How about a story to take your mind off the market carnage?

I love sweet corn. Always did. When I was young (in small town Iowa) , my grade school buddies and I would often raid the neighbors’ fields as the kernels were just beginning to turn from tasteless white to so-sweet yellow. We’d shuck it right there in the field and eat it raw right off the cob, five or six ears apiece. If anyone came by, we would just move farther into the field and sit silently in the dense forest of eight foot tall stalks until the threat had passed.

Once, however, this scenario didn’t play out as scripted. Someone must have spotted us because only minutes after we had slipped into the field, we heard a truck approach and stop. Then the voices of the farmer and his wife. Then of their four sons as they all gathered at the edge of the field devising their own plan. They were going to space themselves every 10 or 12 rows and comb the field from one end to the other. All we could do was head for the other end as quickly and silently as possible.

As I ran, crouched over with my hands clasped and arms pointed straight ahead to deflect the leaves, my mind was reeling. I strained to remember what was at that far end (a fence, or a road, or another field – maybe soybeans?), and trying to devise an appropriate strategy for each.

Once at the end, we quickly huddled silently together and listened. We could hear the faint but growing sounds of their much taller and wider bodies brushing the leaves on both sides as they moved up the rows. We had managed to extend our lead on them to a few hundred feet, And, that was good. We needed time. Because the field ended at a wire mesh fence, which separated the field from a muddy, cattail-choked ditch half full of water next to a gravel road. On the other side of the road was a half-mile deep hay field that had just been harvested. Beyond that, the woods.

What should we do? We each knew we had done wrong, and that surrendering and confessing was the noble thing to do. But, no one dared mention this option for fear of being labeled the wimp, the scaredy cat, the sell-out. And, of course, for the additional fear of what the farmer’s sons, and then our parents, would deem an appropriate penalty for our misdeeds.

So, what could we do? The woods were too far to run – we were certain to be spotted crossing the hay field and they could easily run us down there. Heading to either side of the sweet corn field would probably only delay our capture. So, our only real option was to climb the fence, slip into the ditch, submerge ourselves among the weeds and rushes with only our heads above water, and wait it out, hoping that our pursuers were unwilling to endure the discomfort of slogging into the muddy water in pursuit of a few juvenile corn poachers.

And, that’s just what we did. Almost immediately after getting into position, we heard one of the sons call to the others. “I’m at the fence. No one here.”

From several yards to the side, “No one here, either.”

Seconds later from the other side, “Nothing here. We must have missed them.”

After a long pause – long enough to rekindle our hopes of escape, we heard what we had all been dreading, “They might have gone into the creek.” And, it was said by the one closest to where we were huddled, submerged to our chins among the weeds.

With this, our already high and rising anxiety and fear turned to full panic. Our bodies literally shuddered and our minds raced imagining the humiliation, fear, parental scorn, loss of privileges, pain, and more pain that awaited us. We sat there, breathless and shivering in fear, for what seemed an eternity.

Then, from several yards away, we heard the farmer say, “No, they probably crossed the hayfield and are deep in the woods by now. We’ll get ‘em next time.”

The others voiced their concurrence as they walked toward each other, then they moved back into the field together, calmly discussing the condition of the corn and when it should be ready to pick.

We waited as their voices faded away, but we didn’t move until we heard the sound of the truck doors shutting, the engine starting, and the truck driving away. Only then did we begin to extricate ourselves from the scratching weeds and stinking muck we had so willingly scrambled into a short time before.

Eventually, we all had crawled up to the side of the road, and were scraping mud off of and out of our shoes when we heard a car approaching. We could tell it wasn’t the farmer’s truck, but who was it? As it drew nearer, we saw that it had a light bar on top. It was the county sheriff.

Again, we quickly evaluated our options. The woods were still too far to reach unseen. In fact, the sheriff had probably seen us already, so slipping back into the ditch wouldn’t help, either. The corn field? No, we’d pressed our luck far enough with that option. So, we just sat where we were and continued to clean ourselves off the best we could.

When the sheriff’s car reached us, he leaned out the window, slowly looked each of us up and down, but said nothing. We looked back, also in silence, trying desperately not to convey our feelings of guilt, fear, and dread. Finally, he sat back, sighed, then said, “I suggest you boys do your eatin’ at home from now on, okay?”

We all nodded. One said, “yes, sir.” He turned away and slowly drove on. And, we began the long walk home. (To be continued.)

Time to take cover?

I got an interesting question earlier this week. It began with a list of some of the many challenges facing our economy and markets, from the subprime mortgage mess and our energy dependence to funding the military budget and social security. We had just said to be prepared for more market turbulence, but to stay the course with their long-term mutual fund investment program.

The question: “With all this risk ahead of us, wouldn’t it be prudent to do something about it? Shouldn’t I be taking some money off the table?”

Answer to the first question – Yes

Answer to the second question – No

In times of turbulence (in fact all the time), WE the investment managers are investing to reflect our expectations of the future. And, we share the many concerns listed. So, WE are “doing something about it” in our selection of the individual investments in the funds (for several months we have had more exposure to energy, less to housing, more in high quality, etc.) That’s what active managers (as opposed to indexers) do.

But, we rarely take our investors’ money out of the markets they have chosen to be in long-term and temporarily put them into “safe” investments, expecting to get back in later. Such market timing just doesn’t work long-term. People find it nearly impossible to invest when the future looks most grim and raise cash when things look most rosy. Instead, we would tend to sell when we’re scared (like now), and buy when we’re feeling cocky (like last month when our investments were all going up).

The point is this. When we say, “stay the course,” we don’t mean there is nothing that needs to be done. We’re saying, “Don’t YOU do anything WITH THE ALLOCATION OF YOUR INVESTMENTS.” Don’t expect to – don’t even try to – avoid weak markets with your long-term investments. But, do expect your investment managers to invest prudently and with a good understanding of and appreciation for the risks facing investors.

Other questions?

What, you couldn’t live without me!?

I go on vacation for two weeks, investors panic, and the market plummets. I get back (today) and stocks surge.

I have no more two-week vacations planned. Is this, then, the beginning of the market’s recovery and we’re back on our way to new highs?

Doubtful. Regardless of my vacation plans, the process of unwinding our nation’s excesses will take longer. But, it shouldn’t go a whole lot deeper – to the point of a serious recession and a 2000-like stock market swoon.

Why not? Because the U. S. is no longer the dominant engine of the world economy. It is still the most powerful (for now), but it no longer leads the economic parade. It is now supplemented by many other smaller and faster economic engines, nearly all of which are currently cruising along with relatively little baggage in the form of excess debt like we have in our housing and investment arenas. So, as our economic engine loses power and falls back, it can “draft” (as in NASCAR) the economies of the rest of the world. This should keep us from falling into recession as the excesses unwind.

But, we can’t be sure. Investors’ still have a lot to worry about, especially if the unwinding proves to be messier-than-expected. So, investors may not feel comfortable for some time yet. Even if I never take another day of vacation.

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?

A crisis avoided?

Subprime home loan problems were back in the news recently. A couple of leveraged hedge funds that were heavily invested in subprime mortgage-backed bonds nearly folded when losses on those bonds erased most of the thin margin of equity in the funds. But, the funds ultimately were kept afloat . . . with more loans.

The original lenders to these funds strongly considered liquidating the funds – selling off the subprime mortgage-backed bonds and other assets, using the proceeds to pay off their loans, and then paying any remaining proceeds out to the funds’ investors. But, I suspect they soon realized that this might not raise enough to pay off the loans, much less return anything to investors. Putting a long list of low-quality bonds on the market would hammer the already suffering subprime mortgage-backed bond market as well as bring down the prices of other bonds, possibly starting a downward spiral throughout the investment markets.

So, they just lent the funds more money to keep them in business. For awhile at least.

This illustrates the type of concerns behind my statement of March 28, when Wall Street was saying we had seen the worst of the subprime crisis: “I believe it will have a broader and more negative impact on the economy than is currently reflected in the stock and bond markets.”

I still believe this. The growing impact may be confined to the areas of the financial markets tied most directly to housing. But, as more and more home mortgage loans reset to higher interest rates over the next twelve months, and the mandated higher lending standards prevent many marginal borrowers from refinancing, 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.