Archive for October, 2010

The entrepreneur was being interviewed after a long life.  He had made it through the Great Depression and was looking back.  As he warmly reflected, he straightened up and with a twinkle in his eye told the world the secret of his success.

“It was really quite simple.  I bought an apple for five cents, spent the evening polishing it, and sold it the next day for 10 cents. With this I bought two apples, spend the evening polishing them and sold them for 20 cents. And so it went until I had amassed $1.60.

It was then my wife’s father died and left us $1 million.”

Sudden wealth is certainly one way to make it.  And the lottery is another.

But in reality most of us will need to rely on the principles of growing your wealth slowly.

It may not be sexy and exciting to talk about but over time there are certain principles that will work:

  • Living beneath your means
  • Consistently saving
  • Responsibly using credit
  • Protecting your assets, life and income with appropriate insurance
  • Investing in a broad, diversified mix of assets

Of course there are lots of specifics that need to be tailored for each individual and to reflect what’s going on in the world around us.  From year to year specific investments may need to be changed just as you might change the drapes or the color of your house. But the overall process of building and preserving wealth depends on the foundation you build. And like your house, you want that foundation to be solid.

Over the next several posts I’ll continue to explore the most common mistakes that investors make and how you can avoid them.

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Much of the US economy is tied to real estate.  Buying and maintaining a home creates a very big ripple that impacts lots of industries and jobs.  Certainly, the bursting of the speculative bubble in building and lending has resulted in a devastating chain of events including an increase in home foreclosures.

In the economics textbooks I had to study back in college, the theory is referred to as “creative destruction” as industries change and assets are repositioned.  In reality, we’re dealing with individuals and families and it is a painful process.

In news accounts and on our own streets, we can see the impact as families who once were proud homeowners or even responsible tenants are forced to leave their homes as part of the foreclosure process.  And foreclosures continue to have a negative impact on real estate values.

Aside from the pain it is a necessary process to get to a floor in prices that will help lay a foundation for stable or future increasing prices.  And as the pendulum swings in the positive direction it will hopefully lead to a virtuous cycle for an improving economy.

Between here and there, between continued gloom and future hope, there’s some scary ground still to cover and put behind us.  Just like in the horror movie where the heroine is within sight of safety when the bad guy pops up again, we now have to look over our shoulder at some little noticed trends that threaten the nascent recovery.

Recently, the entire foreclosure process has been forced to grind to a halt in many communities because of the “robo-signing” of foreclosure notices by many of the nation’s largest banks and mortgage servicing companies.

But besides this well-reported issue there are other developments that are easily overlooked by those not involved in the industry.

  • No Title Insurance: Mortgages are secured by collateral.  In this case that means the land and buildings that sit on it.  Evidence of this comes in the form a deed that describes the location and the chain of title showing who owned it and what loans or liens have ever secured it. A loan cannot be closed without the lender being able to secure “title insurance” which protects the lender in the event that there is a claim by someone or some bank that says that the new bank’s borrower really doesn’t own it.  And right now title insurers are protecting themselves by avoiding issuing any insurance on any property that has a foreclosure in its history of ownership.
  • Uncertainty Leads to Gridlock: Nearly 20% of all real estate sales in August 2010 have been of distressed properties.  With the prospect of increased litigation and the drying up of lending sources, this will lead to fewer sales.
  • Legal Challenges to Evictions and Foreclosures Have and Will Increase: Such legal challenges will make it harder to clear the backlog of foreclosed inventory.  Costs to potential buyers and banks to defend claims will increase and make the idea of buying a “bargain” foreclosure property very expensive.
  • Banks Face Higher Unknown Costs That Threaten Their Survival: Aside from legal costs, the potential for fines and other penalties imposed by courts for the alleged fraud perpetrated by “robo-signings” means that banks will need to set aside more in reserve against this potential outcome and have less available to lend to consumers and businesses.
  • The System of Electronic Trading of Mortgages Is in Question: In the fast-paced world that we live in, we prize speed, convenience and efficiency. To help make the processing of lending and refinancing more efficient, the banking industry created the Mortgage Electronic Registry System (MERS) to allow banks to sell, package and transfer mortgages and mortgage servicing rights among them.  But one of the results of the “robo-signing” scandal is that courts may scrutinize MERS and rule that it really doesn’t own the underlying mortgages and has no right to transfer them.  If that happens, that will call into question who actually owns the loan.
    • Without clear ownership rights, then it calls into question who has a right to foreclose on a property.
    • If the lender is not really the lender, then homeowners can and have started ignoring the eviction and foreclosure attempts by these lenders.
    • If it is questionable about which bank owns the loan, then that devalues a big source of bank income from servicing the billions of dollars of mortgage, tax and insurance payments that it handles every month, a source of revenue to the bank and an important part of its valuation which will now also come into question.

However this plays out, it looks like the lawyers will be busy for a long time.  And the rest of us are left with a very big cloud over our head trying to recover from something way worse than any witch or pirate appearing at the front door this Halloween.

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It is said that when the British surrendered to the Colonial Army at Yorktown the band played a tune titled “The World Turned Upside Down.”  True or not, it is a fitting sound track to a seemingly improbable situation: The defeat of a well-trained army and navy of the most powerful empire in the world by an under-funded, out-numbered and ill-equipped army of colonials. It was as if the Sun, Earth and stars had become unhitched leaving navigators without their usual bearings.

In much the same way, the Great Recession has shattered our views on what is ‘safe’ and what it means to be ‘conservative’ or ‘aggressive.’  Looking to preserve capital and produce income?  Invest in government bonds and maybe real estate.  Young and looking to score big on the potential upside of stocks? Go for small company stocks or overseas because if there’s a bust you’ll have time to recover. At least that was the conventional thinking. Everything that was traditionally considered to be ‘safe’ and dull turned out to be dangerous and ‘risky.’

There’s nothing scarier than conventional thinking in a changing market.  And what has evolved after the near melt down of the US financial system – indeed the global financial system – in the Fall of 2008 is certainly a changed market.

Household names including the bluest of the Blue Chips have entered and come out of bankruptcy.  The foundation for wealth for most people – real estate – has crumbled and is a long way from recovery to previous levels. Government debt of developed countries considered at one time to be nearly risk-less have been to the precipice as Greece neared default and threatened the entire Euro zone. Now, it’s not even beyond the pale to consider a future downgrade of the credit rating of the US Government.

Having an understanding of risk is important not just for investors but for the advisers trying to guide them.  In the past, an adviser (or your company’s 401k web site) would have you fill out a questionnaire.  Those eight to 12 questions would identify the type of investor you were and lead to an asset allocation reasonably appropriate for an investor’s Risk Profile, Time Horizon and Goals. This was sometimes considered a “set and forget” type of thing.

But commonsense and our experience tell us that things change.  Take the weather:  Some days it’s sunny and other times it’s rainy or cold.  What you wear on one day or even part of a day may not be right when the weather changes.  That’s just like investing.  A risk profile and asset allocation determined at one point might not be right for another.

So risk profiles are not static things either.  Invariably, they change based on how we feel. Hey, we’re only human. You need to reconsider your risk appetite regularly and now is a good time.  And it should be more than a few multiple choice questions.

After the run-ups in the markets in the late 90’s, people would tend to see things going up perpetually and say they would be more comfortable with risk.  On the other hand, after the two major meltdowns this past decade, the pendulum has swung the other way. Too far, in fact.

Faced with our own emotions and the vagaries of a global economic system, one might consider it to be less risky to sit on the sidelines.  Or maybe it’s safe to put all your chips on what you know – like your company stock.  Or just cash it all out and leave it parked in a money market or bank.

At first glance these strategies may be considered low risk but in reality – even the reality of today’s changed world – they are not.  Your company stock?  Consider Enron or Lucent and ask their employees how their retirement accounts held up.  Cash?  At the minuscule rates banks are offering, you’re already behind the eight ball with taxes and inflation.

There’s more to risk than the volatile nature of an asset’s price. And what should matter most is not which assets are owned but how well they perform on the upside and downside.

If you’re hungry, your goal is to not be hungry.  You say you like to eat steak and always eat steak.  Well, that’s great but the risk of heart disease may catch up to you.  So what you ate before may not be right for you now. Maybe it’s time to substitute more fish and add more vegetables.

That’s the essence of remodeling your portfolio now.  Government bonds still have a place in your portfolio – just like that steak – but it’s time to scale back on the developed nations of Europe with their risks of default and the US where another bubble is brewing and add those from emerging markets. If you own gold or want to buy it because it’s a “safe haven” for inflationary times and you don’t want to miss the boat, consider other more usable commodities like potash.  (As the world adds nearly 75 million people a year, there’s a growing demand for cultivating food for them and potash is a staple needed for fertilizers).  After seeing a huge multi-national like BP get hammered for its lackadaisical approach to employee and environmental safety, it may be time to add more small companies to the mix which have less bureaucracy and may be faster to respond to opportunities and troubles.

The risky stuff may actually be more safe than the traditional stuff.

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