The Seven Steps of Financial Preparedness (2008-10-06)

by David John Marotta

When a hurricane threatens, making a plan and gearing up for emergencies is imperative. Economic emergencies happen too, but it may be less obvious how to prepare. Here are seven steps you should take to weather any financial storm.

First, put $1,000 aside. It doesn't amount to a real emergency fund, but it will do until you get your finances in order. You can accumulate the $1,000 by allocating $10 a day for just over three months.

Most people go into debt because they live hand to mouth, spending 100% of their take-home pay. Then life happens: The car breaks down, the roof leaks or someone needs medical care. Without $1,000 in the bank, families spend the money anyway and go into debt. Having a mini-emergency fund can help you get out of debt and stay out of debt.

The second step to prepare for financial emergencies is to extricate yourself from credit card debt--forever. These first two steps are part of Dave Ramsey's financial peace course, offered in churches around the country. Ramsey suggests paying off your credit card by starting with the smallest balance in order to achieve small successes and then working to snowball your payments as you tackle the larger balances.

He also notes that the only way to get out of credit card debt is to adopt the intensity of a gazelle whose very life depends on outrunning the cheetah. If you are in debt, I highly recommend Ramsey's financial peace course. To be notified about the next course in your area, send your contact information to us at questions@emarotta.com.

These first two steps, having $1,000 and paying off debt, simply prevent you from facing a financial emergency by starting out wounded and bleeding. The third step is to improve your ability to handle fluctuating monthly expenses.

Set up a monthly budget so your day-to-day expenses are less than 65% of your take-home pay. No matter what your income, living off a smaller percentage of what you earn is the way to grow rich and be better prepared for financial emergencies. The difference between those growing rich and those remaining poor is not the salary they make. It is the salary they keep.

Relative to their income, the rich are frugal. They save and invest. They spend less than 65% of their take-home pay on day-to-day expenses. They save at least 10% in their retirement accounts and another 5% in taxable savings. They direct another 10% toward unknown big purchases. And they even live frugally enough to give another generous 10% to charities.

Setting aside 35% for unanticipated expenses is the minimum. When my wife and I first started our life together, we did not make very much. But we still lived off about half of our take-home pay. We were fresh out of college and did not have a very high lifestyle. After starting a family it becomes much more difficult, but not impossible, to save money. Remember that even if you don't earn very much, probably a family somewhere is living on half of what you make and doing just fine.

If you are well off, you can set your sights even higher. Think of learning to live frugally and still be content as part of the emotional training you need to weather a financial storm. That training starts with living within a budget even when financial conditions are good. Some productive families live off less than 15% of their take-home pay and still save, invest or donate generously with the other 85%.

Frugality is a skill needed to live a good life. It is a mindset best learned from parents, but even if yours were spendthrifts you can reeducate yourself and learn to view money differently. The poor buy things; their homes are cluttered with them. The middle class buys liabilities on which they have to make payments, such as second homes, luxury cars and boats. The rich buy investments that pay them money.

If you want to break your poor or middle-class mindset and learn how to be frugal, help is available. In addition to Ramsey's course, I recommend Dana Adams's blog "Frugal in Virginia" (<a href="http://www.frugalinvirginia.com" target=_blank>www.frugalinvirginia.com</a>), which describes where to find deals, both locally and on the Internet, that will stretch your family's budget. Not only will these suggestions save you money, but the mindset of frugality is contagious and will help you overcome any bad habits you may have learned growing up.

Once you've set your budget so money is left over after paying the bills each month, in step 4 you automate your cash flow to promote saving and investing.

Every month, have 10% transferred into your retirement account before you receive your paycheck. Then automate the transfer of 25% of your take-home pay into an investment account a day or two after your paycheck is deposited. Automating your savings makes savings a high priority and ensures that you pay yourself first. This investment account will grow over time, and you can use it to pay for big emergencies and charitable gifts.

Keep the balance in your checking account between two and three times your monthly expenses. If you are paid monthly, your bank account should cover two months of expenses the day before you are paid and three months the day after. You'll have both a generous cushion for your checking and money for unexpected repairs or big purchases. Whenever your checking account exceeds three months of take-home pay, consider moving some of it into a higher paying investment.

You need an emergency fund in case you are unemployed. The first three months of the fund are safe in your checking account. Now invest an additional three months in vehicles you could easily sell within 90 days. Your emergency fund investments should not be in a retirement account, but they do not need to be in a money market account. Many people use no-load, no-transaction-fee mutual funds. They should also be stable enough to guarantee three months' worth of expenses. Therefore if your emergency reserve funds are large enough, you can diversify them fully into investments that fluctuate more but pay a higher rate of return.

Step 5 is creating an asset allocation for your investments that's diversified for safety while being invested for appreciation. Diversification works, and it's never more obvious than in times of market turmoil.

Without diversification, portfolios can have a zero return over a decade. After being well diversified, the likelihood of no return over a decade drops significantly. Your asset allocation should be a guideline in times of trouble. Whenever you are worried or glad about what is happening in the markets, rebalance your portfolio back to your target asset allocation.

Rebalancing means buying stocks after they have gone down and selling stocks after they have gone up. This contrarian move is always wise. When stocks are hitting new highs, rebalance. When stocks are making new lows, rebalance. Studies suggest that the simple act of rebalancing annually earns about a percentage and a half more.

The sixth step toward emergency preparedness is using your taxable investment account properly. You are putting in 25% of your take-home pay each month: 5% is taxable savings and should start to accumulate real wealth, and 10% is for charitable gifting. Each month you buy investments, some will grow in value and become highly appreciated. Each year, find the investments that have appreciated the most, and use these for your charitable contributions.

Done properly, this method of annual charitable gifting plants the seeds for gifts that may not be realized until ten years later. Thus your charity can survive for ten years after you have stopped contributing on the front end.

The last 10% is for unknown large purchases. If your first response to this suggestion is to ask, "Like what?" the answer is "Exactly." Most people who run up credit card debit keep their regular spending within 100% of their take-home pay until some unexpected expense causes them to deficit spend. You can't anticipate unknown unknowns, so the best you can do is set aside some money to cover them when they arise.

Having the discipline to budget for small financial emergencies will help you be prepared when you encounter larger financial crises. When some unknown spending need strikes, take the money to cover the expense from your growing emergency fund. Then, determine if you have been budgeting for this level of unknown expenses adequately.

You should be able to budget for car repairs, medical bills and house repairs. If the expense truly swamps what you have been saving, you may need to increase the amount to better anticipate the level of emergencies.

The seventh and final step is mobilizing during an actual emergency.

In a real financial emergency you should have two to three months of spending in your checking account and another three months in your taxable savings. You should have a pile of money for large unknown purchases (that 10% of your pay) and another pile of taxable savings (that 5% of your pay you have never touched). Finally, you should have been planting seeds toward future charitable gifting that will last through the next decade.

Usually emergencies don't happen. So the money you have socked away makes more money. Keep an emergency fund for several years and it should double in value, giving you an additional emergency fund. Whether you need it or not, being prepared for a financial emergency means peace of mind, knowing that your lifestyle is sufficiently frugal so you won't be in trouble.

 

from http://www.emarotta.com/article.php?ID=304

Our Financial Crisis: The Result of Centralized Planning (2008-09-29)

by David John Marotta

Assigning blame for recent events in the financial markets is today's most pressing political issue. Unintended cause and effect are both complex and subtle, but recognizing the culprits is important if we want to avoid giving them additional power and responsibility.

Two different opinions are circulating to explain the fundamental cause of our failed financial markets. One claims that unfettered capitalism and greed caused excessive risk taking, which harms society. This argument maintains that without constraints capitalism produces grand profits during market increases, but the losses are socialized by government bailouts in times of trouble.

The other opinion holds that regulation and centralized planning have caused financial instability and failing institutions. If this is the root cause, then many of the proposed solutions will only make matters worse.

The pending election politicizes the issue and impedes clear thinking. But clear thinking is paramount. One of these two opinions is closer to the truth, and economic public policy must be based on truth, not emotion. The forensic evidence points to centralized planning. Let's look at whose fingerprints were left behind.

The failed institutions were among the most highly regulated industries in the country. If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully inept to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive.

Bill Clinton's presidential website still boasts of creating the highest homeownership rate on record. In 1994, Clinton hoped to increase homeownership to 67.5% by 2000. He sponsored the revised Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. These changes also allowed the securitization of CRA loans for subprime mortgages.

The revised act resulted in a raft of community organizers who could now prevent banks from merging, expanding their branches or creating new branches simply by protesting to any of four different regulatory agencies. Using regulation as a weapon, community organizers could now bully and blackmail private businesses. Legislation that encourages such thuggery produces anything but free markets.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as positive and encouraging. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had netted $3.8 billion in loan commitments in the city of Boston alone.

Banks were scored on their results rather than the fairness of their process. Those that scored poorly were punished. Most banks complied. As a whole the industry increased its lending to low-income families by 80%, more than twice any other group. Advertisements said that CRA loans were available with "100 percent financing . . . no credit scores . . . undocumented income . . . even if you don't report it on your tax returns." Mere participation in a credit counseling program qualified as proof that the applicant was capable of managing the debt.

The government-sponsored entities Fannie Mae (the Federal National Mortgage Corporation) and Freddie Mac (the Federal Home Loan Mortgage Corporation) were involved as well. Because of their government backing, their bonds have the highest possible credit rating (A1). Only their guarantee was considered as secure as federally issued bonds. This implied backing allowed them to sell their loans at a lower yield than any private firm could muster.

Although Fannie and Freddie were officially created to encourage the development of private markets, they thwarted every attempt to take their influence away. They are powerfully connected, and following their lobbying efforts and campaign contributions leads directly to the politicians responsible for encouraging and continuing regulatory interference.

These agencies became places where former government officials went to enrich themselves and wait for new federal appointments. Their chief executives had contract clauses providing severance benefits when they left for a government post. While homeowners took cash out of their homes, politicians treated themselves by using Fannie and Freddie as political ATMs.

As a result, Fannie and Freddie became two of the largest corporations in the world, with about 80% of conventional home loans. Their monopoly on the housing market is anything but a free market.

Because they are government sponsored, these two entities were expected to engage in public policy as well. They were enthusiastic supporters of the CRA. They even singled out Countrywide as one of the lenders with "the most flexible underwriting criteria permitted."

Countrywide's low-income loans grew from a $1 billion commitment in 1992 to $80 billion by 1999 and $600 billion by early 2003. It was one of the first companies brought down by the current pressures and sold to Bank of America.

Fannie and Freddie were encouraged by their federal overseers. The Office of Federal Housing Enterprise Oversight (OFHEO) was charged in 1992 with keeping tabs on their financial safety and soundness, and the U.S. Department of Housing and Urban Development (HUD) was supposed to manage their housing mission.

The dangers of Fannie and Freddie failure were widely known and discussed publicly before the establishment of OFHEO and HUD's oversight. The regulatory oversight was specifically implemented to avoid complacency and ensure that their social mission would not jeopardize their financial soundness. Oversight obviously did not work.

HUD's mandate was implemented by requiring a certain percentage of the mortgages purchased by Fannie and Freddie to support low-income families. HUD's purchase quotas of low-income loans rose sharply over the past 15 years. Given their implied guarantee against failure, this increase was not perceived as reckless for Fannie Mae bondholders, but it has proven disastrous for nearly everyone else involved.

It isn't as though oversight failed because the issues were not known. In 1991, Carl Horowitz of the Heritage Foundation warned about H.R. 2900, the bill to create OFHEO and HUD oversight. And a 1999 New York Times story stated, "In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's."

The plethora of federal entities that regulated and oversaw all of the failed firms gave us a false sense of security. In retrospect, the cause and effect seems obvious, but none of the agencies already involved took the steps they could have. Believing government bureaucrats are wiser than the free markets is a socialist utopian delusion.

As recently as 2003 the Bush administration was pushing Congress to overhaul Fannie and Freddie and require stricter lending practices. Barney Frank, chairman of the House Financial Services Committee, who is supposed to provide oversight, said, "These two entities--Fannie Mae and Freddie Mac--are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." So much for congressional oversight.

The government itself created the conditions of greed and lack of negative feedback. Free markets use negative feedback instead of regulations and legal constraints. But when the federal government legislatively removes the negative feedback, which is the natural consequence of poor decisions, it makes such decisions more likely and causes more harm than good.

Planning for competition works wonders. Planning substituted for competition wreaks destruction.

Given that socialistic impulses got us into this mess, it isn't likely that further socialization will help matters in the long run.

Now the government is loaning AIG $85 billion, but at what cost? Virtually nationalizing the country's largest insurance company was not the only possible solution. Providing AIG with a loan to allow the company time to sell assets would have been much less intrusive. Instead, the government provided additional bond security at the expense of shareholders' value.

None of this intervention would be the free market solution, and it is all rife for political manipulation. Only by getting government out of the private markets can we reduce corruption.

Popular opinion overwhelmingly supports free markets. According to a Rasmussen survey, only 7% of voters think the federal government should use taxpayer funds to keep a large financial institution solvent. Sixty-five percent favor letting the company file for bankruptcy. And 49% said they worried the federal government would do too much to purportedly solve the financial crisis.

Any kind of bailouts and interventions encourage excessive risk taking in the future. When people gamble with others' money, they take bigger risks. We should be skeptical that financial institutions that made bad investments can somehow infect well-run banks. In fact, letting poorly managed banks go under is good for those still standing. Financial institutions have needed a pending consolidation, and allowing such failures should make the remaining financial services industry more profitable going forward.

Fannie Mae and Freddie Mac should be dissolved, and a more stable diversified collection of private companies should replace them. Any time power is consolidated in the hands of a single government entity with centralized decision making, the resulting structure has a great propensity for harm.

Such concentrated power is infinitely heightened. It can be used monopolistically and has no competitive negative feedback. With multiple private entities, there is naturally less power to be abused or mistaken. There is no way a diversified collection of private companies could have failed so spectacularly.

It requires a savvy voter to understand the root causes of these financial troubles during a time of political blame shifting. But even the average citizen should be skeptical that bigger government and additional regulation will somehow put more money in middle-class pockets. That we are largely left without politicians who endorse these views is most unfortunate.

 

from http://www.emarotta.com/article.php?ID=303

Eastern Europe and Turkey: BRIC Wannabes (2008-09-22)

by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted that the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050.

BRIC nations have surpassed expectations. The original Goldman Sachs analysis projected the four economies would comprise over 10% of the global output by the end of the decade. A year and a half early, they comprise nearly 13%.

Goldman Sachs published an update on the BRIC nations this year, forecasting that although growth is slowing, they will still contribute almost half of all global growth in 2008 and 2009.

It is easy to be lulled into thinking you can simply buy and hold investments in BRIC countries. But emerging markets have faced serious crises every several years. A better strategy is to buy and rebalance, trimming positions as they appreciate and reinvesting as they correct. With the drop in emerging markets this year, 2008 is now an opportunity to reinvest.

These countries have averaged a total return on investment in their stock markets that is now down to 27.49% over the past five years because they have dropped sharply over the past year, falling 24.48%.

The BRIC acronym made four emerging market countries sound like more attractive investment opportunities than the other two dozen. Nobody likes being excluded from the cool crowd. Other countries have been clamoring to add their initials into the mix ever since.

BRICET is the term used to add Eastern Europe and Turkey to the in-crowd. Since the fall of the Soviet Union, Eastern European countries have been struggling out of the darkness of communist rule into the light of free markets.

Eastern Europe has become a fuzzy term that may include a different set of countries depending on who is using the label.

The S&P/Citigroup BMI European Emerging Markets Capped Index includes companies from the Czech Republic, Hungary, Poland, Russia and Turkey. This index, constituted to include the most developed countries of Eastern Europe, is heavily weighted toward Russian companies as a result. Selecting these countries produces an index that is more developed than the typical Eastern European country.

The least developed countries are sometimes not even classified as emerging. Instead they are labeled "frontier markets," a step below emerging. These countries include Albania, Belarus, Bosnia, Bulgaria, Croatia, Estonia, Herzegovina, Latvia, Lithuania, Montenegro, Republic of Macedonia, Romania, Serbia and Ukraine. Many of them are listed in the MSCI Frontier Markets Index.

Although a few of the countries just named, such as Ukraine and Croatia, have very little freedom, others are entering the global scene on the side of free markets. A dozen countries in Eastern Europe have implemented a flat tax on either personal or corporate income. Most of them have a higher percentage of freedom than even Brazil, the best of the BRIC countries, according to the Heritage Foundation's Freedom Index.

In addition to a flat tax, many Eastern European countries are taking advantage of their proximity to Western Europe. Several Eastern European countries have joined the European Union (EU) and benefited from the single economic market representing 31% of the world's total economic output. The lack of trade barriers and a common stable currency encourages growth. To join the EU, a country must have a stable democracy that respects human rights; the rule of law, including EU law; and a functioning market economy capable of competing within the EU.

These requirements have the effect of pushing countries politically toward free markets, which helps them overcome the socialist or centralized planning legacy of communism. In addition to economic alliances with the West, some have also been invited and joined NATO. Turkey also enjoys significant freedom having been a part of NATO since 1952.

All of these economic freedoms and the accompanying social stability have produced good investment returns for Eastern Europe over the past five years, averaging 20.51%. The MSCI Turkey Index averaged 25.20% over the past five years. The BRIC index has earned 27.49% annualized.

But all emerging market countries have a high correlation. Little benefit is gained by diversifying among BRIC, Eastern Europe and Turkey. Currently the BRIC index is down 38.86% year to date. Eastern Europe is down 39.16%, and Turkey is down 31.30%.

Emerging and frontier markets are suitable for a portion of your portfolio, but only a portion. You must take care to limit the percentage of your assets invested in categories that are highly correlated and therefore all move in sync with one another. Diversification means finding asset classes that are not positively correlated to reduce the chances that everything in your portfolio goes down together.

Determining the correlation between your investments is one of the most important steps you can take toward building a defensive investment strategy. Tools are readily available online. Or to find a fee-only advisor in your area, visit the National Association of Personal Financial Advisors at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a>.

 

from http://www.emarotta.com/article.php?ID=302

BRIC Countries: China (2008-09-15)

by David John Marotta

In mid-September, the Chinese observe the Moon Festival. Timed to the moon's fullest and brightest phase, the festival celebrates the abundance of the summer's harvest. In recent years the Chinese economy has been waxing toward ascendance. It passed Japan in November 2007 and began to rival the brightness of America.

One in every five people in the world lives in communist China. Unlike other BRIC countries, the Chinese lack representative government, the rule of law administered by independent judges, basic human rights, freedom of the media, independent universities and the right of workers to move freely. Even the constitution makes clear that the government has no limits or accountability to the Chinese people.

China began its experiment of mixing explosive free-market economics with totalitarian control and repression in 1978 when Deng Xiaoping took power.

After having been purged once by Mao and a second time by the Gang of Four, Deng did not deify Mao. Rather he declared the leader to be "seven parts good, three parts bad." Understanding that Chinese Marxism needed to be reinterpreted to allow market forces, Deng argued that "socialism does not mean shared poverty." His most famous quote clarifies his utilitarian nature: "I don't care if it's a white cat or a black cat. It's a good cat so long as it catches mice."

Deng abandoned centralized planning and protected the unrestricted flow of goods throughout the country. The resulting competition between provinces led to significant growth in China's standard of living. Unlike Gorbachev, who tried to institute his own reforms in the top-down approach of perestroika, Deng simply allowed freedom at the bottom. Then he sanctioned and took credit for whatever reforms worked.

Much of China's innovation has been an investment in infrastructure. The country is spending about 12% of its gross domestic product (GDP) on infrastructure, which accounts for 43% of emerging market investments. Greater investment in infrastructure reduces the cost of moving goods and allows freer trade within the country. Estimates suggest that a 1% increase in a country's infrastructure boosts its GDP by 1%.

So the resulting economic growth in China has been explosive. But containing an explosion is difficult if not impossible.

Free markets thrive when a country guarantees property rights and the rule of law. China possesses neither of these. All land is state owned and can only be leased. The state also owns the banks, either directly or indirectly. A majority of judges are retired military officers and directed by the party. As a result, enforcement of contracts is impossible. Party officials are effectively police, prosecutor, judge and jury for any case of importance.

Currently China is ranked 52.8% free, "mostly unfree," in the Heritage Foundation's Index of Economic Freedom. Although it ranks 126 out of 157 countries, China does place highest among the communist countries, beating Vietnam, Laos, Cuba and North Korea.

Freeing selective market forces produces impressive economic gains until bottlenecks in the existing monuments to centralized power hinder progress. Without a free press and working court system, the resulting internal totalitarian monopoly of economics can't be called capitalism. As a result, most of China's growth stems from its participation in free-trade agreements.

Thanks to China's growth, it will pass the U.S. economy in the near future. But because of its huge population, its average citizens will still be economically poor by American standards. And they will be politically destitute.

The Communist Party in China worries most about religious movements, which pose the greatest threat to the party's supremacy. In 1999, about 10,000 members of the Falun Gong spiritual movement surrounded the Chinese Communist Party headquarters in Beijing. They silently meditated to protest their rejection as an accepted spiritual movement. As a result, China severely repressed Falun Gong's leaders and practitioners.

Religious groups are obligated to register in China. Their leaders must be trained and approved by the government. Sermons and teachings are monitored to ensure they do not confront government decree. Thus spiritual movements such as the Falun Gong and unregistered house church movements provide the biggest challenge to the party's supremacy and power.

Movement toward democracy, freedom and the rule of law is not inevitable. Since the brutal crackdown on pro-democracy demonstrations in Tiananmen Square in 1989, government leaders have used force to remind the population of their control. China has its own gulag where labor camps reeducate, terrorize and torture. According to Amnesty International, human rights violations are pervasive in China where nearly half a million people currently endure punitive detention without charge or trial.

Although movement toward freedom is not inevitable, the yearning for freedom is universal.

China exemplifies how the free flow of information allows a developing nation to leverage other countries' knowledge and double its per capita GDP in a decade or less. And yet China fears this freedom. It is nearly impossible to stop the flow of information, but the government continues to try. Dubbed the "Great Firewall of China," over 60 sets of broad regulations restrict Internet content.

The returns on investments in China have been impressive, averaging 23.8% over the past five years. Despite these returns, we don't recommend selecting China for specific emphasis. It is a component of the Emerging Market Index, which should be a small part of your portfolio. Think twice before investing in China because investments there won't always go up. In fact, over the past year China's return has been down 26.1%.

But you don't need to invest directly in China to benefit from a growing Chinese appetite for goods and services. Several countries in the Far East both engage in significant trade with China and also offer exceptionally open markets. Among economically free countries in the region, Hong Kong at 42.6% reports the highest percentage of its exports with China. Australia is also significant at 8.4% of its exports. Even "mostly free" Taiwan (14.9%) or Japan (12.2%) would be preferable to direct investments in China.

 

from http://www.emarotta.com/article.php?ID=301

BRIC Countries: A Passage to Indian Freedom (2008-09-08)

by David John Marotta

The modern-day Indian republic was born in 1950. During the cold war between the United States and the Soviet Union, India was a prominent nonaligned country. It was highly socialistic with the government exercising control over every aspect of the economy. These restrictive policies caused extremely low growth rates, derisively dubbed the "Hindu rate of growth."

Not until the late 1980s, when facing deficits and a major balance-of-payment crisis, did Prime Minister Rajiv Gandhi attempt to remove price controls and reduce corporate taxes. Growth increased, but partial freedom just moves economic bottlenecks to the next malfunction of Fabian socialism.

Finally in 1991, Prime Minister Narasimha Rao, along with Finance Minister Manmohan Singh, began to privatize publicly owned industries and to relax government controls in earnest. Since then India has emerged as one of the wealthiest economies in the world. Its recent growth rate of 9.1% is second only to China among the large emerging markets.

India scores 54.2% free in the Heritage Foundation's Economic Freedom index, making it "mostly unfree." Although it currently ranks 115 out of 157 countries, it has been improving slowly and steadily since the index began in 1995, gaining 9.1% over those 14 years. But even slow progress counts as progress. According to the study, every percentage point of freedom correlates to a drop in unemployment and inflation and an increase in per capita gross domestic product.

The example of Indian economic liberalization makes a strong case for increasing economic freedom. It is no longer intellectually honest to claim that restricting economic freedom benefits the people. Economic authoritarianism inevitably breeds economic malfunction.

Despite its slow economic improvement, however, India still ranks as mostly unfree. And unfree economies are scandalously wasteful. Indian government enterprises are only about 10% as efficient as the average U.S. output, and private-sector Indian firms attain only 40% of the U.S. level.

Because of globalization, emerging markets today develop much more rapidly. Poor countries like India do not need to reinvent the industrial revolution. They can benefit from the world's knowledge and experience and double their economies much quicker than it took historically. If industries in India used these best practices in technology today, they could triple their output per worker. But because of its lack of freedom, the country uses only a small portion of the rich store of world knowledge.

Poor countries are poor partially because their companies are not free to choose the best technologies. In India, obtaining a business license requires endless trips to government offices and can take a year or more.

India's lowest scores in economic freedom correlate directly with its lack of financial freedom. The country has 28 state-owned banks that control three fourths of all loans and deposits. The government also owns nearly every rural and cooperative bank. Banks are forced to lend to those who are deemed priority borrowers. Foreign ownership of banks is severely restricted.

India even legislates a list of items banned from production in large-scale plants. And because such lists are updated regularly, the potential for bribery is rampant. Like other BRIC countries, centralized planning breeds corruption. India ranks 72nd, tied with Brazil and China, out of 179 countries in Transparency International's Corruption Perceptions Index.

India has a saying for such frustration: "The fence itself grazed through the field." A fence is intended to stop cattle from grazing on your land. But what if the fence is the culprit? For that problem, you need fewer fences, not more. The best check on greedy people certainly is not to create a whole caste system of government bureaucrats and then tempt them with an overabundance of laws to enforce subjectively.

The United States would do well to learn from this example. Far too often, people react to problems by saying, "There ought to be a law." Think of the Indian proverb and translate this sentiment to "There ought to be another fence grazing through my field."

India represents only about 5.6% of the Emerging Market Index. Investments in India have done very well. Although the MSCI India Index is down 12.63% over the past year, this has only pulled the annual average return over the past five years down to 27.25%. India has been volatile but very profitable.

The Indus India Index consists of the 50 Indian stocks selected from a universe of the largest companies listed on two major Indian exchanges. Although mostly energy (28%) and materials (15%), the third and fourth largest sectors are information technology (14%) and telecommunications (8%). These industries represent India's large knowledge outsourcing.

Many of our primary contacts with India occur when we call there, thinking we are reaching an American company's help line. At first, India was the butt of help-line jokes. But now the punch line is more likely to be that you knew your tech support person was in India because he spoke English too well and could solve your problem.

We should celebrate how rapidly India is pulling its people out of misery. Globalization enhances people's welfare to the extent that they participate in the global economy. And the process of globalization is positive even when it empowers abuses and creates sweatshop conditions.

Consider the 100,000 waste pickers in India living on less than a dollar a day who sift through the garbage from Delhi. They recycle about 60% of the city's plastic, paper, glass and metals and were doing it long before it became commonplace in the United States. The stench from the rotting garbage is overwhelming; there are more flies than you can imagine. Some 300 million Indians, more than the entire population of the United States, live off less than a dollar a day.

To these Indians, a sweatshop is a step up out of the grave. They can work indoors. They can eat. They can earn more money. They can sleep under a roof.

Americans point to abuses of power and supervisors who take advantage of young women. But these abuses are only possible because employment, albeit in a sweatshop, offers the possibility of a better life. Even these abuses show to what extremes workers are willing to go to gain the value created by putting factories in India.

Additionally, American companies have nothing to gain from these abuses. Supervisors who use their position to shake down employees take value from the company. Globalization has brought democratic norms of decency and protection that have raised the treatment of women and untouchables after a long history of victimization under India's caste system.

Oddly enough, sweatshops may be the only hope for the 100,000 Delhi waste pickers. The landfills they recycle for free produce methane gas. A new waste incinerator is scheduled to be built in Timarpur, a suburb of Delhi, to collect the carbon credits under the Kyoto Protocol. Money gained from carbon credits is the primary motivation, not the environment. Although the incinerator will reduce carbon emissions, it will emit cancer-causing dioxins, mercury, heavy metals and fly ash.

Under Kyoto's Clean Development Mechanism, carbon credits generated in a poor country can be sold to a rich country and count toward the latter's emissions reductions. Oddly enough, this policy encourages the dirtiest industries and makes them more profitable. Slight improvements there can generate large credits, which the cleanest industries subsequently buy because they have trouble improving their own carbon emissions. As much as it doesn't make economic sense, Kyoto makes the cleanest industries subsidize the dirtiest.

It is already evident that Kyoto is positioned to make billionaires out of eco-traders and marginal corporations that can make coal-fired power plants slightly more fuel efficient or capture waste heat from steel plants. With great power comes great exploitation. It is difficult to imagine that carbon traders are interested in improving human suffering when millions of dollars are at stake and the World Bank is handling deals and collecting a 13% commission on every trade.

Real trade benefits real people. The unanticipated outcome of Kyoto may simply be to eliminate employment for Delhi's extreme poor. If India continues its progress toward freedom, foreign investment could do well by doing good. We can only hope more sweatshops than fences are built in place of the landfills.

 

from http://www.emarotta.com/article.php?ID=300

BRIC Countries: Russia (2008-09-01)

by David John Marotta

Since the fall of the Soviet Union in 1991, Russia has been trying to remake itself and regain its former glory and respect. The country's fall from superpower to emerging market deeply wounded its people's pride. Although the Russian Federation represents over 70% of the economy of the former Soviet Union, a lack of glasnost ("tell the truth") and perestroika ("decentralize power") still plagues the country.

Gorbachev rose to power in 1985. Two years later, at the plenary session of the Communist Party Central Committee, he laid out his plans for economic restructuring, or perestroika. At that point the black market represented the only real activity in a sluggish economy.

Perestroika took baby steps toward economic freedom. For the first time since Lenin's new economic policy in 1921, private ownership of some of the commanding heights of industry would be allowed. For those of us who grew up with the Iron Curtain, the changes seemed radical. After 70 years of communist propaganda in the East and socialist sympathizers in the West, classical free-market liberal views apparently had won the debate.

But baby steps were not enough to save the Soviet economy. Initially, high taxes and employment restrictions discouraged private investment. And foreign investment fared no better because 51% of the venture must be Soviet owned, and the chairman and general manager have to be Soviet citizens. Centralized planning was eliminated in favor of decentralized planning, rather than allowing market supply and demand. Price controls remained, as did state support for unprofitable enterprises. Because the culture long accepted corruption, socialism deteriorated into a more local form of cronyism. Traditional shortages became critical shortages of basic necessities. In short, Russia tried to institute certain economic freedoms from the top down rather than simply allowing them to grow organically from the bottom up. But fish rots from the head.

In August 1991, the military staged an unsuccessful coup against Gorbachev aimed at preserving the party apparatchiks. Unable to contain the furor for freedom and independence, however, the attempt simply hastened the regime's collapse and dissolution.

One of my favorite souvenirs, a KGB (secret police) 70-year anniversary pin, reminds me that the lifespan of centralized planning efforts is limited. These attempts at universal control lack the negative feedback that would encourage them to self-correct. Ultimately, unintended consequences build up, and a revolutionary upheaval explodes and causes the system to reset. China's communism won't turn 70 until 2019.

Russia has the largest landmass in the world, and before 1991 it had the second biggest economy. But today, Russia has become just the second letter in BRIC, four promising emerging market countries: Brazil, Russia, India and China.

During the Yeltsin years, Russian industries were privatized. But the process was rife with political patronage. Russian billionaire oligarchs thrived, confirming the adage "We hang the thief who steals 3 kopecks and honor the one who steals 3 million."

A currency crisis in 1998 devalued the ruble. Russia's gross domestic product (GDP) dropped by 50%, and the stock market lost 93% of its value. Russia defaulted on its government bonds. In the United States, the bond default contributed to the infamous bankruptcy of the hedge fund Long Term Capital Management.

Since then, Russia has demonstrated impressive growth. It has progressed from its standing in 1999 as the 22nd largest economy in the world to about 9th today. Its GDP has increased an average of 6% in recent years, less than China (10%) and India (9%) but about twice that of Brazil (3%). Russia's export growth is nearly 50% a year.

Russia is second only to Saudi Arabia in oil exports; energy companies Lukoil, Gazprom and Rosneft dominate the economy. The Russian stock market index is 39% oil and gas. It has a low correlation with the S&P 500 of only 0.43.

Until recently, Russian stocks were averaging more than a 40% return annually. But during much of this time, they were just recovering from their precipitous drop in 1998. Currently the Russian stock market is down over 30% year to date and struggling again. And at 13% it has the highest inflation rate among the BRIC nations, which eats into the buying power of local returns.

Russia differs from the other BRIC countries demographically. Its population, like Europe's, is both shrinking and aging. To try and reverse this trend, the government offers 250,000 rubles (about $10,000), equivalent to an average yearly income, to women who have a second child.

After a brief encounter with chaos under Boris Yeltsin in the 1990s, Russia moved back to a more authoritarian "managed democracy" during the reign of Vladimir Putin (2000–2008), a former high-ranking KGB official.

This is where Russia's troubles lie. Although it never really tried free markets, Russia has fallen back into the familiar weaknesses of a controlled economy hindered by bureaucratic restrictions, inconsistencies and corruption. Rated at just below 50% free, Russia earned the Heritage Foundation's lowest economic freedom ranking, repressed and on a par with countries like Vietnam, Guyana, Laos and Haiti.

Russian laws do not protect private property. State involvement in the economy has been increasing as the country has retaken its "national champion" industries of energy, shipping, shipbuilding and aerospace. Some of these takeovers represent a renationalization of industries of strategic geopolitical importance under Kremlin control. Some of them are retaliation against those who acquired their wealth in the Yeltsin years by raiding. These are popularly justified as stealing from the thief. In the absence of law, evidently power is all that remains.

And power is wielded at every opportunity. Russia ranks 121 out of 163 countries in Transparency International's Corruption Perceptions Index. Corruption is both widespread and brazen in the number and size of bribes sought.

Enforcing contracts is difficult. The judicial system, corrupt or at best inconsistent, cannot handle complex cases. When money talks, the truth stays silent. As a result, intellectual property rights are routinely violated.

Even President Putin described the corruption and cronyism. He said, "One of the most acute questions is inactivity, red-tape and excessive control in the business life of many regions. Administrative intervention is out of proportion, local markets are monopolized, closed to any activity from the outside, the local authorities are often used as a tool of unfair competition and are vulnerable to corruption."

Until recently, investment in Russia was attracting interest, but positive past returns should never be the primary reason for investing. The invasion of Georgia makes it clear that the Russian ethos still depends more on political thugs than on freedom and the rule of law. Investments in Russia are owned only at the whim of current political opinion. Therefore, we suggest you limit any assets invested in Russia to a very small portion of your emerging market allocation.



from http://www.emarotta.com/article.php?ID=299

BRIC Countries: Brazil (2008-08-25)

by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050. These countries have averaged a total return on investment in their stock markets of 38.28% over the past five years, up 5.02% over the past year.

It pays to look outside the United States for investment options. Every portfolio should be crafted to have the optimum amount of noncorrelated assets in order to lower volatility and increase returns. Understanding BRIC countries helps investors and their advisors determine what percentages best meet those goals.

According to the original investment thesis, these emerging market countries have the preconditions needed in an emerging market to encourage sustainable successful development. Their economic strengths should be able to overcome their economic or political weaknesses.

The term "BRIC" has become synonymous with "emerging markets" in investors' minds. But when the acronym was coined, the BRIC countries were perceived as distinct entities. They have never represented more than 30% of the Emerging Markets Index. The three largest countries, representing more than 40% of the index, are South Korea, Taiwan and South Africa.

Over the past five years, the BRIC subset has beaten the Emerging Markets Index annually by a whopping 11.07%. And the index is down 4.36% over the last year, whereas the BRIC index is up 5.02%.

Brazil, the biggest BRIC country, is credited for most of this performance. It has the fifth largest landmass and the fifth largest population in the world. Brazil also has the best five-year return. As of the end of July, the MSCI Brazil Index showed a five-year annualized return of 53.91%, and it is up 32.05% over the past year.

But these returns came with a price. An editorial last month criticized President Lula for "loving investment grade [securities rating] over the welfare of his people." The Brazilian central bank has set the interest rate at 13%, although inflation is only expected to run at about 5%. This has kept Brazil's currency strong. Contrast the Brazil's strong currency policy with the U.S. current interest rates of 2% while inflation is running an actual 5% to 10%. As a result of the difference in monetary policy, the Brazilian real (R$) has appreciated 222% (16% annualized) against the dollar since January 2003. Brazil's conservative monetary policy has helped it lower government debt to 41% of gross domestic product compared with the U.S. debt currently at 70%.

Brazil has potential, but a lack of economic freedom still holds the country back. Graft and corruption are rampant at every level of government. Injustice is commonplace. Who people know determines the amount of bureaucratic regulation they have to suffer. "For my friends, everything. For strangers, nothing. For my enemies, the law." This common Brazilian adage is a sobering reminder of the mindset there.

Starting a business in Brazil takes 152 days, more than three times the world average. Obtaining a business license is difficult. Just going bankrupt takes four years. Such an environment is difficult for most Americans to comprehend.

The resulting extreme inequity between the haves and the have-nots in Brazil motivates the latter group to seek relief politically. More than 30% of the population live below the poverty line and identify with the socialist and communist political parties.

But as political activists press for more laws, opportunities increasingly open up for unequal application by corrupt officials. This blocks the development of commerce. A professional class of intermediaries is required to facilitate introductions and grease governmental red tape. Substituting personal relationships for the rule of law also creates instability, so entrepreneurs hesitate to take risks. As a result, a well-intentioned socialism actually helps perpetuate the opportunity for abuse and inequality.

One area where Brazil has excelled is making headway toward energy independence. The 1973 oil crisis hit the economy particularly hard. During the recession that followed, Brazilians learned the hard way about the importance of energy. Today, Brazil's extensive system of rivers generates about 90% of its hydroelectric power. The country has also developed a large sugar industry to provide ethanol for domestic use and as an export. In the last few years, Brazil has begun drilling for offshore oil and natural gas. So it may become an oil-exporting country.

The United States imposes a $0.54 cents a gallon tariff on Brazilian ethanol made from sugarcane to protect the ethanol made from U.S. corn, currently at $2.90 a gallon. Ethanol made from Brazilian sugarcane at $1.40 a gallon would be less than half the price. But the tariff pushes Brazil to sell to other markets that do not impose a tariff.

Oddly enough, Brazil itself discourages imports through a wide range of nontariff barriers. As the world economy falters, somehow a majority of people in different countries believe they are the losers in free trade, one of the most simple and easy ways to enrich the world.

Today the winds of trade wars are blowing cold everywhere. Politicians need foreigners to blame for domestic economic troubles. Even our own mantra has become "fair trade, not free trade." But the word "fair" is left vague. This is a political advantage; after all, no one favors unfairness. The unintended harm of trade restrictions are difficult to connect to the cause and take years to unfold.

President Clinton should be praised for moving the United States toward free trade. In the fall of 1991 while running for president, he overruled his campaign's internal debate. "Clinton looked up over his spectacles and said, 'I want all of you to understand something: I'm not going to run as an isolationist, and I'm not going to run as a protectionist,'" recalls political theorist William Galston.

Today, Republican presidential nominee John McCain is the heir to the Clinton administration's economic principles. He says, "Every time the United States has become protectionist we've paid a very heavy price. Free trade has been the engine of our economy." His position won't help him any in the upcoming election.

During the Clinton years, a majority of Americans viewed free trade positively. But after the Democrats lost control of Congress in 1996, fear became a political tool. Job loss to foreign workers is an easy target. Specific anecdotal experiences trump clear economic studies. As a result, unions and environmentalists, opponents of free trade, heavily contributed to the Democrats winning a majority in Congress in 2006. Today, 68% of those surveyed in a Fortune magazine poll believe that America's trading partners benefit more than Americans from free trade.

In Brazil, political sentiments appear to be no different, except that we play the role of greedy foreigners. This occurs despite the fact that much of the country's historical growth has been export driven.

Emerging market countries are volatile. Brazil is no exception. A military dictatorship ruled the country from 1964 until 1985; the constitution was rewritten in 1988. A decade later, Brazil experienced a currency meltdown. Then in 2002, Brazil received a record International Monetary Fund bailout it repaid in 2005, earlier than required. Since that time, the real has appreciated tremendously against the U.S. dollar. It is responsible for 16% of the 53.91% annualized real return in the past five years.

Generally BRIC countries don't move in sync with the U.S. markets. The EAFE Foreign Index has a five-year correlation of 0.81 with the S&P 500. The emerging markets correlation is only 0.72, and Brazil's correlation is only 0.58.

We don't recommend that BRIC countries comprise a major portion of your portfolio, but they should be represented. Although any unstable investment can endanger the chances of meeting your financial goals, a small allocation to a volatile investment can enhance them, especially if that investment doesn't move in sync with your other investments.

 

from http://www.emarotta.com/article.php?ID=298

Behavioral Finance: Patience Is Its Own Reward (2008-08-18)

by David John Marotta

To process financial information, our minds often attempt unwise shortcuts. By understanding behavioral finance, we can limit the information we use and keep our decisions balanced and on track.

Financial information on the Internet is excessive and changes daily. This overload leads to excessive trading, which in turn results in lower returns. Studies suggest that analysts who depend on all this overwhelming advice make poorer decisions even though they feel more confident about them.

Another reaction to information overload is paralysis. When investors have one attractive option, they tend to invest. When they have two or more appealing choices, they may fail to act because they are afraid of making a wrong decision and looking stupid. This regret aversion motivates them to go with the status quo, which is often more costly than either of the promising alternatives.

Over the long term, the U.S. stock markets go up an average of 11% annually, beating inflation by about 6.5%. But to earn this great typical return, studies in behavioral finance indicate that we must be able to tolerate the year-to-year volatility.

In each of the last five years, the stock markets were up. The three years before that (2000 to 2002), the markets were down. Many people worry about the timing of getting into or out of the markets: Will 2008 be an up year? What about 2009?

I will give you the forecast for the next <i>ten</i> years in the U.S. markets: up, down, up, up, down, up, down, up, up, up. These predictions are not in chronological order. This year could be one of the "up" years or one of the "down" years. It is a gamble, but unlike most gambling, the odds are in your favor. About seven of every ten years are up years, and they are usually stronger than the down years.

If you are an investor, the odds are in your favor. But not everyone who buys and sells stocks is an investor. Some people play the markets looking for short-term gains and follow hot tips or quickly timed movements. These people are speculators, not investors.

Compare an investor with an orchard manager who goes to a nursery to buy some peach trees. He buys the trees because he understands about growing and selling fruit. He knows how to care for the trees, harvest the peaches, and deliver them to market. He understands what is involved across the whole spectrum of his business: from nurturing the natural juicy fruit to savoring it baked in a delicious peach cobbler.

Speculators buy some peach trees when they see the nursery's supplies are dwindling. Then they stand in the parking lot hoping to resell the trees at a profit. Speculators do not care what they are buying or selling so long as the price moves quickly. So they never really buy peach trees. Speculators purchase snow blowers when the blizzard is forecast or generators as the hurricane gathers strength, or whatever else they think might show a short-term spike in price.

If the blizzard misses or the hurricane fizzles, speculators lose money. The possibility of more demand raises prices appropriately. If the likelihood increases, prices go up even higher. If the likelihood decreases, so do prices.

As soon as it is feasible, speculators sell quickly because they believe the spike is short lived and temporary. This tendency led to the investment truism "Buy on rumor and sell on news."

In other words, even if speculators are right, their profits depend on being faster to buy and faster to sell. For the speculator, speed is everything. Not so for investors.

Investors, like farmers, substitute seasons of patient labor and care for speed and market timing. They make their money off the gradual growth in the value of their investments. In contrast, salespeople must keep their merchandise moving because their product isn't getting any more valuable. They make their money off commissions on the transaction itself. For them, what is important is the speed and number of transactions. Brokers and those who sell "loaded funds" are salespeople, not peach farmers. Their livelihood depends on the number and rate of trades in an account. These incentives for speed can lead to abuses.

Frequent trading in an account for the purpose of gaining commissions is called "churning," measured by the turnover rate in an investment portfolio. Turnover is the percentage of an investment account's asset that are bought or sold during a year. Churning can be defined as a turnover rate of over 300%, meaning the entire portfolio value is bought or sold every four months.

An important criteria we use for equity mutual fund selection is a turnover ratio of under 50%. We advise you to be patient and try to ignore the market's ups and downs.

Studies show that mutual funds with a lower turnover rate perform better. Short-term trading has a cost and usually reduces performance. To make money, speculators usually must guess the highs and lows in the stock market within six weeks.

This investment philosophy does not depend on what the markets did in the last four months or what they will do in the next four months. We can't imagine a peach tree that would look good to buy and hold for only four months. Investing is like planting a peach tree: You have to wait for the fruits of your labor.

So don't worry too much about the timing of getting in and out of the market. Focus instead on having a diversified enough portfolio to weather any market--up or down. Once you have a brilliant investment strategy, a successful investor's greatest virtue is patience. As scientist and mathematician Georges-Louis Leclerc said, "Patience is genius"--and it is often the best defense against short-term noise that can ruin your long-term results.

 

from http://www.emarotta.com/article.php?ID=297

Behavioral Finance: Herd Mentality (2008-08-11)

by David John Marotta

One of the early studies on herd mentality was the Solomon Asch experiments in the 1950s. The setup was a mock vision test. In reality, all but one of the participants were actors, who after a few correct answers started agreeing unanimously on a wrong choice.

In a control group, participants had no trouble answering correctly. But participants waffled when a group of three or more people who preceded them confidently selected a different answer. Three out of four responded incorrectly to at least one question. In the end, participants answered incorrectly about 37% of the time.

First we must acknowledge that the phenomenon of the herd mentality can be useful in many situations. For example, computer simulations show that even when only 5% of the animals in a herd know the location of the watering hole, the entire herd is able to find it. In nature, keeping the number of leaders low helps minimize those who are put at risk. People use these instincts every day as they leave theaters and navigate crowded streets.

Although the herd mentality may help you find greener pastures if you are a bison, it won't help you find untrampled pastures. In investments, every bison ahead of you has already run the price up, and the only buyers of your investment are behind you. Straggling along at the back of the herd doesn't stop you from reaching the watering hole, but being toward the end of a run-up in the markets can be as deadly as drinking from fouled water.

In the original Asch experiments, those who were persuaded to give wrong answers used two different sets of reasoning. One group believed that everyone was trying to give the right answer and they had somehow fallen victim to an optical illusion. The assumption that three presumably honest people are correct and you must be wrong could help you avoid some mistakes. The herd mentality can keep you from wandering off into the desert seeking to drink from a mirage.

The other group gave the wrong answer knowing it was wrong simply because it wasn't worth giving a different answer. Every time they broke the pattern of giving the same answer as everyone else, the cadence would stop and the entire group would look at them. They suspected that everyone else was wrong, but they saw no harm in going along and agreeing anyway. This is how the herd mentality can help your social life.

Even though a herd mentality can be useful in some situations, equity markets isn't one of them. In the markets, the herd effect benefits those at the front of the herd who can sell their place at the watering hole to those at the tail end before too many bison have fouled the water. Being at the tail end of the herd produces regret as the herd moves on, leaving you in a trampled field. But to avoid the pitfalls of this herd instinct in your investments, you need knowledge and conviction as well as an awareness of when you are susceptible to the influence of the herd.

In the original study, at least three actors were required to achieve this herd effect, and they had to be unified. If even one person gave the correct answer, it provided a role model for defiance and the herd effect was reduced. People seemed to need permission to disagree with the herd.

I give you permission to disagree with the herd.

Countering the herd effect is the essence of being a contrarian, that is, an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn't chase what is hot but often buys a category that has recently underperformed.

Major news sources move markets just by their tone of optimism or pessimism. The financial news often focuses on daily price movements, and like all sports trivia, it tends to emphasize winning or losing streaks.

Stock prices can move on very low volume if it is all in one direction. Even when the vast majority of those who hold stocks continue to hold them, if even a few investors are motivated to buy or sell, the price moves significantly.

In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. The markets offer so much inherent opportunity that even conservative investors get swayed by the siren songs of greed or fear. The strait between Scylla and Charybdis is a narrow path safely navigated only if you have a nymph like Thetis to guide you.

In the financial world, your Thetis is a long-term investment strategy and the discipline to purposefully avoid moving in one direction. Not following the crowd describes a contrarian perfectly. And the cornerstone of that role is rebalancing your portfolio regularly.

Imagine you have a $100,000 portfolio consisting of two different categories, A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, A has earned 30% and B has just broken even. You now have $115,000: $65,000 in A and $50,000 in B.

You are happy with your investment in A, but you still aren't sure about B. All the financial news is about A's stellar returns, how the industry is booming, and why A's products are essential to life on this planet. The news also reports the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.

To make matters worse, your neighbor to the right works in Category A, and his 30% investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in B and adding to his investment in A. So you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.

"Yes," answers your financial advisor, "sell $7,500 of A and invest that in B." You are stunned. You wonder if your investment advisor is so stubbornly enamored by B that she won't admit her mistake and insists on pouring more of your investment gains down the drain.

Although you are not convinced by this so-called strategy, you decide to give it another try. So you sell some of A and buy more B. Now you have $57,500 invested in each.

Fortunes change. The layoffs and new leadership in B return profitability and the industry begins to recover. Stock prices, beaten down because of losses, rebound from their lows, and B gains 30% the second year.

Meanwhile, A's growth falters. Stock prices had been driven up from new investments and were pricing the company for 30% annual growth. When the industry of A only experiences 15% growth, however, the stock prices falter and appreciation ceases. Despite 15% growth, current stock valuations are barely justified and drift sideways for a 0% gain for the year.

Your brother-in-law and your neighbor to the right are tight-lipped.

Your neighbor to the left, however, is ecstatic. He works for a company in B. Not only is his company doing better, his investment made a 30% return this past year!

You are satisfied but not ecstatic. You've never gotten a 30% return. You meet with your investment advisor and ask her, "If you knew B was going to do well, why didn't we put all the money in that category?"

"I didn't know B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15% the first year and 15% the second year. Unlike your neighbors, the second year's gains compounded with the first year's gains produced a total gain of 32.5%."

You are amazed. The simple contrarian act of pulling money out of the investment that was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5%. Not only did your investments do better than your neighbors did, but you avoided the feast or famine volatility inherent in their approach.

As a financial advisor, I can often predict which category will perform the best over the next year just by observing the reluctance of new clients to invest in that category. A savvy Rothschild banker once gave this "contrary" advice: "Buy when there is blood on the street and sell on the sound of the trumpet."

It's tough being a contrarian, but investing in trampled on categories is too critical for your investment returns to let emotions or the herd mentality block your success.

 

from http://www.emarotta.com/article.php?ID=296

 

Behavioral Finance: Overconfidence (2008-08-04)

by David John Marotta

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume they are enjoying above-average returns.

Part of the problem is certainly overconfidence. Research studies indicate that a majority of members of any group will rate themselves above average on a given task. But part of the difficulty may also be what people value in the task.

For example, 82% of students rate themselves in the top 30% of safe drivers. Some new drivers define the quality of their performance by how many accidents they've had. Others use speeding tickets as a measure. And sadly, some young adults consider themselves safe drivers because they can execute trick maneuvers drunk while doing 100 miles an hour. Inexperience often breeds overconfidence.

According to behavioral finance studies, overconfident investors trade more and earn less than those who opt for a buy-and-hold strategy. These brash investors time the market poorly, all the while assuming they're doing better than average. They maintain this delusion by selectively forgetting how they believed all the misleading and confusing indicators that falsely predicted certain outcomes were inevitable. If the outcome happens months later at half what they predicted, they still say, "I told you so." Without calculating an accurate time-weighted return each month, they assume their own brilliance.

We tell stories so we will remember experiences, not forget them. We say, "I don't want to talk about it" because that helps us forget. In investing, we recount our winners and prefer not to talk about our mistakes. This tendency is universal even if we are only reviewing our investment decisions in the confines of our own minds. Thus without a rigorous review methodology, how we remember trumps what actually happened.

Certainly a little overconfidence is better than a lack of confidence. Because the markets on average go up, an emotional bias that keeps us invested helps us earn better returns. Overconfidence that causes us to underperform the market by 2% annually still translates into reaping quite satisfying returns. Therefore overconfidence only becomes dangerous when we can't conceive of failing.

A demotivational poster available at <a href="http://www.despair.com/overconfidence.html" target=blank>despair.com</a>, entitled "Overconfidence," pictures two downhill skiers trying to outrun an avalanche. The caption reads, "Before you attempt to beat the odds, be sure you could survive the odds beating you." That's sage advice.

Deadly overconfidence causes us to break one or all of these five rules of investing humility:

<b>1. Don't borrow money to buy stocks.</b> The markets are inherently volatile, and your investment strategy must be able to survive a prolonged downturn. If you have purchased stocks by heavily margining your account, you will experience a margin call when your investments drop in value. Being forced to sell equities when the markets are down is a surefire way to lock in losses and lose your shirt. Many options and other investment derivatives also leverage your investments and increase the potential for disaster.

Here's a humbler approach: Err on the side of caution and keep a portion of your portfolio in cash or fixed income. "Keep some dry powder" is the maxim. Having cash to buy back into stocks after a market correction both boosts as well as smooths your investment returns. And thanks to the effect of compounding, smoother returns produce better returns.

<b>2. Diversify.</b> Even if you are right nine out of ten times, if you always bet the farm, then one mistake will lose everything. No matter how confident you are, plan on doing OK even if you are wrong. Diversification means you will always have something to complain about. But it also means you won't make more than half a mistake.

Many investors make their fortunes through a few lucky picks and mistakenly believe they can maintain their wealth the same way. Easy come, easy go. Especially if you got rich by being lucky, you need to wise up and realize you don't know it all. Find an asset allocation that will survive the next 30 years.

<b>3. Avoid correlated investments.</b> Correlated investments all move in sync with one another. Investors at the end of the 1990s believed they were diversified because they had five different large-cap growth mutual funds. They all moved in sync with one another and lost 69% of their value shortly thereafter.

When the correlation between two investments rises, the value of diversifying between them diminishes. Stay alert about events that always appear more unlikely based on historical statistics than they actually are. Past performance always underestimates the actual volatility. Because it is often these unknowns that pose the real risk, take precautions that help protect you no matter what the disaster may be.

<b>4. Keep short-term spending safe.</b> Maintain a cash emergency fund that can provide three months of spending. Keep another three months' worth in safe fixed-income investments. During retirement, keep the next five to seven years of spending in fixed income. This strategy allows you to put the remainder of your portfolio in the markets and survive the inherent volatility.

<b>5. Lean toward indexed investing.</b> Select funds with low expense ratios based on an index that follows the asset class you are investing in. Even using index funds, you may end up with a few dozen funds, but each should provide a low-cost way of investing in that asset class.

Low-expense passive index investing has been receiving a growing percentage of investment dollars. This suggests that investor overconfidence in beating the market is decreasing. Investors have learned that just achieving a good market return is sufficient to achieve their goals.

Self-diagnosing investment overconfidence is nearly impossible. It's safe to say that if you are invested as much as you should be, you are likely overconfident. You are probably losing a few percentage points to this overconfidence, but because you aren't keeping track of your time-weighted return, you remain blissfully unaware.

A quarterly review of your portfolio for the five rules of investment humility just described can help you avoid a world of hurt. Brokers and agents don't have a fiduciary duty to act in your best interest. Visit the National Association of Personal Financial Advisors (<a href="http://www.napfa.org" target=blank>www.napfa.org</a>) to find a fee-only advisor in your area.

 

from http://www.emarotta.com/article.php?ID=295

Behavioral Finance: Overconfidence (2008-08-04)

by David John Marotta

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume they are enjoying above-average returns.