This is a continuation of my previous entry on Social Security.
I have received some comments, via my blog, e-mail and also directly from those know me in real life, questioning whether the rationale expressed in my previous post holds even considering the massive 'baby boomer' retirement. Some wrote saying that the demographic tidal wave that contributed to the economic growth over the past few decades in the U.S. is now going to 'sink' into retirement, implying those who were propping up the U.S. economy over the past few decades will soon be in need of being propped up themselves.
This point appears powerful at first glance, yet it does not seem to hold up to a basic analysis of current data. The millions of baby boomers who are set to retire from this year on out till early 2020s, are not going to drop off the map. Let's examine this from investing and consumption perspectives separately. If one agrees that a retiring boomer needs at least 60% of his/her pre-retirement income, a basic analysis shows that this money is not going to come from Social Security or personal savings. Let's examine the savings scene first.
Based on Federal Reserve statistics on net worth (2004 data), the situation is grim (median and mean data):
Under 35 years old = $14,200 ($73,500)
35-44 years old = $69,400 ($299,200)
45-54 years old = $144,700 ($542,700)
55-64 years old = $248,700 ($843,800)
65-74 years old = $190,100 ($690,900)
Over 75 years old = $163,100 ($528,100)
In analyzing data like the above table for the entire U.S. population, the median values are far more meaningful than the mean values, which inevitably skew up due to the high wealth disparity among every age group in the country. After all, U.S. is the country with the world's largest number of millionaires and billionaires. It is known that the top 10% of the U.S. is estimated to hold over 70% of the country's wealth and even across the world, the richest 2% hold half of all global wealth. So, let's forget the mean and focus on the median values.
About 50% of the people at or nearing retirement have a net worth below the $150-250K median range for the age groups from 45 till over 75. For the sake of simplicity, let's take the midpoint of this range ($200K) and consider, based on recent data, about 46% of this median net worth is in home equity. Taking this portion away (as housing is required even during retirement), the median investable net worth for this group is about $108K. When I plug this figure into an annuity calculator assuming a 6% moderate growth rate for a 30-year payout period, I get a fixed annual payout of $7,400 (not adjusted for inflation). An inflation-adjusted annuity may only start at about $5,200 a year (I got this for a 65-year old male using Vanguard's annuity calculator while making a few other assumptions).
The average personal income (2006 data from Social Security Administration adjusted for inflation till 2008) is about $41,000. Even if an average retiree needs only 60% of this pre-retirement income, the income needs during retirement are $24,600 on a post-tax basis for the first year, which will rise with inflation in subsequent years. The average beneficiary (May 2008 data from Social Security Administration) receives about $990 in monthly benefits or $11,880 in the first year of retirement. So, SSA benefits and the annuity payout (inflation-adjusted) yield about $17,000 in annual income. This still leaves a 30% shortfall compared to the $24,600 expense requirement and likely a 35-40% short-fall when you consider Medicare premiums (which will be deducted from the SSA payment) and maybe a 45% shortfall if one considers taxes (modest but still has some impact) at these income levels. The shortfall grows further if more than 60% of the pre-retirement income is required during retirement. Remember that all of this applies to the median case, so 50% of U.S. residents will fare even worse than this scenario.
What's the implication of all this? Even for the "median" baby boomer case, staying employed during his/her 60s and possibly into 70s is going to be required to maintain a reasonable standard of living. Guess what happens when the boomers continue to work till say, 70, instead of withdrawing from Social Security at 62 when become eligible? Those 8 years of extra employment generates 6.2% of taxes paid into the SSA system (~$2,500 of SS taxes at 2008 median income levels). This is a double-benefit for SSA. Instead of paying out benefits for 8 or more years, the system is now taking in taxes to shore up its fund. Even if some of the boomers opt for Social Security benefits in their 60s, they will need to supplement it with earned income as the median case example shows. Under current rules, every $2 of earned income reduces SS benefits by $1. All this can only mean that the SSA will have more to payout for those in the queue later.
Staying employed into their 60s and possibly into early 70s is the only option I can see for the current generation of 45+ year-olds with the median net worth figures cited above. So, contrary to being a strain, I see this as a strengthening of the Social Security system. I suspect this may be one reason why the trustees keep extending the year when the trust fund is expected to be fully depleted. I remember the first projection as 2030 about a decade ago, then they adjusted it to 2035, then 2038 and now they project 2041. I believe this will continue to be extended as people are forced to extend their employment horizons and delay taking their social security benefits.
Showing posts with label Financial Freedom. Show all posts
Showing posts with label Financial Freedom. Show all posts
Jul 17, 2008
Jul 14, 2008
Investment Risk & Market Timing
“O Fortuna! Like the moon everchanging, rising first, then declining.”
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
Jul 2, 2008
When Money is Turning into Confetti
Reading about Zimbabwe’s 1,000,000% inflation in recent times inspired the title of this post. I saw a beautiful picture of a 50 billion dollar note printed by the Reserve Bank of Zimbabwe. I have never owned or even seen a currency note with so many zeros. It is currently worth a princely sum of four U.S. dollars. Even if we ignore this extreme case of a sub-Saharan African country, there are examples of larger, more influential countries where inflation has been 1,000%+. They include Russia, Argentina and Brazil. Yes, that Brazil – the ‘B’ of the darling BRIC countries - where the last 5 years of impressive growth and amazing reforms have made it the most stable of all emerging markets, even with the global credit crisis in full swing. A 1,000% inflation results in the infamous long lines for bread, where the price of bread paid by people towards the end of the line is considerably more than what the people at the front pay. In a 1,000% inflation economy, a worker’s salary must increase by a factor of 10 every year, just to keep his standard of living the same. Pretty soon, the central bank printing the nation’s currency and the school children learning their multiplication tables will grow weary with the number of zeros added every month!
When money turns into confetti, what can the residents of a country do? If most of their money is in cash, it is essentially becoming worthless, as even interest-bearing accounts will not be able to keep up with hyper-inflation. Even before the interest rate is revised, the inflation beats the bankers to it. Bonds become practically worthless as the nominal value of the principal is diluted by an order of magnitude in just one year if the inflation is 1,000%. Stocks may hold a little value because the companies that make the essentials that people want will increase prices with inflation while looking desperately for ways to manage the hyper-inflating cost structure. Still, they are not safe havens for the long term because the economic base (i.e. the people’s affordability) weakens so quickly in a hyper-inflationary situation that no company can count on making long term profits in such a country.
So, what can a small investor do to protect his wealth? He can have a sizeable portion of assets in relatively stable “hard” currencies such as USD, EUR, GBP etc. Ah, I can hear some of you complain, these are fiat currencies that are backed by no more than the “full faith and credit” of the issuing countries. Sure, but compared to the faithless currency of a hyper-inflating country with poor governance mechanisms, this is a vastly superior choice. Yet, this option is not always available due to foreign exchange restrictions placed on many residents, especially those living in developing countries that do not float their currencies freely in the global market. The next option is to own “hard” assets like Gold and Real Estate. Both react differently, in my view, during hyper inflation. Gold may preserve its value because it is a globally consistent and tradable asset with universal purity standards. Yet, owning gold physically carries risk and is expensive (due to transaction premiums and security charges) in many developing countries. Gold ETFs are not available in many developing countries but countries like India now offer gold ETFs for resident investors. Owning real estate on the other hand is easier but it is not liquid and it also has some risk, depending on the country’s property rights laws and enforcement infrastructure. Moreover, since all real estate is local, real estate may not offer a safe refuge in a hyper-inflating economy where the real affordability is declining and economic activity is shrinking. Whether real estate will hold its value in the long term in a country where affordability is declining is highly questionable. After all, the value of real estate is dependent on people’s ability to either pay rent or buy the property outright, both of which are dependent on economic prosperity.
Searching for an answer to this question led me to the Oracle of Omaha himself, who addressed this issue in a Q&A session. Warren Buffet said that the best thing an investor can do in a hyper-inflating economy is to invest in himself! This response deserves some careful thought. Regardless of what a currency’s worth is, a competent doctor or engineer or a hair stylist will earn his/her share of the economic output. Even within the same discipline, a highly skilled professional will earn more than his less skilled compatriot. In other words, skills useful to society never become worthless in any economy. In a country where financial investments are worthless, personal skill sets alone will ensure the long term living standards for individuals. This response is of course disappointing if you are, say, a septuagenarian investor, who no longer has the physical capacity for earning wages and so, depends only on income from investments. Well, old age sucks in any country, but it is brutal in a hyper-inflating country. This is why, owning hard currency-based assets becomes crucial for investors who have no other means of earned income.
Does the above apply even to ‘modestly high’ inflationary economies, say India and Southeast Asia, where inflation reached double digits recently? Staying employed is one of the best ways to deal with double digit inflation as incomes rise on par with inflation or better, at least for most skilled occupations. In addition, every year of staying employed is one less year to worry about income during retirement. On the other hand, facing a 15% annual inflation over a 30 year horizon can be brutal to an investor who is unable to earn income through employment. If you were hoping to retire on say, Rs. 50,000 a month ($1200 a month in today’s exchange rates), it is worth only about Rs. 12,000 a month in today’s value 10 years from now, barely Rs. 3,000 a month 20 years from now, and a piddly Rs. 750 a month at the end of your 30-year planning horizon. One way to protect the value of the initial Rs. 50,000 a month is to have it as a safe withdrawal from a well-diversified portfolio (that should have inflation-beating and likely volatile asset classes). This introduces asset price volatility (market risk) into the picture. So, depending on when your 30-year horizon begins, adverse market conditions may prevent you from withdrawing the same amount monthly (inflation-adjusted for future years) or you risk exhausting the portfolio before the 30-year horizon.
This is why I don’t always subscribe to the concept that all or even most of one’s assets must be in the country where the retiree lives. This advice, while sound for retirees in many “hard” currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one’s assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel “stupid” for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the “hard” + “soft” currency strategy of assets is that one’s returns would be lower because a sizable portion of the assets are in a ‘low yield’ country or a ‘high inflation’ country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.
And, in the remote possibility that you are reading this blog from Zimbabwe, I am told that the special paper and ink used to print currency notes has a decent heat index value, so you can save fuel costs while cooking your meals every day. You now have money to burn.
When money turns into confetti, what can the residents of a country do? If most of their money is in cash, it is essentially becoming worthless, as even interest-bearing accounts will not be able to keep up with hyper-inflation. Even before the interest rate is revised, the inflation beats the bankers to it. Bonds become practically worthless as the nominal value of the principal is diluted by an order of magnitude in just one year if the inflation is 1,000%. Stocks may hold a little value because the companies that make the essentials that people want will increase prices with inflation while looking desperately for ways to manage the hyper-inflating cost structure. Still, they are not safe havens for the long term because the economic base (i.e. the people’s affordability) weakens so quickly in a hyper-inflationary situation that no company can count on making long term profits in such a country.
So, what can a small investor do to protect his wealth? He can have a sizeable portion of assets in relatively stable “hard” currencies such as USD, EUR, GBP etc. Ah, I can hear some of you complain, these are fiat currencies that are backed by no more than the “full faith and credit” of the issuing countries. Sure, but compared to the faithless currency of a hyper-inflating country with poor governance mechanisms, this is a vastly superior choice. Yet, this option is not always available due to foreign exchange restrictions placed on many residents, especially those living in developing countries that do not float their currencies freely in the global market. The next option is to own “hard” assets like Gold and Real Estate. Both react differently, in my view, during hyper inflation. Gold may preserve its value because it is a globally consistent and tradable asset with universal purity standards. Yet, owning gold physically carries risk and is expensive (due to transaction premiums and security charges) in many developing countries. Gold ETFs are not available in many developing countries but countries like India now offer gold ETFs for resident investors. Owning real estate on the other hand is easier but it is not liquid and it also has some risk, depending on the country’s property rights laws and enforcement infrastructure. Moreover, since all real estate is local, real estate may not offer a safe refuge in a hyper-inflating economy where the real affordability is declining and economic activity is shrinking. Whether real estate will hold its value in the long term in a country where affordability is declining is highly questionable. After all, the value of real estate is dependent on people’s ability to either pay rent or buy the property outright, both of which are dependent on economic prosperity.
Searching for an answer to this question led me to the Oracle of Omaha himself, who addressed this issue in a Q&A session. Warren Buffet said that the best thing an investor can do in a hyper-inflating economy is to invest in himself! This response deserves some careful thought. Regardless of what a currency’s worth is, a competent doctor or engineer or a hair stylist will earn his/her share of the economic output. Even within the same discipline, a highly skilled professional will earn more than his less skilled compatriot. In other words, skills useful to society never become worthless in any economy. In a country where financial investments are worthless, personal skill sets alone will ensure the long term living standards for individuals. This response is of course disappointing if you are, say, a septuagenarian investor, who no longer has the physical capacity for earning wages and so, depends only on income from investments. Well, old age sucks in any country, but it is brutal in a hyper-inflating country. This is why, owning hard currency-based assets becomes crucial for investors who have no other means of earned income.
Does the above apply even to ‘modestly high’ inflationary economies, say India and Southeast Asia, where inflation reached double digits recently? Staying employed is one of the best ways to deal with double digit inflation as incomes rise on par with inflation or better, at least for most skilled occupations. In addition, every year of staying employed is one less year to worry about income during retirement. On the other hand, facing a 15% annual inflation over a 30 year horizon can be brutal to an investor who is unable to earn income through employment. If you were hoping to retire on say, Rs. 50,000 a month ($1200 a month in today’s exchange rates), it is worth only about Rs. 12,000 a month in today’s value 10 years from now, barely Rs. 3,000 a month 20 years from now, and a piddly Rs. 750 a month at the end of your 30-year planning horizon. One way to protect the value of the initial Rs. 50,000 a month is to have it as a safe withdrawal from a well-diversified portfolio (that should have inflation-beating and likely volatile asset classes). This introduces asset price volatility (market risk) into the picture. So, depending on when your 30-year horizon begins, adverse market conditions may prevent you from withdrawing the same amount monthly (inflation-adjusted for future years) or you risk exhausting the portfolio before the 30-year horizon.
This is why I don’t always subscribe to the concept that all or even most of one’s assets must be in the country where the retiree lives. This advice, while sound for retirees in many “hard” currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one’s assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel “stupid” for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the “hard” + “soft” currency strategy of assets is that one’s returns would be lower because a sizable portion of the assets are in a ‘low yield’ country or a ‘high inflation’ country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.
And, in the remote possibility that you are reading this blog from Zimbabwe, I am told that the special paper and ink used to print currency notes has a decent heat index value, so you can save fuel costs while cooking your meals every day. You now have money to burn.
May 18, 2007
Personal Peace & Prosperity Index
Have you heard of the famous PPP (Purchasing Power Parity) index or its ruff-collared cousin “Big Mac Index” developed by The Economist magazine? It is designed to compare the equivalent cost-of-living across countries based on a consumption of selected goods and services. This is a widely accepted method to compare the earning power of a job across different countries, rather than using currency exchange rates. Simply put, the Big Mac Index is a comparison of the price of McDonald’s Big Mac hamburger (presumably identical in quality) between two countries to arrive at the PPP rate of the currencies. So, if a Big Mac costs say $2.50 in U.S. and say, £1.50 in U.K., the PPP rate is 2.5/1.5 = $1.67 to a British Pound. However, £1 buys nearly two dollars today, so by this measure the Pound is over-valued! While PPP is a useful parameter in macro-economics, my issue with it is its relevance to globally-mobile professionals or even retirees wanting to spend their sunset years in another country. The problem with the Big Mac Index or even the PPP is that life and choices we make as individuals are not identical across countries even though we may be at “parity” in the sense of the PPP index. This comparison becomes even more meaningless between a developed country and a developing country. An average American may choose to have a Big Mac, French fries and Coke for lunch everyday but an average Chinese or Indian may prefer a street vendor’s fried rice and a cup of tea for lunch. Moreover, a trip to the local McDonald’s is a common man’s sojourn in U.S. but is still a privilege of the well-heeled or high earning individuals in India.
Based on World Bank’s data on Nominal and PPP-based Gross Domestic Product (GDP) data on U.S. and India, the PPP of a U.S. dollar is about 10-12 Indian Rupees (INR). A classic interpretation of this would mean that the purchasing power of a person earning $20,000 per year in U.S. is the same as a person earning about INR 0.2 million in India and that a person earning $100,000 annually in U.S. would find equivalent lifestyle at INR 1-1.2 million. Can this be true? I doubt it. I would rather buy the PPP comparison at lower income levels than higher levels. I believe that at higher income levels, the aspirations and lifestyle expectations become more aligned regardless of which country a professional works in. Moreover, non-essential goods and services tend to be priced closer to each other across countries, so the 10-12 ratio may apply for a decent haircut but not for say, air tickets. I know from personal experience that I can get a similar quality haircut for INR 100 in India that I can get at a discounted hair salon for $10 in U.S., so the ratio works there. Even a discounted airfare between two cities in India (say, Mumbai-Chennai) is about INR 7000 ($160-$175), whereas for flying similarly distant cities in U.S., I only pay about $150-$200 round trip. The PPP ratio is completely irrelevant in this case. However, is it not reasonable that a high income earner in both U.S. and India may prefer to enjoy personal air travel at least once a year? At less than 0.2% of annual income, air travel is about 4 times more affordable to the U.S. professional earning $100K per year than the “parity” Indian. So, the high-earning Indian may be at parity as per PPP index, but knowing the disparity in affordability of a simple convenience such as air travel, you can bet that he will not feel ‘on par’ with his American counterpart. After all, our sense of peace and prosperity is not based on absolute numbers but relative affordability of the goods and services of relevance to us. This is especially important for people wanting to retire in a foreign (or home) country based on the earnings and assets from a home (or foreign) country.
I wonder whether we should consider a new “PPP” – Personal Peace & Prosperity index. If you are a U.S. based professional wanting to retire abroad, it does not matter what the ratio of hamburger prices between U.S. and your destination of choice is. It also does not help you much to know the traditional PPP measure because we saw earlier that INR 1-1.2 million/year in income does not mean a “parity” lifestyle with US$100,000/year. Then, how does a prospective retiree get a sense of peace and relative prosperity - a more relevant measure of retirement happiness - in the retirement destination of their choice?
To estimate your new “PPP”, you must compare how your sustainable income (from your net assets) compares with that of employment-based earnings in the country of your choice. Let me explain. If you are a professional earning $100,000 per year in U.S. and have say, $300,000 in investable assets at the time you are contemplating retirement abroad, you need to ask yourself the following questions:
1. What is the sustainable or safe withdrawal rate (SWR) considering the number of years you plan to stay retired? SWR is the percentage of your portfolio that you should withdraw during your first year of retirement, adjusted for inflation annually. For more on SWR, see here. Let’s say the SWR is 4%.
2. What does the SWR mean in terms of real dollars for your portfolio? For 4% SWR in the above example, you can count on $12,000 (0.04 x $300,000) as income during the first year from your portfolio. Convert this figure into the currency of the country where you intend to spend your retirement. For India, at current exchange rates, it works to about INR 0.5 million.
3. Where does the withdrawal income figure in your chosen country’s employment data? First, find a professional group in your retirement country that is high-earning (say IT professionals for India). Why a high-earning 'peer' group? Because your sense of relative prosperity will come from being able to fit within such a group versus other others in your chosen country. If your aspirations are considerably more modest, you may choose to compare yourself with the average salaried class.
4. Consult salary surveys of the chosen peer group and figure out where your withdrawal income figure would fit in that salary survey. Using the above example, and the 2005 salary survey data (most recent available for free) for IT professionals in India, an income of $12,000 (~INR 0.5 million) per year is comparable to an IT professional with 5-10 years experience. Comparing with the range of incomes in the same salary survey would also tell you that 52% of professionals in this high-earning group earn more than INR 0.5 million. This determines your “peace” level as a retiree knowing that your passive income places you about the middle of a high earning professional group. For some of you, the same “peace” may require that your passive income put you in the top 10% of this comparison group, which in this example is an income of INR 1-1.5 million ($24,000-36,000).
5. To complete the picture, you should then determine how much income is required in U.S. to place you at the same level. For example, a median IT professional with 5-10 years of post-college experience may earn about $70,000 per year in the U.S. To generate this level of passive income, your net assets must be at least $1.75 million (70,000/0.04), which is almost 6 times what is required to be in the same personal peace & prosperity (PPP) level should you choose to retire in India.
That’s it. You now know your own Personal Peace & Prosperity (PPP) rating based on your actual net worth and expected passive income, matched with the ground reality of where that income will place you among the aspiring working class in your chosen retirement locale.
I can see some of you calculating ratios here to wrongly conclude that my new PPP concept is nothing more than a USD: INR ratio of 5.8 ($70,000/$12,000). Don’t use such short cut formulas. The ratio of 5.8 is just what it has worked out to be for the specific example discussed above. If you follow the approach I outlined above, you will arrive at a new PPP unique to your situation and expectations. And isn’t that the whole point of doing this analysis? There is no one-size-fits-all approach as the traditional PPP or Big Mac index suggests. The only cross-country comparison that is relevant is one that is tailored to your asset base, risk tolerance and lifestyle expectations matched to the country where you expect to live the rest of your life. The new PPP is personal and designed to give you a sense of peace and relative prosperity during your sunset years.
Expecting to transplant an opulent Western lifestyle to India or the other extreme of aiming to live like a home-grown ‘average’ retiree are both unreasonable in my opinion. As a future transnational retiree, the realization that my passive income puts me in the middle of a high-wage profession aspired to by the country’s best and brightest, is far more comforting to me than knowing I can buy two Big Macs for the same price as one in the U.S.
Feb 13, 2007
True Financial Freedom
You have seen it in magazines, TV shows and movies. They always portray someone in front of a yacht near crystal clear water on a cloudless sunny day sipping champagne as the picture of financially freedom. This is a gross distortion of reality. Most financially free people (especially FinGho Walkers) will shy away from advertising their wealth.
Financial freedom does not mean you have to leave your job. In fact, you have no reason to leave your job except when it sucks energy from you and if so, by all means leave the job to enjoy your freedom. However, for many people, their jobs provide meaningful activity - physical, mental and social. These forms of activity keep you plugged into the real world rather than being alone on a yacht or a golf course. They also help keep your sanity. Try golfing every day for a week. I guarantee you, it will drive you crazy (no pun intended!).
Before we get into what financial freedom can do for your work life, let us first define in the simplest way what it means. How do you know when you have achieved financial freedom? No need to rush to the complex spreadsheets that 'experts' develop to justify their existence to define it. Here's my simple formula:
You have achieved financial freedom when:
Annual Expenses '<' SWR x Total Financial Assets
('<' means "less than")
SWR = Safe Withdrawal Rate, which is 2% if you want to be financially free in your 30s, 3% if you do it in your 40s and 4% if you are in your 50s and beyond.
Before anybody complicates this formula by several additions and subtractions (some are valid, which I will get into later), let me propose that if you are pondering this when you are 55, you have achieved financial freedom when your total financial assets (not considering your home) grows to a level where withdrawing just 4% of it annually fully covers your living expenses. Put another way, you should have total financial assets of at least 25 times your annual expenses.
As you can see, there are two factors contributing to financial freedom. Increasing your assets is just one piece of it. Controlling your living expenses is an equally important piece. This is why some smart retirees who made their money working in developed economies choose to retire in developing countries in Latin America or Asia, where their living expenses can shrink by a factor of 2 to 5 compared to U.S. Consider this example: to support $60,000/year in living expenses in U.S., one needs 25 times that figure or $1.5 million in financial assets. If you choose to live in a low cost location where your living costs can be cut to 1/3rd of your current costs with no noticeable change in your quality of life, you need only $500,000 to achieve the same financial freedom. This cost-of-living arbitrage is one of the advantages for those working in high-wage economies like U.S. or Europe. It is one of the very few "free" lunches available in the world today. I am not advocating that all baby boomers pack their belongings and head to the third world but I wanted to point that option as it has increasingly become feasible in today's connected world.
Note that I have not included any passive income you may receive. This includes social security and company pensions, neither of which an a person younger than 40 should rely on given the shaky SS system and fast disappearing company pensions. If you are fortunate enough to get anything from social security or company pension, consider it as gravy.
Regardless of whether you achieve financial freedom by growing assets or cutting down your expenses (or preferably doing both), there is no requirement that you leave your job. This is especially true for long-time FinGho Walkers who have amassed substantial wealth over their working life and find themselves in an enviable position of having achieved financial freedom before they turned 50. Naturally, I have not seen many 'experts' talk about the benefits of working after achieving financial freedom. So, here is my list:
- You can truly speak your mind at work and not worry about adverse consequences. You have no reason to suck up to anyone.
- You can ask for and work only on the projects that you care deeply about and say 'no' to ones that do not interest you (If you are really good at what you do, most organizations will give you this freedom anyway).
- You will become the envy of your fellow workers who desperately need their jobs
- The income, health and other benefits (however, meagre) from your job are gravy for you. Each year you spend without depending on your financial assets means more moolah for you (and your heirs) to enjoy later.
- You can indulge in several luxuries that you denied yourself while achieving the financial freedom. (yes, FinGho Walkers can finally buy the luxury cars!)
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