Monday, January 4, 2010

The Sleep at Night Portfolio

During my years of investing I have found that I am very risk adverse. I hate taking risks in my investments although I also find it distasteful to miss out on big gains in the stock market. My portfolio needs to trend with the S and P but at times trend away from The Herd. The Herd is the group of momentum speculators that distort valuations in dysfunctional markets. The Herd does not look at historical valuation trends. The Herd drove the market to unsustainable highs in October of 2007 and also to extreme value in March of 2009.

I was out of the market in October of 2007 and dove into the market in March of 2009. Presently the stock market is 20% overvalued by historical standards. I have adjusted my portfolio to take only 15% of the gains on upswings in the market. I will move in and out of the market for the next year or so trending away from the movements of The Herd. I would like to lean toward market neutral until The Herd realizes that the taxpayer ATM can't create future wealth. It took The Herd 5 years to realize that the homeowner ATM was not the road to riches.

My concern back in 2007 was capital preservation. My sleep at night portfolio managed well during the recession. It is up about 14% since October 2007. The S and P index is down 25% over the same period.

My portfolio will always under perform during periods of market overvaluation. Presently the S and P is about 20% overvalued. I have only taken 60% of the profits in the S and P since May. But when the market was undervalued in March and April I was able to take 120% of the profits of my benchmark. My investments ended the year only taking 95% of the S and P gains. Very boring but of course I didn't lose an hour of sleep worrying about my investments.

My 95% take rate for 2009 does not include the small 1.2% distribution that I pay myself for managing the account. This distribution is annuitized so that I don't have to pay the early distribution penalty to the IRS. The management payment that I pay myself is similar to what most people pay their financial advisors or mutual fund managers. Most people don't realize how much money is siphoned out of market gains from investment management. I keep this money separate just as a reminder.

If you have a financial planner that invests in mutual funds there would be a 1% charge for the planner on top of an average 1.25% charge for the mutual fund manager. In my situation I am my own money manager and the bulk of my investments are invested directly in stocks. Therefore I pay no fees or charges. This is a very large savings in the long run. Let me explain why.

Presently the stock market is overvalued by 20% so I feel that it is prudent to only expect to make gains on the 6% corporate profits over the next 20 years, not including inflation. Let us assume that your financial planner takes 1% of your investment and your mutual fund company takes 1.25%. If there are 6% stock gains over the next 20 years then your portfolio will end up with an overall 3.75% year over year return. That works out to a little over 131% return before inflation for twenty years. Without the money management fees you would make 221%. Quite a difference.

If you feel that the 6% return is low please Google "Japanese lost decade". You will see that thanks to the advice of top Wall Street economists Japan has been able to have almost zero equity growth for twenty years. So I don't think 6% growth is unrealistic.

Our Financial Elite have a very impressive track record in Japan and they are presently providing the same unsound advice to our government.

So in theory, assuming 6% stock market returns, you can almost double your investment return by managing your own account and investing directly in stocks. It's not for everyone but it is sure something to think about. There is also a side benefit to managing your own investments. Less of our nation's resources are funneled to the Financial Elite of Wall Street.

One other area that will be a disappointment in the future are bonds. As interest rates rise long term bonds decrease in value. We have spent the last twenty years on the windward side of the interest rate mega bubble. These gail force tailwinds have made massive gains for stocks, real estate and especially bonds. We are starting a new mega bubble which means severe headwinds for bonds and real estate. This is the end of easy money and no one is talking about it or seems to care. It is a little disconcerting.

This is my advice. Don't plan on using speculation as an investment vehicle. Learn to save. I sold my house in 2007. Presently I am saving 50% of my "take home" household income while renting a home. It sounds crazy but to me it just seems like the prudent thing to do in this dysfunctional economic environment. This is an extreme contrast to 15 years ago. From 1995 until 2005 I didn't save a dime. It was almost foolish to save. There were huge stock gains and even bigger housing gains. During that period saving was unnecessary.

This easy money period is over. We have ended the interest rate mega bubble and we are creating another. There will be no gains in housing or bonds for the next 10 years. Stocks will gain 6% a year. If you are worried about inflation please Google "Japanese lost decade" to quell your fears. It is very unlikely that The Federal Reserve can create significant inflation before interest rates rise above historical trend. Once we see real interest rates above 10% then we can talk about inflation. Presently we have no idea what the real interest rate is. The government is spending trillions to distort the market. This market manipulation could go on for a generation just like Japan of the last twenty years.

As a country we need to save, pay down our debt and stop speculating. During the 1990's and 2000's the easy money made anyone who borrowed money and speculated with it a financial genius. Stocks, bonds, real estate, collectables, commodities, it really didn't matter where the money was invested. It was a boomtime and everyone made money.

The investment winds have shifted. For the next 10 years we will have a lot less financial geniuses. The smart money will be saved.

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