Productive Worrying

I recently read an excerpt from Seth Klarman’s Year End Letter that addresses the idea of worry and how it relates to investment returns. Whenever my wife starts to worry about things that I think are unimportant, the song made popular by Bobby McFerrin, “Don’t Worry, Be Happy,” comes to mind. When it comes to investing, that seems to be the mantra of the day. Don’t worry, everything is fine, this time it’s different, we’ve rounded the corner, the future is looking rosy, and every other manner of crap that comes out of Wall Street.

Almost all investment advisors, stockbrokers, and financial gurus spend their time marketing returns. In most of the advertising you will read about results. One year returns, five year returns, ten year returns, and so on. The purpose of this kind of advertising is, of course, to entice you and I into sending these folks our money. What they do not tell you is how much risk you must take on to achieve these fabulous returns.

When investment promoters do talk about risk, they typically only talk about is systematic or market risk. This is the type of risk that diversification will help to reduce. Notice that I say reduce. Market risk cannot be totally eliminated no matter how well you diversify because if the market suffers a large decline, all stocks tend to be affected to some extent.

The other type of risk is known as non-systemic or non-market risk. This type of risk is associated with individual stocks and has to do with such things as business risk, liquidity risk, and financial risk. These types of risk tend to show up when you invest in individual stocks or in sector funds that concentrate on one particular industry segment. Things that can affect non-market risk include such things as competition, new technology, and earnings shortfalls. I mention risk because in the current investment environment, decent returns have been hard to come by without taking on a tremendous amount of risk.

Investment managers are under tremendous pressure to deliver returns and as a result, take on increasing levels of risk in an attempt to beat the market. These investment managers are paid based on returns, not risk, because risk is hard to quantify. The only time we as investors concern ourselves about risk is when things are already going badly for us. This is not the time to worry. The time to worry is before things go bad.

Productive worrying allows you to identify risks and take appropriate action before you suffer lose. Concerned that a stock you hold may fall sharply? Then establish an appropriate hedge by buying puts or investing in an inverse fund.

Here’s the key…successful investing goes hand in hand with productive worrying.

Oil Update

I mentioned in my last post that I would talk about what I see as price gouging by the oil companies. As I am sure you are all aware, prices tend to rise a lot faster when the price of crude oil goes up. As crude oil drops, gas prices tend to stay high and never return to their starting points.

I found a chart that shows how much revenue at the big oil companies has increased over the last two years. I bet you wish that your revenue had increased that much…

Here it is from the Financial Sense website. http://www.financialsense.com/Market/puplava/2005/0314.html

Tech vs. Oil
	2yr Earnings Growth %	P/E	Yield %	ROE
Exxon-Mobil	121.6%	15.4x	1.8%	26.5%
ChevronTexaco	1,077.4%	10.5x	2.7%	32.7%
ConocoPhillips	*389.4%	9.1x	1.9%	21.1%
Occidental Petroleum	*159.6%	11.3x	1.7%	27.8%
Marathon Oil	144.4%	11.9x	2.4%	23.7%
Microsoft	4.3%	19.6x	1.3%	11.7%
Cisco	132.5%	22.1x	0.0%	16.3%
Dell	43.4%	30.8x	0.0%	47.7%
Intel	141.1%	21.1x	1.3%	19.7%
Oracle	20.5%	23.0x	0.0%	37.5%
Source: Bloomberg L.P.

Pretty impressive eh?

What’s Up With Gas Prices?

I don’t know about you, but lately, when I pull into the gas station to refuel my car, I get really grumpy. How can gas prices be so high? What’s up with gas prices? And why is it that when crude oil prices increase, our gas prices seem to immediately jump higher, but when crude oil prices fall, it takes forever for gas prices to come back down?

Well, I’ll tell you, it is a complicated picture and there is some price gouging going on as I’ll show you in a minute. Anything to do with economics seems complicated because there are so many variables that come into play, but for today let’s look at some simple reasons why crude oil prices and in turn, gas prices have been going up.

Supply and Demand

It’s the old supply and demand game. If more people need gas to power their cars, prices tend to rise. In a world with unlimited resources, this increase in price would cause an increase in supply through increased exploration, increased production, or both. The result would be that eventually, prices would stabilize.

We, however, do not live in a world of unlimited resources. We are using up our crude oil supplies at a rate of 84.3 million barrels per day. That’s a lot of oil. What’s more, China’s demand for oil is expected to grow by 100,000 to 500,000 barrels per day this year. And China is just getting started. They currently have about 20 million cars on the road. In the next 15 years, that number is expected to top out at between 120 and 145 million cars. Where is all of that gas going to come from?

Now, you may be thinking or reading that OPEC is going to increase production and that they have adequate supplies to handle all of this grow. After all, that’s what the news media says on a regular basis, but the fact is, experts are telling a far different story. Matthew Simmons of Simmons and Simmons, Intl. (Click Here) and Kenneth Deffeyes, author of “Beyond Oil” believe that the world may hit peak oil this year. So what is peak oil? It is the point where total world oil production starts declining. Based on their latest research, all of the non-OPEC countries have reached peak oil and are in decline. OPEC may have less than one million barrels of capacity left before they hit peak oil. In fact, last weekend, Algeria’s minister for energy and mines said that OPEC had reached its limits.

So, from our brief study of economics what happens when demand increases (read Chinese), and supply decreases, (peak oil)? That’s right! Prices increase. See this economics stuff isn’t hard. Forbes Magazine reports that in the next 4 or 5 years, crude oil could hit $100 per barrel. Let’s see, oil at $53 per barrel equals gas at $2.25 per gallon, so oil at $100 would equal gas at almost $5.00 per gallon. Whew.

Recession Here We Come

You would not believe how many things in our every day lives are made out of or with oil. And how many more things are trucked, shipped, and delivered using oil. All of this points to increasing costs for just about everything we eat, wear, and use. When prices go up, total purchases go down and so does the economy. All the more reason to make sure your investment house is in order.

Inflation, Inflation, Everywhere Inflation

It is interesting to see our government telling us on a regular basis that there is no inflation or very little. Of course we all think inflation and begin looking at prices and how much they have increased lately.

Inflation isn't really a measure of how much prices have increased but how much the money supply has increased. Price increases are the result of an increasing money supply. When the Federal Reserve determines that we need more money floating in the banking system, they create more dollars. Used to be, they did this by firing up the printing presses. Now it is simply a matter of digitally crediting banking institutions with more funds.

Basic economic theory says that if you create more money, that money will be used to buy more goods and services. Prices go up for two reasons; either increased demand or limited supply.

The Feds, in their infernal wisdom, believe that by manipulating the money supply, they can control swings in the business cycle. What really happens is that they cause companies to spend money to meet the increasing demand for their products. Demands that wouldn't be there if there wasn't so much extra money floating around. This malinvestment by companies creates imbalances in the economy, which at some point must be dealt with, usually in the form of an economic bust.

An example is the currently red hot housing market in several cities around the country. The run-up in prices has been fueled by unusually low interest rates. Interest rates that cannot stay low forever. This is bubble waiting for a sharp pin in the form of higher interest rates. When, not if, interest rates start moving up, the real estate markets will fall, in some cases, rapidly. You do not want to be overextended in those hot markets when that train roars into town. I predict that people will literally walk away from their homes and leave huge mortgages behind.

Since the Federal Reserve's formation in 1913, the dollar has lost 98% of its value. This is a result of a continuous increase in the money supply. There was once a time when we held gold as a backing for our dollars. The exchange rate was fixed at $35 per ounce; however, in 1971 President Nixon closed the gold window and floated the dollar, no longer tying its value to gold. It is estimated that if we were to fix dollars to gold once again, gold would be valued at over $4000 per ounce. That's how many extra dollars we have floating in the system right now.

Some day this problem is going to come home to roost and when it does, we as a country will suffer. We will no longer be an economic super power. The government will no longer be able to pay for all of the stuff they pay for. We will have to take care of ourselves. That is why it is so important to make sure that your financial house is in order and well diversified. (See my previous posts about this important subject.)

Review and Rebalance

Review and Rebalance

We finally come to step 5. While this step may not seem that important, it is necessary to protect your investment. Reviewing your portfolio involves a couple of steps. First, you want to check the performance of your overall portfolio and then the performance of each individual investment. Obviously, the old adage about letting your profits run and cutting your losses short applies here, but there is more that needs to be done.

One of the major shortcomings of most investment strategies is the idea that you create a mix of stocks and bonds based on some measure of your aversion to risk and then you maintain that mix no matter what happens with the market or the economy in general. What research has found however, is that the stock market goes through various stages or cycles and the overall level of risk in the market rises or drops based on what stage the market is currently in. If you or your financial advisor do not pay attention to these stages, your chance of suffering major loses increases dramatically.

So when you begin your annual (or semi-annual, or monthly) review, you must take into consideration where the market is. A couple of things to consider: Which direction is the overall market moving? And is the market overvalued or undervalued? The first question can be answered simply by looking at a chart of the market. I recommend a chart of the S&P 500 or the Russell 2000. These indexes are based on a larger number of stocks than the Dow Jones Industrial Average. Either the market is moving up, down, or sideways. Next look at the Price/Earnings ratio for the S&P 500. Is it above 17 or below 17? Once you have the answers to those two questions, you are in a much better position to decide how best to invest your money.

If you look at these two factors right now, you will find the market is drifting sideways to a little higher and the P/E ratio is above 17. That indicates that the risk of loss in the stock market is higher than normal. To give you some idea of what that means, Warren Buffet, CEO of Berkshire Hathaway, one of the most successful investment funds of all time, is not buying stocks. He says that stocks are too risky right now. Instead, he has accumulated about $40 Billion in cash.

So where do you put your money when the market is overly risky? Well, any detailed individual help is definitely beyond the scope of this weblog, but areas to look at include inverse market funds, gold and precious metals, natural resources, foreign currency CD’s and real estate. All of these areas are available through mutual funds, certificates of deposit and ETF’s or Exchange Traded Funds. Your allocation should be based on your personal aversion to risk and how close you are to retirement. This is not the type of information you are likely to read about in the Wall Street Journal. Wall Street has a big financial interest in keeping as many people as possible in the stock market. It is a well-known fact that as interest rates rise the market suffers. The Fed has been raising interest rates for over a year and we are now seeing long-term rates creeping up.

As I have stated before, I have no way to predict which way the market is going to go in the coming months, but I do know this; the stock market is a risky place to be right now.

Diversify, diversify, diversify

This if vitally important to your financial future and any hope you have for enjoying retirement. So, why do we need to diversify and why is it so important?

Because of a little something called uncertainty. Uncertainty means exactly what you think it means. We have no idea what the future will bring. If you have ever read any ads for investment advice or financial services of any kind, you have seen claims by various individuals and companies for unbelievable returns. How do they make such claims? They are convinced that they see into the future and can predict the price movement of various stocks and indexes. There are two reasons why this just isn’t true.

First of all, if someone found the holy grail of investing and was somehow able to predict price movements with any accuracy at all, they would never tell anyone about it. Nor would they sell the secret for any price. They wouldn’t need to. They would be the wealthiest person on earth.

Second, the market is constantly changing. It is after all, a market with human beings buying and selling. As new information is absorbed into the market, the market itself changes. That’s why trading techniques that once seemed to work, stop working. As more and more people use a specific technique, say moving averages or stochastics or whatever, the effectiveness is diluted and it becomes harder and harder to make money.

The fact of the matter is, that we cannot predict with any certainty, the future direction of the market. While I can tell you that we are in a long-term bear market, I cannot tell you when the market will continue to sell off. It could be weeks, months, years, or maybe just minutes.

The only way to protect yourself from losses like the ones most investors suffered in 2000 is to diversify your assets. If the stock market is fundamentally weak, then the risk of a major market sell-off is more likely and your risk of loss is heightened. So, if the market is weak, what do you invest in? The old 80% stocks and 20% bonds is NOT my idea of diversification. In fact, both of these asset classes are horribly weak and risky right now. Especially with the latest comments from Greenspan about the threat of inflation.

My idea of diversification is a mix of several asset classes. Everything from stocks and bonds (both domestic and foreign), to precious metals, natural resources, inverse funds, real estate, tax liens, mortgages, deeds of trust, and limited partnerships to name a few. Exactly what you invest in and in what quantities depends on your personal feelings about risk and where you currently are with respect to your retirement plans.

Look, I never said it would be easy and it is only fun for those of us who enjoy this sort of thing, but it is vitally important to your financial future that you make it your business. Don’t delay; tomorrow could be the turning point in the markets that finishes off your retirement account.

Next time, we look at the final point, an annual investment check up and rebalancing...

Take Charge of Your Finances…Now!

Take Charge of Your Finances…Now!

Last week, I presented five steps to guarantee your retirement.
Admittedly, those steps were very brief and some of you may be
wondering how you can make these things happen in your investment
accounts.

So, with that in mind, let's start with step number one. Take
charge of your finances. What does this involve? Well, if you are
currently following the advise of a financial adviser, you need to
have a "come to Jesus" meeting. Here are four questions you should
ask your advisor:

1. What is your current asset allocation? What you are looking for
here is how heavily your adviser is recommending stocks. If his or
her allocation is heavy in stocks with no downside protection, then
he or she does not understand bear markets.

2. How have your accounts done since 2000? You will want a year by
year accounting of returns so you can judge performance. As a guide,
the S&P 500 registered a 7% gain for 2004. If your adviser's
accounts did not perform as well as the S&P, then they are not
earning their keep.

3. What changes has your adviser suggested for 2005. If he or she
are still relying heavily on stocks and bond and not recommending
other asset classes, then they are living in the past. You need
someone who is staying current with the times.

How about ETF's (Exchange Traded Funds)? These are fairly new
investment options that offer the diversification of mutual funds
for a fraction of the management cost. There are also ETF's
representing every asset class in the investing world including gold.

4. Under what circumstances would your adviser sell? After asking
this question, if your adviser indicates any hesitation about
selling, that represents a red flag and you should look for a more
educated financial adviser.

These questions will help you assess your current adviser or any
potential adviser you may be considering.

A final question for you is this: How does your adviser get paid? I
strongly recommend hiring only fee-based advisers. Advisers that
charge commission make money every time they recommend an
investment. Those commissions could be as high as 4%, 5%, or even
6%. Remember, the higher the expenses, the less money you have to
reach your financial goals.

Finally, to give yourself the most investment freedom in your IRA, I
suggest setting up self-directed IRA. This is not a standard IRA
offered by banks, brokerages, and insurance companies. This is a
special IRA that allows you the flexibility to invest in many
different asset classes. How do you tell if you have a truly self-
directed IRA? Easy, call your current trustee and ask if you can
purchase real estate for your IRA. Most will tell you no. That is
because most institutions limit your investments to products that
they sell. Go to this website to read more about Self-directed
IRA's. I am not suggesting you use this company, in fact UNB offers
a similar product so do your own investigating prior to choosing. I
recommend this site only because they have a very informative website
that explains self-directed IRA's in detail.

That's all for today. Next we look at diversification…stay tuned.