 years in a row, captured the imagination of the average citizen because, unlike previous challenges, Dennis Conner insisted on year round training of his crew. Prior to this, the challenge, which was offered as a goodwill gesture among nations, was the playground of the super rich. That winning streak was the longest in sports history (which Conner had the distinction of breaking when he lost in 1983 to Alan Bond of Australia).

Connor’s approach to the sport was based on what he liken to consistency rather than flash or brilliance. This is the cornerstone of what retirement planning should be even if you are just beginning to save. There are some schools of thought that suggest all out risk taking for the most youthful investor trying to build a retirement portfolio. I disagree.

There is a psychological element to losing that not all beginning investors share. There is the chance that once an investor feels the sting of an investment downturn, they might not see it for the opportunity that it presents. More than one financial writer, myself included, has suggested that starting young (in their twenties) will provide over twice the investing opportunities than if they waited until they were in their thirties. Compounding provides some of that proof. The other is given to investors via the markets.

No one can predict what the markets will do from day-to-day and it becomes even more difficult as you look at a month-to-month or quarter-to-quarter snapshot. What does become clear though is how the chance of your investment increases over longer time spans. But not many twenty year olds can see very far into the future.

Connor did write a book about his successes called the Art of Winning. In it he outlines what could be considered no-brainer ideas that have been repeated numerous times over numerous books. He suggests that attitude (envisioning success) performance (seeking to learn from the best in your field), teamwork (surrounding yourself with competent people who share your goals), competition (nothing like a little challenge to help you on the road to self improvement), and goals (knowing what you are capable of and how you plan on getting there) all play a role in who wins and who does not.

Sunday, January 13, 2008

Retirement Planning and Risk, Uncertainty, and Profit

Frank Knight, as I mention in the book, was an economist, who seeking out a subject to do his thesis on, choose profit. In today’s terms, this topic would have little significance. We all know what it is and how it is created. In its simplest form, it is the difference of price between the cost of making a good and the price a consumer is willing to pay for it.

But when Knight decided on profit, economists had yet to understand the nature of the corporation fully or its impact on what was about to become one of the most significant changes in economics. (The other was the development of economics as an exact science, one that shared the field with mathematics and physics – in other words, it was about to become abstract.) What Knight found was a system that, prior to the turn of the century, was built on the notion that someone could make money, but only if the capitalist was willing to take the risk.

The system was set up like this: Men used money that they had, hired workers as they needed them and paid rent for the land or buildings they used. They did borrow money to begin these enterprises but that seed cash was the result of sacrificing the financial and often, the managerial side of the business to the banker or trading company. Those two entities became the dominant partner and often one that stifled the very businesses they were funding.

But things were changing. Competition was beginning to exert a force on the business model. His book Risk, Uncertainty, and Profit was published in 1921 and changed the way we looked at randomness and why it was important in making risk work.

Knight suggested that a businessman’s paycheck was not profit but merely a contract interest. He writes that, “Even Adam Smith and his immediate followers recognized that profits normally contain an element which is not interest on capital.” One of the first recognizable references to this change came from a French author J. B. Say. In his fourth edition of Traité he noted that income was once the best way to reward risk-taking but because of shift away from what the capitalist had previously accrued, the reward was now the province of the entrepreneur.

There have been numerous instances where the subject of risk requires a definition. I can’t begin to tell you how often I alone have tried to explain the topic, using a wide variety of analogies to explain that some risk is good because it increases the likelihood of reward. It is almost as if the topic is fluid and cannot be contained by simple words.

I have explained that risk needs to account for inflation, taxes and a whole variety of other distractions including the most problematic element – which I describe in my “Investing for the Utterly Confused” book as the mental maniac inside all of us. But it persists in what it can provide for the investor - and take away and yet, we are all seeking the right level, the perfect balance, and the prize that awaits the person who can.

Mr. Knight also pointed out a flaw in the current thinking about work. Trying to look at how men act rationally, he pointed out that it was “superficially natural to assume that a man will work more – i.e., work harder and more hours per day – for a higher wage than for a lower one.” Calling this assumption incorrect, suggesting instead, that they will in fact divide their time “in such a way as to earn more money, indeed, but to work fewer hours.”

Encouraging risk taking among the youngest members of our society is unfortunately difficult. You can explain the rule of 72 (Divide 72 by the annual interest rate you are receiving on a simple account, and you will be able to pinpoint when that money will double – 72 divided by 6 percent=12 years. Other cool rules at the bottom.).

Risk comes from deduction, which is the use of probabilities to guess how things will turn out for a specific investment or induction, hat is commonly referred to as behavior. You know deductions as forecasts, something all of us make at one time or another based on what we know that could influence what might happen.

Induction is backward looking. How something performed might offer an indication of how it might perform in the future.

Risk can be, more or less quantified, understood or even predicted with a certain degree of accuracy. But behavior is what drives uncertainty both in the marketplace and in your retirement planning portfolio. We second guess ourselves despite knowing the consequences of doing so – lack of savings, inadequate retirement goals, etc. and that creates more uncertainty than is needed.

As I write in the book: “Risk provides the investor with innumerable opportunities. Problem is, we rely on the past to point the way.”

Suppose you want to calculate the inflation rate and the effect of that rate on that dollar in your pocket. This is important for two reasons, saving too little will create a gap in what your money was actually worth and what is actually is. For instance, suppose the inflation rate was 3%. (This is higher than the current rate.)

Your money will be worth half as much 23 years from now. So that dollar you stuffed under the mattress would only be worth 50 cents. To determine the time for money's buying power to halve, we use the “Rule of 70” dividing 70 by the current inflation rate. See why that rate is so important to the Federal Reserve.

Fees play an important role in our financial decisions and it is important that we know how they impact our savings and investments. Fees usually come with investments such as mutual funds (which have both fees and expenses) and variable universal life insurance policies (loading and expense charges). To calculate the impact of those fees, divide 72 by the fee.

Simply divide the number 72 by the fee to determine when the policies value will be cut in half compared to an investment without fees.

You can use the “Rule of 72” provides a good approximation for annual compounding, and for compounding at typical rates but those approximations become less accurate at higher interest rates – above 10%.

Friday, January 11, 2008

Retirement Planning and the Tanabata

The use of this popular Japanese festival in the book is not of an accidental nature. The long-term belief throughout all my years writing about personal finance, investing and retirement planning as the ultimate goal, I have always looked at the world of finance with a less than trustful eye. It is sort of a “where there’s smoke, there must be fire” kind of thinking.

When the opportunity to create a profit is coupled with someone else’s inexperience, the money involved needs to be closely watched. In other words, if there is a financial product in close proximity to an individual who is just the slight bit confused, deception has more than ample chance to rear its ugly head.

Tanabata is a festival built on deception. With a little love story as an aside and the right amount of penance to be served, the story resonates with not only adults, but especially with children.

Tanabata is referred to as the Star Festival. It is traditionally held on July 7th and involves the placing of wish-filled notes on colorful strips of paper and hanging them on the trees. Then the children and a good deal of adults as well, pray for their wishes to come true.

Does that sound like your retirement plan?

(In the book, I actually tell you about one of the numerous celebrations held worldwide. 77 BoaDrum is celebrated in New York City each year in honor of the festival.)

There is a sadder story associated with the celebration that originated in China and made its way to Japan. It tells of a how a young farmer, smitten by a beautiful goddess, lies to gain proximity to her. They search for a robe she assumes I missing. His plan worked. They fell in love and spent many years together.

But one day, as fate would have it, she found a small piece of the robe tucked among some roofing material. Mikeran, the farmer has his the robe and forgotten it. Time had left only a shred of the clothing, but just enough for the goddess Tanabata to recognize the robe she had lost all those years ago.

She was furious, leaving him until he completed the penance she had punished him to complete. He was to weave a thousand pairs of straw shoes. The festival, in their honor, occurs on the one day the lovers are permitted to meet.

The astrological event surrounding the festival, also steeped in the lore of the holiday, occurs when the stars Altair and Vega intersect in the Milky Way.

This particular facet of the festival revolves around another less than savory story. This one was also centered on love but was focused on the ethic of work and loyalty to family. The young princess Orihime, a weaver, worked long hours at her craft, weaving beautiful cloth for her father by the river. She dreamed of one day meeting someone but feared her longing would never be fulfilled.

Her father, Tenkou, worried about his daughter’s happiness, arranged a marriage of sorts with a herder from across the river. His daughter fell in love and like so many young people filled with newfound passions, the two neglected their work in favor of spending time with each other. Her husband Ushikai’s cows wandered – since the story is celestial, those cows scattered across the heavens, and his wife’s weaving ceased.

Tenkou was furious separating them on opposites sides of a river. Orihime was devastated and begged her father to let the two to meet. He did and that day is July 7th.

I write in the book that it is “vitally important to build this structure piece by piece, with the right amount of thoughtfulness and the right amount of risk.”

Your retirement planning should be more than just tying colorful wishes to a tree. But too often, we only visit our retirement portfolio once a year, if at all, and we tie those plans to be fated to the wind.

Tuesday, January 8, 2008

Retirement Planning and Social Security

I should tell you that this entry does not appear in the book. Perhaps my editor deemed it too political. I didn't argue his red pen but saw it as something worth discussing here instead.

Nothing without a price

Reform always costs money. But it doesn't necessarily mean that the change in the program is the best way to spend it. Two things should happen first. If the solvency of the program is at stake, Congress should look elsewhere for money. For decades, they have been dipping into the Social Security surplus - and yes, even during this age of fewer workers supporting increased retirees, there is still an estimated $500
billion in surplus received through payroll taxes - and leaving IOUs.

Congress should pay those IOUs back instead of legislating them away.

That would, by default, expose the folks in Washington to fiscal policy that would be embraced by the nation. Changing the way our elected officials do business would have a ripple effect throughout the economy by encouraging savings. Unfortunately, they would have to borrow money to make up for their previous transgressions.

The estimated cost for dismantling the program - and do not kid yourself on this one, once the change is begun, it will continue to be taken apart until the program does not resemble the current system in any way – will be over $2 trillion. And that is just for starters.

This was recently evidenced by two announcements from the White House. The first from Gregory Mankiw, the then chairman of the Council of Economic Advisers who was quoted during a conference on tax policy: "There are no free lunches here", and the second from the President himself: "We will not raise payroll taxes to solve this problem".

Creating personal accounts will not decrease the national debt even as more is created to change the program. National savings, now at an anemic .02%, depending upon which month you look at will not change without some sort of increase in debt. In our current model of economic health, savings, while worthy, is not something that is encouraged.

In other words, the more we save, the more debt will be needed to make up for the shortfall under current economic conditions. A shift to a savings based society will have short-term budgetary issues as money for expansion dries up.

The President has been quick to point out the advantages of Chile's reform of their social system in 1980 as the model for our reformation. But we should be careful before we jump to conclusions. There were several things in place when the program in that country shifted.

In the real world however, it is quite different. References to Chile’s success with their privatization program are mostly superficial.

What many supporters of change in Social Security miss when they tout Chile’s success lie in two distinct differences: When the Chilean government embarked on this change 25 years ago, they built surpluses in the Treasury to ensure against any initial pitfalls and in the system and the workers, who kick in 10% of their pay do so under a mandate, not a choice.

From a purely economical standpoint, the program has failed on several fronts. One, the Chilean government has been forced to heavily subsidize the program as the first generation of retirees begins to tap the system. And the belief that the system would be self-supporting has largely proved to be false.

The Chilean government tied this changed to "one-time" government bonds with costs spread to future generations, a residual payroll tax, governmental privatization of many state run industries and a that deliberate surplus that was created before the reform could be enacted to help pay for the change. None of these conditions are available to us.

It would be much more apt to compare our efforts to those of Argentina, whose national debt ballooned because of their effort to borrow to fix a debt problem in their social system.

The bottom line: for the President’s plan to work, he would be forced to raise taxes.