Financial Literacy

There is an audio recording of personal finance expert Dave Ramsey talking about a study that he had read. This was a large study of retirees that had become wealthy and the researchers looked into the most important element that made that happen. Some of the usual suspects for building wealth for retirement are: a high rate of return on investments; low fees and costs on investments; or choosing a specific type of investment, such as stocks or real estate. None of these mattered as much as the #1 predictor of retiring wealthy.

This very important element is: how much money you add to investments each year. Obvious, of course, but most people skip right past this concept. Instead, the average investor focuses upon growing their money with unrealistic returns and beating up their financial advisers to lower their costs and fees. Or they think they will add money later, in a few years when it is easier but rarely actually do so. Meanwhile, sitting there, clear-as-day, is the simple practice of adding more money.

This exact lesson was repeatedly driven into me by my father as he built up his net worth:

• “Your return is a meaningless amount of money until you reach over $100,000 in your account, so focus on adding money and not fantasy returns,”
• “Everybody gambles and loses on risky stocks and exotic mutual funds while the tortoise passes by ALL of them. I see this happen over and over with speculators for capital gains falling behind the simple income investors,”
• “Just use prudent investments earning a stable 4-6% return and you’ll do great; passing by the stock index investors after a couple big market downturns,”
• “There is always an investing bubble-of-the-day and nearly all bubbles collapse. Just keep adding money and seek a reasonable return. Then, after the collapse, you’ll be well ahead of any average investor,”
• “Compound interest isn’t anything of note until you’re 20 years in, so you have to build up a meaningful balance well before then. Speed matters – and the fastest way to do that is adding new money,”
• “Stop looking for the quick buck and pile it up in a few solid stocks that grow their dividends, or even a stock index fund,”
• “Don’t even think of putting money into an individual stock until you have over $50,000 to $100,000. Just put your money into a safe very-short term bond fund and keep adding,”
• “The most important thing for wealth accumulation is to keep putting in money. Otherwise, you have nothing to compound over the years,”
• “Wealth is not a dollar amount, it is your perspective about how you view money and manage it. $100 can be spent on a concert ticket – or – it could kick off a new investment and habit to build an early retirement.”

This critical lesson of “keep adding money” was highlighted when a former neighbor gave me a recent update. He had retired 5 years ago but was recently forced to get a part-time job at a library because money was too tight. He says, “We had saved very little for retirement and unexpected expenses were killing us.” Since he had earned a very-good salary, his lack of retirement savings was not due to a lack of income or some hardship; it was because of his spending priorities. (This is common: 68% of Americans age 55-65 have less than one year’s salary in a retirement account). It is my best advice that you make it your priority to continually add new money to your investments.

In the long, long ago, when a stock, industry, or the overall stock market fell in price, there were bargain hunting investors willing to step in and purchase shares once they fell low enough to be a good deal. Today, passive investing into index funds accounts for over 40% for all stock institutional trading – and this percentage is rising. When passive index investing grows well beyond 50%, there is a new and substantial structural risk slowly being drizzled upon the portfolio of unknowing investors.

There are several reasons why an index fund may need to sell their shares of a stock: company names are added and deleted from indexes all the time, individual or institutional investors may sell their fund shares, forcing the fund to sell stocks to free up cash, to name a few. Now, imagine a scenario where the increasing trend toward index investing grows for another 15 years. Perhaps by then 90% of all stock shares are traded by index funds. In this future scenario, a company named XYZ is removed from a major index. Then, 90% of market participants will be trying to sell their shares at the same moment but only 10% of the entire stock participants are even available to buy any of it. The price of XYZ shares must plummet and may be in a freefall because there simply isn’t enough money available to support the old stock price. Now, what about other scenarios where index fund managers decide to get out of an industry or reduce their exposure to the whole market altogether – again, we’ll have a plummeting sector, or stock market, with no index-fund manager using reason to make a purchase.  

This is because passive index investing requires active money managers to generate “price discovery.” It is only this free-market price discovery that creates a fair price. If passive index investing dominates the stock market, then there is no one left to create a fair price; so what remains is price instability and unfair pricing (meaning prices far above and below a reasonable fair-market value). I won’t add algorithmic trading to this caldron today, but you can correctly guess that it does not add price stability.

If passive index investing continues to increase their market share, is there anything we can do to lower our exposure to a potential for flash crashes? Yes, there are two ways to hedge your portfolio:

1. The simplest way is to move some money from stocks and bonds to cash and gold. It is a personal decision to determine a correct ratio for your portfolio, but consider holding 10%-25% of your money out of riskier stocks and bonds into cash and something non-correlated like gold and silver.
2. Employ a “Risk Parity” method of portfolio construction. A common asset allocation model could be something like a portfolio made up of 70% stocks and 30% bonds. Risk Parity uses math to evaluate how much risk you have added to the portfolio with each asset component. For example, your portfolio’s components may be stocks, bonds, real estate, commodities, and cash. Perhaps your stocks add so much risk that to equalize its portion (parity), you should only have 24% of your portfolio in stocks. This method is something you can learn about online, but just consider that most money managers consider “managing risk” one of their most important priorities.

The future scenario of stocks plummeting from index fund activity 15 years from now may never occur. However, the more knowledgeable you are as an investor, the more you can prepare your portfolio from any potential risks on the horizon. If you can partially sidestep just one market downturn, you’ll be miles ahead toward your financial goals.

Wall Street is skilled at turning financial products (loans, leases, royalties, bonds) into securitized investment packages. Many of these turn out to be garbage which create huge losses for investors; such as: sub-prime auto loans, sub-prime home mortgages, trailer-park loans, credit card loans, and more. Some of these securities have collapsed on their own or are subsumed from an industry downturn. The most famous of which is the collateralized-debt obligations (mortgage CDOs) that were central to the 2008 financial crisis.

Since 2007, there has been an asset-backed security nicknamed SLABS (Student Loan Asset-Backed Securities). Public loans to college students are owned by the U.S. Treasury Department but private student loans are packaged and sold as SLABS. The student loans outstanding today is $1.5 trillion and growing; which some analysts are calling the next potential ‘debt bomb’ on the economy.

When interest rates are relatively low (as they have been since 2008), then some investors jump on any ridiculous and risky investment in order to gain a higher return. One of these was SLABS – they have been over-subscribed by a market that is starving for a reasonable yield. Investors that jumped in big overlooked two important factors: 33% of student loans are in deferral (not being paid currently) and 11% are in default. SLABS are a very poor risk pool with no collateral and, in my opinion, investors are not being nearly compensated enough for the risk that they are taking. Meaning that a portfolio of SLABS will most likely result in a net loss for investors no matter how well the future job market becomes. So, in 2016, it was not surprising when many tranches of SLABS were downgraded to junk credit. These ‘investments’ were issued with a high credit rating and just a few years later, their credit rating has fallen below investment grade to a junk rating.   

SLABS are an investment that you do NOT want in your portfolio. Well, how about buying the U.S. public entity servicing these student loans? Navient (that trades like a stock with ticker symbol NAVI) is a candidate which is currently yielding 4.9%. Is this something to buy? Just the opposite: there are more investors talking about shorting this than buying it. This is partly because investors want to profit like the movie The Big Short when a few smart people made a fortune from the real estate downturn in 2008. Similarly, these investors are looking at NAVI as a short candidate to profit from the student loan defaults, and then, capture profit when the economy softens and the student loan default rate will soar.