Previously on “As the Housing Bubble Deflates,” . . .

Yes, the subprime soap opera plays on. To recap, from my March 28 entry:

“I believe (housing in general and the subprime problems in particular) will have a broader and more negative impact on the economy than is currently reflected in the stock and bond markets.”

Then, the June 29 issue related how a couple of hedge funds were close to being shut down due to losses on bonds backed by subprime loans, but were then bailed out by their sponsor – with more borrowed money. I concluded that “. . . more and more mortgage-backed bonds will see declines in value, and more and more investors in those bonds will be looking to get out. Crisis avoided? I’d say more like challenges deferred.”

Well, the challenges weren’t deferred for long. The hedge fund sponsor announced this week that, due to continuing losses on bonds and related derivatives, the funds are now basically worthless. Even top-rated bond issues owned by conservative investors are becoming suspect. But, no one knows exactly where we are with this because, as the hedge fund sponsor stated, “. . . there isn’t much of a market for the bonds.”

It is this one aspect of the problem – the illiquidity of the assets – that was behind my initial concerns, and that convinces me that there are more problems to come.

Liquidity is important for all investors, but especially for retirees who will generally be selling assets in the months and years ahead. They must recognize that most assets’ “values” are assumed to be the prices at which similar assets most recently sold. That’s how appraisers set home values, car dealers determine used car values, and investors value stocks and bonds.

But, even in the most liquid markets, the “last trade” took place between the then most eager buyer and most agreeable seller. Lined up behind each of them are increasingly less eager buyers, and increasingly less willing sellers. So, if anything happens to make the buyers even less interested and the sellers a bit more eager to unload their holdings, prices can plummet in very short order. And, the less “depth” there is in a market – the shorter the lines of buyers and sellers – the more severe the price change.

Assets like subprime loan-backed bonds have an additional valuation problem. There often are no recent “last trades.” As a result, there are no arm’s length transactions to give guidance for the next trade, much less for the trades that might follow.

So, when a hedge fund values its portfolio, the prices used are often little more than educated guesses. And, with the lack of transparency and the pressure to perform in this business, these guesses can be little more than wishful thinking. Until the next trade.

So, stay tuned. This soap opera has many more episodes to come.

Investor’s worst enemy

Studies have long shown that most of us aren’t very good at investing. (See, for instance, Dalbar, Inc.’s 2007 Quantitative Analysis of Investor Behavior which analyzed the 20 year period 1987 through 2006). Driven by our emotions more than our logic, we typically buy high and sell low, which makes our ultimate returns less than they would have been if we had just steadily bought and held (then held and gradually sold) a diversified list of funds.

People in or near retirement seem to be particularly prone to such misbehavior. We’re our own worst enemy. We tend to diddle with our investments when we should be leaving well enough alone.

The usual advice for how to counter this is to practice abstinence. Establish an investment plan, then leave it alone (besides an occasional rebalancing). Don’t even look at the monthly statements; just file them away. But, since we are living, breathing organisms, we find this extremely difficult to do.

Fortunately, there is another way to shield our accumulated mutual fund wealth from our all too human urges. We can protect it with an impenetrable wall – in the form of a hired professional to manage our overall portfolio.

One very effective way to achieve this is with a separately managed, mutual fund “wrap account” from a financial advisor. But, there may be an easier way. The most recent Dalbar study found that the more widely available “allocation funds” are also providing this protection.

(For those not familiar with allocation funds: Allocation funds contain a diversified portfolio of other funds – the “underlying funds.” The types of underlying funds used differ from one allocation fund to another to reflect a range of the most important investor attributes – risk tolerance for “lifestyle” funds, or investment time horizon for “target maturity” or “lifecycle” funds. So, all the investor has to do is estimate their risk tolerance (conservative to aggressive) or time horizon (when the investment will begin being liquidated), and select a matching fund. The fund manager builds and maintains the portfolio of underlying funds over time.)

The latest Dalbar study found that investors typically hang onto allocation funds significantly longer than stock or bond funds. It also determined that stock fund investors, due to their bad habits, averaged only 4.3% annual returns, and bond fund investors 1.7%, for this very challenging 20 year period. So, if the average investor was 60% in stock funds and 40% in bond funds for this period, the overall return would have been 3.3%. Dalbar calculates the average allocation fund investors’ return for these 20 years at 3.7%, and these funds also typically have about a 60/40 stock-to-bond allocation. Disciplined buy-and-hold investors in these fund types, of course, did even better on average.

So, the best approach for most investors is to ignore their natural urges and let their well-designed portfolios of diverse mutual funds do their thing. For those of us with less confidence in our ability to control ourselves, though, it may be best to invest via an allocation fund where the structure itself protects our investments from our untoward advances, well-meaning as they may be.

Too Much Stuff

A piece of advice for those preparing for retirement: Get rid of stuff. Now. And, don’t buy any new stuff “that you’ll want in retirement.”

I know of what I speak. I just sent yet another yearly rent check for our three 10x20 storage units, but I can’t remember half of what’s in them. And, half of what’s in our closets should be in them, too. Or, in the landfill.

I somewhat expected this challenge. After all, we’re of the era of “save everything.” You spent good money on it. It served you well. Someday you might need it again. It’s still perfectly good, or it can be easily fixed; just needs a couple of parts.

And, not only do we save stuff, we save it in the box it came in. Tied with a string. Protects it, you know. And, makes it easier to find (and to stack).

Our kids don’t save anything. They even throw away those plastic boxes that CD’s come in. And, after they load the CD onto their laptop, they throw it away! Of course, they never even consider trying to fix anything; if it breaks, they toss it. We’ve become a disposable society, plain and simple. So, get on the train, pre-retiree. Dispose of all that stuff you haven’t touched in years (except to move it around).

And, then there’s the issue of buying things “that you’ll want in retirement.” No, you won’t. Here, too, I know of what I speak.

The casual clothes you’ve been accumulating at end-of-season sales – not only will they be hideously dated, they are likely to be made of material that isn’t produced anymore because there is something better. And, they won’t fit.

The cordless power tools you just laid in – they’ll be available with more power, and be lighter and cheaper. The Nikon you bought a few years back with all those lenses – well, people don’t use film anymore. Try to unload it on eBay. The big screen TV, the stereo, the cordless phone – think flat-screen monitor, surround sound and iPhone, all wireless, of course. Besides, wait a couple of years and they’ll be even better, cheaper and simpler to operate.

The culprit here is technological change. It’s not going to stop. In fact, it’s accelerating. We all know that. But, we haven’t all adjusted to it. We need to shift gears from being accumulators to being user/recyclers.

One hint: You might get a little comfort if you think about the concept of recycling. It’s just like keeping/saving. But, it’s kept/saved somewhere else. Next time you need it (if ever), you’ll have to pay for it again, but it will be cheaper and even better than it was. And probably disposable. That’s progress! Isn’t it?