Money Management and the Economy

Friday, April 10, 2009

Chicken or Egg

You aren't smarter than the market. It really is that simple.

There have been a few articles recently on the financial meltdown with the same theme. That is that the housing bubble lead to the collapse of the financial markets. The reality is a little different. The financial markets, specifically the creation of derivatives based on real estate loans, created a housing bubble.

Beginning in the late 1990's trillions of dollars poured into the housing market, forcing prices well beyond what people could afford for housing. In most parts of the country, the median price of a home was no longer affordable to someone with a median income. Renting was far cheaper than owning. How did that happen? Where did the money come from.

The answer is that the Wall Street bankers had figured out a way to hedge most of the traditional risk of real estate. Instead of directly investing in real estate themselves, they loaned money to people who were buying a home. Then they took the resulting loans and bundled them into bonds that could be sold as low risk investments. Those "low risk" real estate investments, called Collateralized Debt Obligations (CDO's), produced far better returns than the government or AAA corporate bonds they were competing with. And they produced large profits for the Wall Street banks that created them.

The result was that money poured into the real estate market. As a result prices escalated and the terms of the loans got looser and looser in order to maintain the flow of investment opportunities. And that fed the bubble even more, as people who could not traditionally afford to buy a home entered the market. Thus the real estate bubble was a creation of the Wall Street bankers. Despite the recent collapse, businesses like Goldman Sachs made huge profits in the process and most of those profits were protected when the inevitable collapse came.

While much has been made of the problems created by "toxic assets", the truth is that when the bubble burst, most of the losses were to homeowners, not their lenders. It was the overpriced homes that were the really toxic assets, the bonds were considerably better investments. In effect, much of the risk of real estate investment had been transferred to people who bought a home to live in. Millions of those home owners now owe more than their house is worth.

If you look at the total losses in real estate in the last couple years, the losses to investment banks and lenders pale compared to the total losses to home owners. And all those losses can be traced back to the highly profitable business of taking real estate loans and bundling them into derivatives, shielding investors from the real risks of investing in real estate. And that is what created the financial crisis, not the housing bubble. It was just an unpleasant sid effect.

Wednesday, April 1, 2009

Why Cost Averaging Really Does Work

You aren't smarter than the market. It really is that simple.

There are a number of places on the internet and in the media where people have questioned the value of "cost averaging". Cost averaging is investing in regular amounts over time, rather than in one lump sum all at once. It has been standard investment advice, but now some critics are arguing that, since the market in the long run tends to go up, the earlier you invest the better. Cost averaging will reduce your return in the long run.

They are, of course right. On average, you will get a lower return. But cost-averaging is not done to maximize returns. Its used to minimize risk. It is a strategy to make sure you get an "average" return instead of hitting just one peak or one valley.

Think about it this way. Suppose someone offered to flip a coin and pay you $51,000 if it was heads, but you would have to pay them $50,000 if it comes up tails. Would you take that bet? On average, you would come out ahead. But only a gambler makes that kind of bet unless you can afford to lose the $50,000. On the other hand, if they offered to flip a coin 1000 times with the same odds, you might be tempted. The odds are still in your favor and you are unlikely to lose every time and cost you $50,000. Of course you are also unlikely to win every time and win $51,000 either. Instead you have a good chance of coming out ahead somewhere between those two exremes.

The market works the same way. If you want to maximize your return you, flip the coin once. If you want to minimize risk you spread your flips out. Most of us are trying to be investors, not gamblers. We want to make a reasonable return while preserving what we have. So lets look how this works in practice.

If you have $5000 to invest in your IRA and invest it on the first of the year you will do better, in the average year, than if you put $100 into your IRA over the course of the year. The problem is that not all years are average. More importantly, not all starting points are average. Some years the value of stocks will be higher to start the year than the average over the course of the year, other times it will be lower than average. In fact, in the current market, that is true from week to week as you can see in the example below.

This year I decided to basically add $100 each week to my IRA. The details are a bit more complicated than that, but I am simplifying here. So what do those investments look like:

Date Shares Security $Invested

1/6/2009 5.893 Vanguard Balanced Index Fund Investor Shares $100 
1/13/2009 6.127 Vanguard Balanced Index Fund Investor Shares $100 
1/20/2009 6.427 Vanguard Balanced Index Fund Investor Shares $100 
1/27/2009 6.250 Vanguard Balanced Index Fund Investor Shares $100 
2/3/2009 6.301 Vanguard Balanced Index Fund Investor Shares $100 
2/10/2009 6.329 Vanguard Balanced Index Fund Investor Shares $100 
2/17/2009 6.489 Vanguard Balanced Index Fund Investor Shares $100 
2/24/2009 6.588 Vanguard Balanced Index Fund Investor Shares $100 
3/3/2009 7.018 Vanguard Balanced Index Fund Investor Shares $100 
3/10/2009 6.887 Vanguard Balanced Index Fund Investor Shares $100 
3/17/2009 6.562 Vanguard Balanced Index Fund Investor Shares $100 
3/24/2009 6.394 Vanguard Balanced Index Fund Investor Shares $100 
3/31/2009 6.460 Vanguard Balanced Index Fund Investor Shares $100 

You will notice that the first shares I bought were also the most expensive. Had I invested to my IRA limit to start the year, I would likely end the year with many fewer shares than I will by my strategy of cost averaging. In January and February, I came out ahead with lower prices later in the month. In March, I would have been better off to purchase on March 3rd, when prices hit bottom for the year so far.

That is true, even if stock prices eventually recover to the level they were in January. The only way I will come out behind is if the average price I pay over the course of the year is higher than it would have been in January. Otherwise I will end the year with more shares of stock, regardless of their price at the end of the year. If 20 years from now, I sell the shares from these transactions, I am going to get 20% more money for the shares I purchased on March 3rd than I will for the shares I purchased on January 6th. That is a pretty significant difference.

I am looking only at share prices here. But there is another factor to consider in evaluating the overall return. That is any dividend payments I receive. Because my IRA is not getting dividends on shares I don't yet own.  Of course, the dividends in the future will also be higher since I own more stock. 

Which just clarifies when cost averaging makes sense. If you are buying investments where the primary return is from dividends and/or interest, you probably don't need a risk limiting strategy like cash averaging. But if you are buying securities whose price is volatile, cost averaging will reduce your risk and sometimes save you from paying a premium price that you will never recover.