How to Reduce the National Debt by 15%

I usually hate it when a blogger gives a long introductory build-up before getting to his point, so I will cut to the chase and then explain later.  How can we reduce the national debt by 15%?  Default on it.

Wait!  How can we default on 15% of the national debt without ruining our ability to sell bonds to investors, pension plans and foreign governments?  Simple, by defaulting only on the debt owned by the Federal Reserve.

Here is a chart of who owns the federal debt.

US Debt Pie Chart

As you can see, the Federal Reserve owns 15% of the debt.  All we have to do is tell the Federal Reserve that all those Treasuries they hold are now worthless.  BOOM!  We wiped out 15% of our debt.

Who would complain if we wiped out the Federal Reserve debt?  Would China and other foreign bondholders complain.  I don’t think so, because we are now less likely to default on their debt.  The same goes for pension plans.  We demonstrated that all these others debtors are so important, that we chose to default on the Fed to make our other debts more stable.

The Federal Reserve might complain, because they were looking forward to collecting the interest payments on that debt.  But, the Fed has to give most of their profits back to the US government anyway.  But won’t the Fed be less likely to buy more Treasuries with printed money?  Maybe, but if you could print money to buy guaranteed bonds paying three percent, would you stop?

Now, let me do the background and refresh your memory on how we got into this debt situation.  It’s all the fault of the Federal Reserve.

I believe that it’s one of a government’s primary responsibilities to protect and regulate the currency.  The United States (and other major governments) have abdicated this responsibility by farming out the responsibility to a separate entity, the Central Bank (the Federal Reserve in America’s case).

How did America get talked into giving up its responsibility and power to regulate the currency?  The idea was that if the government were allowed to print money, the irresponsible politicians would just vote to keep printing money, and the value of the currency would decline.  That certainly sounds like a good argument, but it didn’t work.

Now, since Congress can’t vote to print more money, they vote to increase the debt.  In addition to the money being printed, we now have to pay it back with interest.  What kind of sense does that make?

But if the government just printed money, wouldn’t that result in inflation?  Yes it would.  The pain would be immediate rather than delayed by going into debt.  The citizens would immediately feel the adverse effects of money printing rather than delaying the pain so their children will feel it.

The housing bust was caused by people being able to borrow equity from their house to spend on consumption.  This spending boosted the economy for a few years until the pain, delayed by debt, came home to roost.  If people had to earn more money to spend more, the pain would have been immediate rather than delayed.

It’s easy to understand how a person, or a government, can overspend if the pain is delayed.  If you want to control a system, you need immediate feedback.  Any delay in the feedback loop can cause instability.

If the government could just print the money, the citizens would know the cost and could decide if a stimulus plan created enough jobs to warrant the decreased purchasing power of the dollar.

If the existence of the Federal Reserve actually kept the government from spending too much money, then it might be a good idea.  But really, do you think it has worked?

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Sunday, October 28th, 2012 Currencies Comments Off on How to Reduce the National Debt by 15%

Revisiting Our Diversified ETF Portfolio

I think it’s time that we revisited our Diversified ETF Portfolio that I published on May 31, 2011.  It’s been fourteen months, and we should see how well we have done.

This posting will prove that I am not a professional investment advisor, because I am willing to document how my investment picks lost money.

Fourteen months ago, I constructed a portfolio of eight ETFs to demonstrate that we could create a diversified portfolio using only a small number of ETFs.  You can read that post here.

To recap, here are the components of that portfolio:

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–
Domestic Stocks VTI Vanguard Total US Stock Mkt. 13%
Foreign Developed Mkt. VEA Vanguard MSCI Euro Pacific 5%
Foreign Emerging Mkt. VWO Vanguard MSCI Emerg. Mkt. 7%
Gold/Silver Bullion IAU iShares Gold Trust 20%
Gold/Silver Miners GDX Market Vectors Gold Miners 5%
Commodities GCC GreenHaven Equal-Weight Commodity 15%
Real Estate VNQ Vanguard MSCI U.S. REIT 25%
Bonds BSV Vanguard Short-Term US Bond Mix 10%
——-
Total 100%
.

To chart the portfolio’s performance, I used a handy program called EzBacktest, that you can find at http://ezbacktest.blogspot.com.  I really like this tool, and its free.

Here is the portfolio performance from May 31, 2011 through August 10, 2012.
ETF Portfolio Performance
The blue area shows the portfolio’s value and the red line is the S&P 500.  These are the statistics provided by EzBacktest:

Avg. Dividend Yield:   1.55%
Annualized Return:    -0.5%
14-Month Return:       -0.6%
Under-performed the S&P 500 by 5.1%

If we had invested $10,000, our portfolio would now be worth $9,940.  We lost $60, whereas investing everything in the S&P 500 would have given us a profit of about $430.

To illustrate which ETFs were the worst performers, here is a relative performance chart provided by StockCharts.com.
Portfolio Components Performance

As you can see, the worst performers were GDX (gold miners), GCC (commodities), VWO (foreign emerging markets), and VEA (foreign developed markets).  The best performer was VNQ (real estate investment trusts).  VTI (total stock market) was just marginally better than the S&P 500.

The problem with a diversified portfolio, is that you have exposure to bad sectors as well as good sectors.  Over these fourteen months, the bad sectors were horrible, and the good sectors were mediocre.

So, the question to ask is “What do we do now?”  I still like the component ETFs of the portfolio.  So, assuming that we still want to be diversified, I will merely adjust the percentages.

I think we had a little too much exposure to gold, so I will reduce the percentages of IAU and GDX.  I would also like more exposure to US equities, so I will increase the percentage of VTI.

The foreign markets (developed and emerging) did horribly over the past year, and they may not do very well for the next year, but I still want exposure to them.  I expect Bonds to stay about the same for another year, and then decrease in value, but I will keep some exposure to them.

Commodities didn’t do well, but I expect that to change over the next year, so I will keep some exposure to them.

Here is my Rebalanced Diversified ETF Portfoio:

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–
Domestic Stocks VTI Vanguard Total US Stock Mkt. 17%
Foreign Developed Mkt. VEA Vanguard MSCI Euro Pacific 5%
Foreign Emerging Mkt. VWO Vanguard MSCI Emerg. Mkt. 8%
Gold/Silver Bullion IAU iShares Gold Trust 16%
Gold/Silver Miners GDX Market Vectors Gold Miners 4%
Commodities GCC GreenHaven Equal-Weight Commodity 15%
Real Estate VNQ Vanguard MSCI U.S. REIT 25%
Bonds BSV Vanguard Short-Term US Bond Mix 10%
——-
Total 100%
.

Let’s see if I am still willing to post the portfolio performance next year.

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Sunday, August 12th, 2012 Stocks Comments Off on Revisiting Our Diversified ETF Portfolio

For Many People, It is Best to Delay Taking Social Security

From MarketWatch:  It pays to delay taking Social Security

A “delay” strategy is particularly beneficial for married couples, according to Laurent Belsie, a writer for the NBER Digest. The primary earner can delay claiming benefits, while the secondary earner takes benefits early. If the secondary earner outlives the primary earner, he or she gets to step up to the primary earner’s benefits.

Read the article for a complete explanation.

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Thursday, July 12th, 2012 Social Security Comments Off on For Many People, It is Best to Delay Taking Social Security

Buy Your Dream Home This Year. Buy Your First Home Next Year.

IMHO, this is the year to buy your dream home, but not your first home.

I agree with many of the experts who predict that the average sales price of homes will continue to decline, or at best stagnate, over the next year or two.  The primary reason for this is the large number of foreclosures that will hit the market over this time period.  They will keep the average price down because they are keeping down the price of entry-level homes.

If you are looking for a first home, which is usually priced below the average price in your area, you will see a buyer’s market.  Foreclosed homes coming on the market will be priced well below their original purchase prices.  For a new homebuyer, especially one who is willing to put some work into a neglected foreclosed home, the low end of the market will offer an abundance of choices.  Because of foreclosures, supply of lower-priced homes will exceed demand until the foreclosures are off the market.  This could take a couple of years.

If you are planning to buy an above-average-priced home, you might want to start looking right now.  Without the pressure of foreclosures coming to market in your price range, there is little to cause prices to fall.

Most of the homeowners who were forced to sell have sold already.  Remaining homeowners are the ones who could afford to wait for a market recovery.  They may be willing to consider selling at today’s prices, but not at lower prices.

Homeowners who want to upscale their home may think that if their home value goes up just a little more, they can afford to sell and buy a more expensive home whose price is also discounted.  If homeowners who are only slightly under water see their home value rise to break-even, they may be willing to sell and buy a larger home.  In other words, future sellers will most likely be buyers at a higher price.

Employment is also starting to improve.  People who already have jobs are feeling more confident that their jobs are safe.  People who are re-entering the job market will be less likely to sell unless they can move up.

Mortgage interest rates are very low.  It’s hard to believe that you will get a lower rate by waiting until next year.  The problem with mortgages seems to be that it’s harder to qualify for one than it used to be.  If the Federal Reserve raises, just slightly, the rate it charges banks to borrow from the Fed, the banks will be more willing to lend money to home buyers.

Currently, banks can borrow money from the Fed at essentially zero interest.  They can then buy risk-free Treasury Bonds that pay over two percent.  Traditionally, banks are willing to lend money if they can make at least two percent over their borrowing costs.  If the loan is even slightly risky, they want to make more margin on the loan.  If the Fed requires banks to pay even 25 basis points (0.25 percent) more interest, banks can’t make enough money buying Treasury Bonds.  The next level up in risk is mortgages.  With banks more willing to lend, more people will qualify for mortgages, and home prices will rise.

So, my theory (and without supporting evidence, it’s just a theory) leads to the conclusion that if you would like to buy an average-price or above-average-price home, start looking now.  Get pre-approved for a mortgage in your price range and start talking to a realtor.

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Tuesday, April 3rd, 2012 Real Estate Comments Off on Buy Your Dream Home This Year. Buy Your First Home Next Year.

Occupy Wall Street

The “Occupy Wall Street” movement is like modern art. It depends upon the interpretive ability of the observer to give it value.

By focusing on the parts you like and believing that the originator(s) are giving expression to your unspoken feelings, you can see merit in it.

Permanent Link to this post: http://richardkinnaird.com/blog/occupy-wall-street/

Saturday, October 22nd, 2011 Work Comments Off on Occupy Wall Street

A Sustainable Jobless Recovery

The July 8, 2011 jobs report was shockingly disappointing:  The USA added just 18,000 jobs in June.  For the workforce just to maintain the status quo, we need to add 125,000 jobs every month.

The unemployment rate is 9.2%.  If you add in the number of workers who have stopped looking for work, those whose unemployment benefits have expired, and those who are severely underemployed, the unemployment rate is 16.2%.

There is now a lower percentage of Americans working than at any time since 1983.  The percentage of American adults (16 years and older) who are working has dropped to 58.2%.

So, the US economy is doomed, right?  Not necessarily.  Businesses have downsized and become more efficient.  They have learned how to produce goods and services with fewer employees.  These employees may be overworked compared to their workload three years ago, but they have a steady job, and they are more confident that they will keep the job than they were a couple of years ago.  When you believe you have a stable job, you are more willing to spend.

American business has entered a “new normal.”  In truth, business has never sold much to unemployed people.  So the American worker/customer base has dropped from 94% (6% unemployment is considered “full employment”) to 91%.  American manufacturing and retail businesses are expanding their customer base overseas to the 80% to 95% of foreign workers who are employed.

Due to the expanding international customer base, sales are increasing.  Due to workforce reduction and technology, profits are increasing.  Business is adapting much more quickly to the new economic situation than individuals are.  Let’s face it, most of the lost jobs are not coming back.  Business is moving on.  The economy has changed; as investors we have to change with it.

Bursting the housing bubble is a bigger hurdle to business growth than the unemployment hurdle.  The destruction of home equity has reduced the spending ability of employed Americans.  Gone are the days of using your home as an ATM machine to give you cash to spend.  Working Americans are actually having to learn to “live within their means.”

In the short term, the housing bubble bust has hurt the economy; but in the long term, living in a growth economy rather than a bubble economy will be a good thing.  Industries will shift; spending patterns will change; and priorities will realign.  Get used to it.  The future will not be like the past.  Go ahead and moan and whine and then get over it.

That’s not to say that unemployment won’t have lasting negative political and social effects.  I’m lucky; being retired, I don’t have a job to lose.  I truly feel very sorry for people who have lost their jobs.  I personally know recently-unemployed workers, and I know business owners who have had to close their businesses due to the changing economy.  Politically and socially it’s bad to have too many people unemployed.  It’s much better for society if people are able to earn a living in productive ways.  I don’t know what to do about that.  I try to live with the way things are, rather than the way I would like for them to be.

Providing jobs is not the primary goal of business.  Hiring is needed only when demand for the company’s goods or services is too great to be met by the current number of employees.  The good news is that the recent downsizing has very likely resulted in companies having the minimum number of workers to produce the current sales.  Any increase in business should result in gradually increasing employment.  But there will be a lag.  Businesses are skeptical about demand increasing very quickly, so we will initially see part-time employment increase until the “new normal” is understood.

The stock market will have ample opportunity to grow in the new economy.  In fact, if the US dollar loses value, as I expect it will, all asset values will be inflated.  This means that the dollar-value of assets will increase.  This applies to Gold, Commodities, Stocks and maybe even Real Estate.

Just because things will be different, doesn’t mean that they will be catastrophic.  It also doesn’t mean that things won’t be unsettled for a while.  I expect that it will take about six to twelve months for the “new normal” to be fully accepted and adapted to.  I expect Gold and Commodities to adapt in three to six months and Stocks in six to twelve months.

Real Estate is another story.  You need to have a job to buy a house, and 84% of US workers have steady jobs.  A declining dollar should inflate the values of Real Estate, but Real Estate is a leveraged investment.  Most people have to borrow money to buy Real Estate.  The availability and affordability of borrowed money directly affects the value of Real Estate.  Currently, mortgage rates are low, but mortgages are hard to get.  It takes a very good credit rating to get a mortgage, and larger down-payments are required.  With a declining dollar, interest rates will be higher, but banks will be more willing to lend.  Banks will want to get rid of their declining dollars and earn good interest on loans backed by Real Estate.  Therefore, the recovery of Real Estate is hard to predict.

The important point here is that for growth in Stocks, Gold and Commodities, decreasing unemployment is unnecessary.  From a cold-hearted investment perspective, the Jobless Recovery is sustainable.

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Saturday, July 9th, 2011 Work Comments Off on A Sustainable Jobless Recovery

Three Things You Can’t Say About Social Security

“Social Security needs a big fix, and soon.   If you have any doubt, take a look at this week’s analysis of Social Security’s annual trustees report, by Alicia Munnell of the Center for Retirement Research at Boston College.” — Eric Schurenberg, The Fiscal Times

The year in which Social Security will no longer be able to pay all of its promised benefits is 2036 (Last year, they thought it would be 2037).

Social Security began running at a deficit in 2010.  This wasn’t supposed to happen until 2015.  This means that every year, Social Security pays out more in benefits than it collects in taxes.  It theoretically has enough in its Trust Fund to continue paying benefits until 2036, but there is no money in the Trust Fund.

The Trust Fund has IOU’s from the federal government.  Tapping the Trust Fund means that Social Security presents a bill to the US Treasury, and the Treasury has to pay.  Of course, the Treasury has to get the money from somewhere, and that means higher taxes, reduced spending elsewhere, or more borrowing.

These facts, reported by Eric Schurenberg on July 28, 2011, publicly expose points I made in my previous posts about Social Security.

Schurenberg lists Three Things You Can’t Say about Social Security:

1. You can’t say that Social Security doesn’t increase the deficit. As of 2010, we are permanently running in the red.

2. You can’t blame it on the boomers. The usual explanation for Social Security’s funding problems is that the baby boomers are too big a load on the system.  But the program doesn’t get any better after the boomers die off.  The reason:  The boomers’ kids aren’t having enough kids themselves.

Remember, Social Security is a pay-as-you-go system: today’s workers’ taxes pay today’s retirees’ benefits.  [I told you, Social Security is Welfare.]  To keep going, the program needs a lot more workers than retirees.  Or as financial writer Jane Bryant Quinn put it, “It’s a saving program in which you deposit children.”  The younger boomers and Gen-Xers haven’t been depositing enough future workers to take care of their parents.

3.  You can’t say the payroll tax cut is temporary. You and everyone else with a paycheck got a two percentage point cut in your Social Security payroll tax this year.  Taxes, once cut, are hard to reinstate.  (Remember the Bush tax cuts that were supposed to expire in 2010?)  And, in fact, the main topic among policy makers regarding this year’s Social Security tax cut is not when to restore it, but how long to extend it and whether to stretch it to three percent and maybe to offer it to employers as well as employees.  That’s great for your pocketbook, possibly helpful for the economy, but it, too, widens the deficit.  The law says the payroll tax cut  has to be replaced by general revenues, so the tax cut doesn’t change Social Security’s accounting, but that’s just fiscal sleight-of-hand: you the taxpayer eventually cover the cost, whether it comes out of your FICA taxes or your income taxes.

More to the point, the shifty accounting dodges the “Big Question about Social Security.”  While Social Security’s shortfall is manageable, it is also real.  The long-run deficit can be eliminated only by putting more money into the system or by cutting benefits.  There is no silver bullet.

[I have quoted extensively from an article by Eric Schurenberg.]

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Tuesday, June 28th, 2011 Social Security Comments Off on Three Things You Can’t Say About Social Security

A Diversified Portfolio of ETFs

Several weeks ago, I posted an article titled Asset Classes For Portfolio Diversification.  In that article, I presented a chart showing how I categorize investments to determine how well-diversified my portfolio is.

Today I decided to create a sample diversified portfolio using only Exchange Traded Funds (ETFs).  I wanted to use the fewest number of ETFs possible to achieve diversification.  I used ETFs because each ETF invests in many stocks, bonds, options or futures contracts, so that each ETF has its risk spread over many investments.

DISCLAIMER:  I am not recommending that you buy any of these ETFs.  I chose real ETFs to demonstrate how an investor could construct a diversified portfolio and to calculate how that specific portfolio would have performed.  As I discussed in the previous article on diversification, everyone will have their own desired percentages for each investment category.  Any specific example portfolio, such as this one, will not be suitable for everyone.

Although I will discuss why I chose each ETF, and may give alternative choices, the particular ETFs may not be suitable for you.  One website that you can use to select ETFs in various categories is the ETFdb Category Tool.

The Example Portfolio

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–

Domestic Stocks

VTI

Vanguard Total US Stock Mkt.

13%

Foreign Developed Mkt.

VEA

Vanguard MSCI Euro Pacific

5%

Foreign Emerging Mkt.

VWO

Vanguard MSCI Emerg. Mkt.

7%

Gold/Silver Bullion

IAU

iShares Gold Trust

20%

Gold/Silver Miners

GDX

Market Vectors Gold Miners

5%

Commodities

GCC

GreenHaven Equal-Weight Commodity

15%

Real Estate

VNQ

Vanguard MSCI U.S. REIT

25%

Bonds

BSV

Vanguard Short-Term US Bond Mix

10%
——-

Total

100%

Using these ETFs our Asset Diversification Chart looks like this:

ETF Portfolio Diversification

Notice that there is nothing allocated for Cash.  Any portfolio should have an allocation for Cash, but since that doesn’t affect the performance (measured in dollars) I have left Cash out of the portfolio.

There is also no allocation for Currencies or Other.  That is on purpose.  It’s hard to measure the performance of “Other” investments, and I don’t think most people should fool around with Currencies.

Portfolio Performance

I used a “backtest” tool to see how this portfolio would have performed. [Update: A better backtest tool is the free program EzBacktest, that you can find at http://ezbacktest.blogspot.com.]

Over the past two years, this portfolio would have had a total return of 59.1% compared with 50.1% for the S&P500.  The compound annual growth (CAGR) of this portfolio would have been 26.1% per year compared with 22.5% for the S&P500.

The following chart shows the performance.  The portfolio is in green and the S&P500 is in blue.  $100K invested two years ago would grow to $159,100 vs. $150,100 for the S&P500.  This is 6% better than the S&P500.

ETF Portfolio 2-Yr. Performance

It should be noted that this two-year period is after the crash of September, 2008 to March, 2009.  The following chart shows the performance from February 1, 2008 through May 27, 2011.

ETF Portfolio 2.5-Yr. Performance

Including the crash, the portfolio would have had a total return of 21.9% vs. only 2.6% for the S&P500.  The portfolio’s CAGR would have been 6.1% per year vs. 0.8% for the S&P500.

About the Specific ETFs

In choosing the ETFs for this portfolio, I tried to use Vanguard products, because Vanguard usually has lower management fees than other companies.  If you are a Schwab investor, you can invest in Schwab ETFs with low fees and no sales commissions.  Other brokers have commission-free arrangements with some of the ETFs.

Three of the ETFs weren’t my first choice for the portfolio.  I would have preferred to use GDXJ, the “junior miners” (small cap.) ETF instead of GDX, but GDXJ hasn’t been around long enough to demonstrate performance.

Also, I might have replaced VTI with SCHG and SCHA, two newer Schwab ETFs.  SCHG is large-cap growth, and SCHA is small-cap growth.  Because VTI is classified as a “large-cap blend,” the allocation chart doesn’t show any small cap stocks.  It’s OK for all the foreign stocks to be large-cap, but I would have preferred for about half of the domestic stocks to be small-to-mid-cap.  Schwab also has an equivalent ETF to VWO (SCHE, emerging markets).

In Commodities, the most obvious choices would probably have been DBC or RJI.  However, since I was only going to choose one ETF for this category, I chose GCC, because it has more exposure to Agriculture and less exposure to Energy than the other two ETFs.

Which ETFs Performed the Best?

Over the past two years, the best-performing ETF was VNQ the Real Estate Investment Trust ETF.  Its total return was 106%.  The second-best performers were a tie between VTI (total stock market) and IAU (gold) at 55%.  The worst performers were BSV (bonds 0.8%) and GDX (gold miners 1.6%).

Conclusion

It isn’t difficult to construct a diversified portfolio using eight to ten ETFs.  In the example portfolio, if your total investment was $10,000 then you would still have at least $500 in each ETF.

Our example beat the S&P500, which is usually used as a benchmark for investment performance.  Making 6% more than the benchmark over a two-year period may not seem very impressive, but a 6% beat is not bad.

Also, the example portfolio was slightly less volatile than the S&P500.  Over two years, its volatility was 16.1% vs. 16.6% for the S&P500.  However, in the second timeframe, which included the crash, the portfolio volatility was 21.4% vs. 28.8% for the S&P500.

These eight ETFs may not perform as well in the future, so this is not a recommendation.  In fact, the only one of these ETFs that I own is IAU.  Also, the allocation percentages of my personal portfolio are not the same as the percentages of this example portfolio, so even I am not putting money into this particular portfolio.

[Update: See how this portfolio performed during the first fourteen months after this article was posted.]

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Sunday, May 29th, 2011 Stocks Comments Off on A Diversified Portfolio of ETFs

Re-visioning Climate Change – April 1, 2011

Previously called Global Warming, our modern climate crisis is currently called Climate Change.  This change in nomenclature is primarily due to the realization that the side effects of modern society cause more than a unidirectional global warming.  Some parts of the planet are experiencing cooling, some experiencing warming, and some experiencing more wildly fluctuating temperatures and other weather conditions.

I am proposing a re-visioning of the problem including a new, more comprehensive, and accurate nomenclature.  Instead of declaring that we are experiencing increased Climate Change, I believe that it is more accurately termed an exponential reduction in Climate Stagnation.

For centuries our planet has been mired in this Climate Stagnation with precious little fluctuation.  Human society has become lazy and complacent wallowing in this epoch of diminished climatic evolution.  An unreasonable, conservative expectation of future replication of past climatic stasis has developed based solely on empirical observation.

As a side effect of modern civilization, this Climate Stagnation is being reduced to some extent.  This has resulted in liberal, out-of-the-box thinking that, indeed, the future may actually be different from the past (at least climatically).  Although, to date, these radical thoughts are confined to a fringe group of creative thinkers, these trend-setters will certainly spread their visionary ideas to society as a whole.  This new, less conservative, more forward-thinking and creative mindset will lead us to a new era of innovation and shake us out of our climatic complacency.

A reduction in Climate Stagnation will lead to a more mobile, quick-witted society more open to change and more industrious in character.  When a society’s environment becomes stagnant, so does its population, and any reduction in Climate Stagnation will increase the rate of societal evolution.

Permanent Link to this post: http://richardkinnaird.com/blog/re-visioning-climate-change-april-1-2010/

Friday, April 1st, 2011 Uncategorized 1 Comment

Asset Classes For Portfolio Diversification

“Don’t put all your eggs in one basket,” is a traditional idiom that warns us not to risk everything on a single venture.  If you divide your eggs into two baskets, and one basket is dropped, you have still preserved half your eggs.  Applied to investing, this strategy is referred to as diversification.

Many years ago, when I was in the financial planning business, “diversification” was interpreted to mean, “Divide your investments between US stocks and US bonds and make sure the stocks cover all the market sectors.”  Today, even the average investor can be much more sophisticated in portfolio diversification.  Using Exchange Traded Funds (ETFs), any investor can diversify much more broadly than was possible in the old days.

For example, you shouldn’t limit yourself to only US stocks and bonds.  It is very easy to invest in foreign stocks and bonds using ETFs.  Going back to our egg-harvesting example, international diversification is analogous to, “Even if you have your eggs divided into two baskets, don’t let the same person carry both baskets.”  This way if one person (country) stumbles, you have another person carrying some of your eggs.

How to Diversify

The diagram below illustrates how I approach asset diversification.  It may be a little complicated for some people, but it illustrates my view of the investment universe.

Asset Diversification

As you move from left to right in the diagram, each box represents a filter or a categorization for the asset to the left.  For example, both Stocks and Bonds are first divided into either Domestic or Foreign.

To be more accurate, I should have called “Stocks” “Equities” because further to the right I divide them into Stocks, Funds/ETFs or Options.

For each Domestic Stock, I categorize it by my goal for that stock.  My goals are either Growth, Income or High Risk/Reward.  Both Growth and Income Stocks are intended to be held long-term, while High Risk/Reward Stocks probably can’t be held for very long because they are volatile and were purchased with the hope of a good short-term gain while being watched carefully.

If a Domestic Stock can’t provide me with Growth, Income or the prospect of a short-term gain, I shouldn’t own it.

Foreign Stocks are first classified as Developed Markets or Emerging Markets before assigning each Stock to a Sector.

Second in importance, after the investment goal for a Stock, is the business Sector it falls into.  Most often, you see sectors categorized in a couple of ways:

Morningstar Sectors S&P 500 Sectors
Business Services
Consumer Goods Consumer Staples
Consumer Services Consumer Discretionary
Media
Energy Energy
Financial Services Financials
Health Care Health Care
Industrial Materials Materials
Hardware Industrials
Software Information Technology
Telecommunications Telecom Services
Utilities Utilities

These categories are too granular for me.  I divide stocks up into eight categories:

My Sectors

  • Technology
  • Consumer
  • Health
  • Energy
  • Financials
  • Industrials
  • Utilities/Telecom
  • Commodities

I group Consumer Staples, Consumer Discretionary, Consumer Goods, Consumer Services and Media all together into “Consumer.”

I also group Telecommunications Services (e.g. AT&T, Verizon) and Utilities (e.g. Con Edison, Duke Power) into one category.  The rationale here is that they are both semi-regulated services for the consumer that bill monthly and usually pay dividends.

There is one obvious overlap/redundancy in the diagram.  One of the Stock Sectors is “Commodities” and one of the major asset types on the left is also “Commodities.”  Following the Commodities major type all the way to the right shows that one of the three ways to invest in Commodities is Producer Stocks.  These Producer Stocks also fall into one of two Stock Sectors: Commodities or Energy.  The reason I have this in two places is because many stock ETFs are diversified across Sectors including Commodities and Energy, so I have Sectors for this.  Other Individual Stocks or specialty ETFs are exclusively Commodities, so they go into Commodities Producer Stocks or Commodities ETFs.

Both Foreign and Domestic Stocks are classified as either Large Cap or Small Cap.  After you have allocated a portion of your portfolio to Domestic/Foreign, Goal/Market, Sector and Capitalization, you can put that money into either Individual Stocks, Mutual Funds or ETFs.  For Domestic Stocks, I also consider Options.

The diagram shows a similar treatment for classifying the other investment types.

I have a separate major asset type for Gold & Silver.  In a previous post I explained why I don’t consider Gold to be a Commodity; it should be thought of as the Universal Foreign Currency.  However, I only put fiat (paper money) foreign currencies into their own major asset type — Currencies.

Gold could be a major type all by itself, and Silver could be under Commodities, but Gold and Silver are enough alike and track together well enough to lump them together.

Why Bother?

So, why do I bother with this taxonomy of assets?  Two reasons:  1) If you already have an investment portfolio, you can see what percentage of it fits into each box.  This will reveal holes in your coverage which you can decide to ignore or fix.  2) If you are planning a portfolio from the top down, you can allocate percentages to each box according to your individual needs, goals and philosophies.

Although I am not as rigorous as the diagram might indicate, I do try to keep track of the percentage of my portfolio I have allocated to each box.  If I think I’m too heavy or too light in a category, I will fix it.

For many investors, this level of analysis will be overkill.  There are so many category possibilities that you may not have enough money to allocate to all, or even most, categories.  That’s perfectly OK.  In fact, even if you do have enough assets, you may choose to put nothing into one or more categories.  For example, contrary to conventional wisdom, I have almost nothing in Bonds of any type.  I have very little in the Currencies box or the Other box.  When I was an entrepreneur, all my assets were in the Other box.

How Much Should Be Allocated to Each Box?

This is the fundamental question, and, unfortunately, one answer does not apply to everyone.  In fact, even if every investor agreed with my taxonomy and had lots of money to invest, each investor would probably have a different allocation.

For example, let’s look at a traditional (old-fashioned) allocation strategy.  The following is copied from a Schwab newsletter I recently received.  They gave an example of three different portfolios:

Conservative Moderate Aggressive
15% Large Cap 35% Large Cap 50% Large Cap
0% Small Cap 10% Small Cap 20% Small Cap
5% Foreign Stocks 15% Foreign Stocks 25% Foreign Stocks
50% Fixed Income 35% Fixed Income 0% Fixed Income
30% Cash 5% Cash 5% Cash

Large Cap and Small Cap both refer to US Stocks.  Fixed Income usually means Bonds.  For Foreign Stocks, Schwab recommends for all three portfolios:  65% Foreign Large Cap, 15% Foreign Small Cap and 20% Emerging Markets.

As you can see, this is a much simpler diversification strategy than I have for myself.  It is easier to explain and (more importantly) to sell.  I can see the logic in their strategy, and I suspect that most investors are not even this diversified.  At my age, they would recommend that I have the Conservative portfolio, which I most certainly do not have.

Their portfolios completely ignore Gold & Silver, Commodities, Real Estate and Currencies.  I can understand this because the only Real Estate most people have is their home; Currencies are difficult to trade; and Gold is for paranoid nut jobs (Just kidding. I’m putting words into Charles Schwab’s mouth).  But even in Schwab’s simplified model, it takes three portfolios to meet everyone’s needs.

If I go into too much detail on how to allocate investment assets, I might cross the line into giving investment advice, which I am not qualified to do.  That being said, I think when it comes to stocks, I like to have between 60/40 and 40/60 allocated to Domestic/Foreign.  The same could be said for Developed/Emerging in the Foreign Stock category.

When it comes to Gold, even Jim Cramer recommends 10% to 20% of your assets in Gold, and I agree with him.

When it comes to Real Estate, I don’t include my home in my portfolio.  I realize that for many people, their home is their largest investment, but I choose to put as little money into my home as I comfortably can.  In fact, a case can be made for renting, but that could be the subject of another blog posting.  I do think that some of your assets should be in Real Estate, even if it’s your home.

I am also a fan of Commodities, especially Agricultural Commodities.  We are entering into a period of global food shortages, and I think this is a good investment category.

When it comes to Currencies, most people should probably not put too much money into this category.

Cash is probably the most important category, because it is the first box a beginning investor should fill.  If you don’t have enough Cash saved to cover at least four months of bare-bones expenses, you probably shouldn’t have any other investments.

I think I’ve rambled on long enough on this subject.  Maybe later I’ll have a few thoughts on some other aspects of my diagram.

Permanent Link to this post: http://richardkinnaird.com/blog/asset-classes-for-portfolio-diversification/

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Sunday, March 6th, 2011 Gold, Stocks 1 Comment

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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