Posts
Overview
Most investors know investment prices move up and down over time. However, many investors panic when things get tough and make investment decisions that are opposite of what should be done. With the current worldwide dramatic fall in prices of so many investments (stocks, real estate, etc.), emotions can be even more dramatic resulting in many people selling (and buying) at the wrong time.
Seasoned investors count on fear driven selling
In a previous post, I wrote how professional investors count on panic selling by unseasoned investors to determine good buy points (click here to read the article). Usually during very heavy sell volume days when prices drop dramatically for a stock, that is the point that the price starts to turn around as most sellers finish selling their shares. At this point the professional investors know they can get a rock bottom price when buying into the investment. However, in this market, there is no assurance the low price won’t get lower in the near future if these buyers also begin to sell through even lower prices.
Remember a loss is not real until you sell the investment
It is scary holding one or more investments where the price has dropped 40%, 50%, or more just in the past few months. If you have continued to hold your dropping investment through this downturn - whether it be stocks, real estate, or other investment – remember you have a paper loss until the investment is actually sold. As an example, if you have a rental property that was previously worth $250,000 and is currently worth only $150,000, it can be very tempting to sell the property for fear of even lower value in the future. If you don’t sell, then the perceived loss of $100,000 ($250,000 past value - $150,000 current value) is not realized. Only if you actually sell the property will there be a $100,000 loss in value.
Commenting on a recent article on CNN
This past week money.cnn.com ran a story on a young couple who have done a good job saving and investing money. The story can be found at: http://money.cnn.com/2009/02/18/retirement/makeover_savers.moneymag/index.htm. Financial advisors provided thoughts on whether the couple should make changes in their saving/investing strategy based on losses experienced with the recent downturn in stock and real estate values. One of the recommendations was to sell the rental property this couple has that has a $400 per month negative cash flow over rent. The sales recommendation is not necessarily based on fear, but was suggested to free up the $400 per month for use in other after tax investment accounts.
That recommendation really bothered me since this couple is in their late 30s and don’t plan retirement for 20 more years. In my mind, they have many years to wait for the real estate value to recoup the $100,000 drop, while collecting rent all the while to pay down the associated mortgage. After 20 years, the mortgage will be largely paid off and the monthly income from raising rent over those years should have erased the $400 negative. Since the property was bought in 2006, they would only have seven years left on the mortgage. Even if they do retire in 20 years as planned, holding onto the property seven more years to pay off the mortgage would provide a nice rental income to use for whatever purpose they needed during the rest of their lives. Hopefully, the value has grown over all of those years as well to increase the value of their estate as an added benefit for the heirs.
Assume they sold the property out of fear
For purposes of discussion, let’s assume this couple was getting very nervous about the perceived $100,000 drop in property value and sold out of fear of losing even more. In that case, they would miss out on the scenario I provided above where eventually the property could be debt free with a large cash flow going into the couple’s future retirement needs. If the couple had a mortgage on the property higher than the current $150,000 value, then the couple would owe taxes to the IRS on the difference between what the couple owes on the property and what the mortgage lender was able to get paid back from the sale. The IRS treats this difference as income to the owner. This all assumes new tax laws are not implemented as part of the stimulus package. Check with your tax advisor if you are in a similar situation before taking any action.
In this case, fear would prevent the couple from enjoying the benefits of owning the rental property as I outlined earlier. The couple could potentially owe a large tax to the IRS on the portion of the mortgage loan that was not paid off from the property sale. They would add shame and a sense of failure to their self image, likely keeping them from considering other potentially good investments in real estate for fear of losing large amounts of money again. The loss of self image and lack of confidence in their ability to chose investments could lead them toward investing only in safe assets like CDs or even savings accounts. Those investments will lose money over time as inflation eats away what money they do have saved. All of this because the couple sold, rather than rationally thought through that there isn’t really any loss unless the property is sold. Even though you should mainly focus on buying rental properties that have a positive cash flow from the beginning, in this case, the loss is only $400 per month against their combined income of $250,000 per year. That, to me, makes no sense to sell with the added costs that could result from selling the property vice the monthly loss of $400.
These consequences of fear selling apply to other investments as well
Personally, I sell stocks when I first see technical indicators showing a down term coming. However, if you have already ridden down the price drop without selling and are scared of losing more, sit back and take a breath. Look at the reasons you bought the stock – hopefully rising market share, increased net cash flow, etc. If those same indicators are still valid, then think twice about selling into a significant loss if the stock should have a good chance of making up the loss over the next 5 or 10 years. You need to consider each stock on its own merits. Of course, there are many stocks where the fundamentals have changed dramatically for the worse where they no longer have any prospects of increasing income or market share, etc. In that case, you may need to sell now to prevent even further loss. All I ask is that you don’t sell out of fear. Look at all the information you can get on the company. Look at how much debt they have on the books and how likely they are to pay off those debts to remain profitable. Look at the industry the company is in. Is the industry one that is being hit and continues to be hit seriously? Make your decision based on facts, not on emotions of the moment.
Summary
Don’t play into the hands of seasoned investors who count on the inexperienced investor selling at the worst possible time, handing these seasoned investors potentially great bargains. Many of these seasoned investors make this part of their investment strategy to wait for the panic sale periods in the market before making purchases. Imagine if you were patient enough to wait for these periods of uncertainly to build a portfolio of investments at very good prices. Now imagine how much money you would have when the markets then recover and grow beyond where they were before the market fell. You would have bargain priced investments with strong growth over time. It is like looking for fire sales at the store before making your purchases. It builds your self esteem and reinforces your confidence as an investor. Learn to control your emotions and invest based on facts to increase your long term prospects for success as an investor.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13
- - - - - - - - - -
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.
Find similar articles by clicking the Sphere.com icon below:
Sphere: Related Content
Sunday, February 22, 2009
Tuesday, February 17, 2009
The cost of borrowing from your tax deferred account
Overview
If you have a sizeable balance in your tax deferred 401, 403, IRA, Keogh, or other tax free account, it can be tempting to borrow against the account for hardship, medical, education, or the purchase of a home. There are times when a loan makes good financial sense. However, most of the time it is best to leave your funds in the account to take advantage of the tax free compounding (click here to read a previous series that covers compounding in detail). This article will go over the “cost” involved with borrowing against one of these accounts.
Revisiting the effect of compounding
If you read the previous series on compounding interest, you understand the enormous benefit compounding brings to multiplying your final account balance after many years. Most advisors recommend you invest in a combination of stocks and bonds to spread the risk and still participate in the higher historical return stocks provide.
Costs of borrowing funds
When you borrow from your account, the borrowed funds are usually paid back at the lowest rate – usually the bond rate (approximately 4%). In that case, you lose out on the significant long term gains that would have been achieved from a higher compounding rate closer to the historical stock gains of 8%. However, another “penalty” that many people are not aware of is that funds used to pay back the loan are after tax money. You can’t deduct the money used to pay off the loan. Therefore, you are using money that has already been taxed to pay back the loan. The money you paid in taxes could have also benefited from compounding interest over time. So, you lose two ways – the higher compounding the funds could have received if left in the account and the compounding of the taxed dollars spent to pay back the loan. There is also the potential for a third penalty if the borrower decides to lower the ongoing regular investment into the account in order to afford the new loan payments. In this case, there is additional loss of compounding growth against the reduced contributions over time. Lets look at an example to help illustrate the issues involved with borrowing.
Simplified example of borrowing from a tax deferred account
Assumptions: 1) Joe has $75,000 in his account earning a long term average annual return of 6% and is contributing $1,000 monthly; 2) He borrows $25,000 (for whatever reason) from his tax deferred account; 3) The current bond rate is 4% and that the loan will be paid back over 15 years at this 4% rate with a monthly payment of $184.92; 4) Joe pays a combined State and Federal tax of 30%.
Had Joe had continued his investment plan of $1,000 monthly and not taken out a loan, he would have a ending balance of $474,876 in 15 years. By removing $25,000 as a loan, the remaining $50,000 balance with the $1,000 monthly contributions would grow to $413,523 after 15 years or $61,353 less ($474,876 - $413,523). However, the $25,000 would add back a 4% compounding return into the account over the 15 years of $8,286 as the loan is paid back. This lessens the difference to $53,027 ($61,353 - $8,286).
Adding real life complexity to the example
That was a very simplified example since the 4% loan payments would actually be added back into the same investment split that the new contributions are distributed across - bonds, stocks, etc. So, if the account is earning a 6% average return from the current investment split, then each payment would compound at this 6% rate through the remaining years. This would lessen the $53,027 difference. Another complexity is the 4% loan is paid back with after tax dollars. Since the combined tax rate is 30%, then it takes $1.30 of before tax funds for every $1.00 paid toward the loan. Since the monthly payment on the 4% $25,000 loan is $184.92, then approximately $55 is paid each month in taxes (185 dollars x 30 cents taxes on each dollar equates to $55 in taxes). If there was no loan, then this $55 could have been invested monthly into the tax deferred account at the average 6% rate to earn $15,995 after 15 years. This is an added loss on top of the $53,027 difference calculated earlier.
Summary
You need to see a qualified financial advisor to look at your particular situation. Information provided above are hypothetical and not meant to be financial advice for any specific situation. However, as you can see, there are many variables that could affect the calculations. But, in all cases you end up with less in your tax deferred account over the long term by borrowing funds that by not borrowing. Again, there are situations where loans may make sense, but you need to be aware of the long term consequences of missing out on compounding over time for the funds borrowed from the tax deferred account. A financial advisor is usually going to be much cheaper than the amount of money you may lose over time by borrowing.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13
- - - - - - - - - -
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/
Your feedback is wanted: Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.
Sphere: Related ContentMonday, February 9, 2009
Part 3: Understanding Inflation – The dollar to gold price relationship
Overview
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. The first article provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. Last week’s article discussed the importance of investing in assets that grow faster over time than the rate of inflation. This article will discuss the relationship between the value of the dollar and prices of high demand commodities such as gold during times of inflation.
Valuing the dollar
Normally the dollar is worth more or worth less based on the demand for U.S. goods, services, and assets/products. If foreign investors buy lots U.S. items such as real estate, treasury bonds, stocks, or other, then they must first convert their currency into dollars in order to pay for the purchase. When there are many foreign investors converting to dollars, then the demand for dollars is high and the value of the dollar rises. When demand is down, then the dollar is worth less.
A crude analogy to illustrated to change in value of the dollar
Assume there is a small town of 5,000 people in the middle to high income bracket that all live in apartments due to lack of available land for building homes. Then assume one home is finally built in the town and it is in very high demand. Would it be unreasonable for the asking price on the home to be at least 2 or 3 times as much as for a similar home in a large town that has plenty of housing? Could the price even go as high as 10 times as much or more? Well this is a crude example of how the value of the dollar also goes up when there are fewer dollars available to meet a rising demand by foreign investors wanting to purchase our treasuries, stocks, real estate, etc. Similarly, when there are many more dollars available than demand, then the value of the dollar declines – it is easy to find dollars to convert from their currency. In those times, foreign investors are not seeking to buy as many our things so there is less demand for dollars to convert with.
The current world-wide demand for dollars
With the world-wide financial crisis hitting most foreign countries harder than the U.S., investors in those countries want to buy U.S. issued securities such as treasuries that are backed by the full faith of the U.S. government. Since we have the largest economy in the world, foreign investors feel U.S. securities are the safest available, at least they perceive them more safe than investing in their own country. That is why the dollar has soared in value recently with so many foreign investors seeking these perceived safer investments that must be purchased with U.S. dollars.
Relating gold to the dollar to inflation
Currently, there is also a demand for gold since most investors around the world view it almost as a standard currency that is valued by everyone. That gives it a large base of investors that keep the price high, especially in times of high uncertainty such as the world is currently experiencing.
In terms of the dollar, you need to realize part of the price of gold rising can be attributed to times when the value of the dollar decreases. In those normal times, it is not so much that gold has risen in price, but that it takes more dollars to buy the same amount of gold. As an example, assume you can buy gold for $1,000 per oz. Later, the value of the dollar decreases by 10% to only be worth 90 cent when compared to what it was worth when purchasing $1,000 oz worth of gold. In this case, you would need to have $1,111 to buy the same oz of gold under the current lower valued dollar. This is derived by taking the $1,000 originally paid divided by 90cents for each lower value dollar meaning you will pay $1,111 using these lower value dollars for the same ounce of gold. So, it isn’t that gold has risen, but instead, gold has stayed the same and the value of each dollar to buy that gold has gone down. This is a time of inflation when the value of the dollar goes down, which is why prices paid for many things seem like they are going up
Relating gold to the dollar to deflation
This also works in the opposite. If over time the value of the dollar had instead increased by 10%, then each new dollar would be worth $1.10 of the older dollars. In that case, we take the original dollar paid $1,000 oz of gold and divide by the new $1.10 value dollar to only pay $909 per ounce of the same gold. In this case it looks like deflation since the price has decreased over time. This would also be true of many other items when the dollar increases in value as we are currently seeing.
Amplifying my point about the price of gold during inflation and deflation
An interesting observation I’ve made recently is in times of very high uncertainty, as we have around the world today, there is the added demand for gold that is also causing the price to increase on top of whatever the value of the dollar does. If the value of the dollar increases, as it has recently due to the high demand for our treasuries, gold has still increased due to high demand by investors around the world. So you can’t always only count on the straight mathematical price model I used above to calculate the price of gold during inflation and deflation.
Summary
Notice that many commodities follow a similar pattern during inflation and deflation where their prices move in the opposite direction of the value of the dollar, under normal market conditions. As the dollar rises, it takes less dollars to buy the same commodity like oil (affecting the price you pay per gallon for gas at the pump), silver, gold, etc. As dollars fall, it takes more dollars to buy the same items. Just a general rule to think about when investing – keep a close eye on the value of the dollar and world demand trends for the dollar (rising demand or decreasing demand).
Accredited sophisticated investors are very mindful of such trends before making investment decisions. Don’t let them take advantage of your fear when you sell or buy at the wrong time when they are doing the opposite. Continue educating yourself about the investments being considered and all factors that affect those investments.
I hope this article helps you to not just look at the price of gold or other commodities by itself. Consider the valuation of the dollar, world demand trends for both the dollar and the commodity being considered, etc. Look for patterns and relationships. Understand those well before moving forward. Be an educated investor and you will be way ahead of the ordinary investor who wants to “get in before it is too late” or “get out since it is going to crash”. Those are opportunistic times for the educated investor to do the opposite of the crowd.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13
- - - - - - - - - -
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. The first article provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. Last week’s article discussed the importance of investing in assets that grow faster over time than the rate of inflation. This article will discuss the relationship between the value of the dollar and prices of high demand commodities such as gold during times of inflation.
Valuing the dollar
Normally the dollar is worth more or worth less based on the demand for U.S. goods, services, and assets/products. If foreign investors buy lots U.S. items such as real estate, treasury bonds, stocks, or other, then they must first convert their currency into dollars in order to pay for the purchase. When there are many foreign investors converting to dollars, then the demand for dollars is high and the value of the dollar rises. When demand is down, then the dollar is worth less.
A crude analogy to illustrated to change in value of the dollar
Assume there is a small town of 5,000 people in the middle to high income bracket that all live in apartments due to lack of available land for building homes. Then assume one home is finally built in the town and it is in very high demand. Would it be unreasonable for the asking price on the home to be at least 2 or 3 times as much as for a similar home in a large town that has plenty of housing? Could the price even go as high as 10 times as much or more? Well this is a crude example of how the value of the dollar also goes up when there are fewer dollars available to meet a rising demand by foreign investors wanting to purchase our treasuries, stocks, real estate, etc. Similarly, when there are many more dollars available than demand, then the value of the dollar declines – it is easy to find dollars to convert from their currency. In those times, foreign investors are not seeking to buy as many our things so there is less demand for dollars to convert with.
The current world-wide demand for dollars
With the world-wide financial crisis hitting most foreign countries harder than the U.S., investors in those countries want to buy U.S. issued securities such as treasuries that are backed by the full faith of the U.S. government. Since we have the largest economy in the world, foreign investors feel U.S. securities are the safest available, at least they perceive them more safe than investing in their own country. That is why the dollar has soared in value recently with so many foreign investors seeking these perceived safer investments that must be purchased with U.S. dollars.
Relating gold to the dollar to inflation
Currently, there is also a demand for gold since most investors around the world view it almost as a standard currency that is valued by everyone. That gives it a large base of investors that keep the price high, especially in times of high uncertainty such as the world is currently experiencing.
In terms of the dollar, you need to realize part of the price of gold rising can be attributed to times when the value of the dollar decreases. In those normal times, it is not so much that gold has risen in price, but that it takes more dollars to buy the same amount of gold. As an example, assume you can buy gold for $1,000 per oz. Later, the value of the dollar decreases by 10% to only be worth 90 cent when compared to what it was worth when purchasing $1,000 oz worth of gold. In this case, you would need to have $1,111 to buy the same oz of gold under the current lower valued dollar. This is derived by taking the $1,000 originally paid divided by 90cents for each lower value dollar meaning you will pay $1,111 using these lower value dollars for the same ounce of gold. So, it isn’t that gold has risen, but instead, gold has stayed the same and the value of each dollar to buy that gold has gone down. This is a time of inflation when the value of the dollar goes down, which is why prices paid for many things seem like they are going up
Relating gold to the dollar to deflation
This also works in the opposite. If over time the value of the dollar had instead increased by 10%, then each new dollar would be worth $1.10 of the older dollars. In that case, we take the original dollar paid $1,000 oz of gold and divide by the new $1.10 value dollar to only pay $909 per ounce of the same gold. In this case it looks like deflation since the price has decreased over time. This would also be true of many other items when the dollar increases in value as we are currently seeing.
Amplifying my point about the price of gold during inflation and deflation
An interesting observation I’ve made recently is in times of very high uncertainty, as we have around the world today, there is the added demand for gold that is also causing the price to increase on top of whatever the value of the dollar does. If the value of the dollar increases, as it has recently due to the high demand for our treasuries, gold has still increased due to high demand by investors around the world. So you can’t always only count on the straight mathematical price model I used above to calculate the price of gold during inflation and deflation.
Summary
Notice that many commodities follow a similar pattern during inflation and deflation where their prices move in the opposite direction of the value of the dollar, under normal market conditions. As the dollar rises, it takes less dollars to buy the same commodity like oil (affecting the price you pay per gallon for gas at the pump), silver, gold, etc. As dollars fall, it takes more dollars to buy the same items. Just a general rule to think about when investing – keep a close eye on the value of the dollar and world demand trends for the dollar (rising demand or decreasing demand).
Accredited sophisticated investors are very mindful of such trends before making investment decisions. Don’t let them take advantage of your fear when you sell or buy at the wrong time when they are doing the opposite. Continue educating yourself about the investments being considered and all factors that affect those investments.
I hope this article helps you to not just look at the price of gold or other commodities by itself. Consider the valuation of the dollar, world demand trends for both the dollar and the commodity being considered, etc. Look for patterns and relationships. Understand those well before moving forward. Be an educated investor and you will be way ahead of the ordinary investor who wants to “get in before it is too late” or “get out since it is going to crash”. Those are opportunistic times for the educated investor to do the opposite of the crowd.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13
- - - - - - - - - -
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content
Sunday, February 1, 2009
Part 2: Understanding Inflation – choosing the right investments during inflation
Overview
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. In last week’s article, I provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. This week I want to show the importance of investing in assets that grow faster over time than the rate of inflation. Sophisticated investors know they must increase the value of their portfolio at a higher rate than inflation in order to grow their wealth. Any growth rate lower than inflation (such as the interest rate paid on most savings accounts) would still erode the value of the investment portfolio over time. Lets look closer at this balance of growth against inflation.
Overcoming the effect of inflation
As stated above, there are two opposite forces that affect what your long term investment portfolio will end up accumulating: inflation and rate of growth. Any long term investment strategy must consider the effect of both and incorporate a plan for accumulating assets that will increase in value faster than the rate of inflation. To do this, many investors seek assets that have limited quantity such as rare high grade coins, rare art, gold, desirable real estate. Over time, the scarcity of the asset will make them harder to buy so the price usually goes up. In addition, accredited investors have access to other investments that have high risk of loss, but demand high rates of return such as participation in a private placement, special hedge/leveraged funds, providing seed capital for a new or young business/product/service, etc. These investments each carry different levels of risk and expected returns. All of these factors need to be incorporated into a long term investment strategy/plan.
You must have an investment strategy/plan
An investment strategy must have set investing rules and boundaries you will maintain no matter what. Consistently applying a strategy over time will take out emotional decisions that usually go against what needs to be done during times of uncertainty. Your strategy should incorporate your end goal, how long you plan to invest, and what you are going to invest in to get there. You can make improvements in your plan, but only change one thing at a time - don’t make another change until enough time has past to confirm if the change worked or should be reversed. Continuing this refinement process will go a long way toward getting you to your end goal and help refine your investing skills.
Research historical returns on your prospective investment
Keep in mind a general estimate of inflation is about 3% to 4% per year. You want to make sure your entire portfolio gets at least 4% over time just to keep up the same real overall value. Ideally, your return should consistently be higher than the historical rate of inflation to increase your buying power by the time you retire. Maximizing contributions into tax free accounts is one of the best ways to increase compounding of your long term investments by deferring taxes on the gains.
We are currently in a very scary down market. Seems like everything has dropped considerably including “blue chip” stocks, real estate, minerals such as oil and gas, etc. However, if this down turn is like so many others in the past, then these assets will again come into favor with increasing prices along historical averages. Research the historical average of assets you want to learn about investing in. Within those assets, learn what makes some more desirable than others (for example, different locations of real estate have dramatically different historical returns). Chose those assets that provide the historical returns you need to reach your goal as part of your strategy. Diversify enough to decrease the risk of loss to your portfolio, but not too much as to dilute any gains made by each asset. Periodically shift funds from one asset to another to rebalance your portfolio.
Putting it together
In a previous article on compounding interest, I showed how a $1,000 investment in a tax free compounding interest account after 40 years can provide an additional 122% return at 4% interest rate ($2,224 account total minus the $1,000 invested, then divide that difference of $1,224 by $1,000 to get 122%), 394% at 8% ($4,940 balance - $1,000, then divide by $1,000), and 5,759% at 16% ($576,923 balance - $1,000, then divide by $1,000).
In last week’s article, I showed how inflation does the opposite by reducing the buying power of $1,000 over 40 years to only $201 for a consistent 4% rate of inflation. This is a 80% reduction ($1,000 - $201, then divide by $1,000) in buying power. In other words, $201 is only 20% of the value the initial $1,000 after 40 years. In reverse, to maintain a $1,000 buying power after 40 years you would have needed to initially invest $5,000 the first year ($5,000 x 20% after 40 years leaves $1,000). Starting with five times the initial $1,000 investment defeats the purpose of keeping that initial $1,000 investment at the same buying power after 40 years. Therefore, we need to invest the $1,000 at a compounding rate that negates the devaluing rate from inflation. Since we need the initial $1,000 invested to act like $5,0000, we must invest at an annual rate that generates 400% return after 40 years ($5,000 - $1,000 invested means we need to generate the equivalent of $4,000 additional dollars in the beginning over the 40 years or 400%). From the previous paragraph, we need an annual tax free compounding interest rate of 8%. Interestingly enough, this is the historical growth rate you hear that the stock market has grown. That is why many financial advisors recommend investing in a stock index (S&P 5000) to keep up with inflation. Of course, these days that seems like bad advice with the significant drop stocks have taken in only a few months. But, if you believe history will repeat itself again, then you should still include stocks in your investment strategy to assure gains keep up with inflation. As mentioned earlier, there are many other investments that historically have met or beat the historical rate of inflation such as choice real estate, private placements,
Summary
A small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. Your investment strategy/plan must include investing in assets that increase with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.
Next article in this series
Next week's article covers the relationship between the price of gold and value of the dollar during times of inflation and deflation.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/
- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors. This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. In last week’s article, I provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. This week I want to show the importance of investing in assets that grow faster over time than the rate of inflation. Sophisticated investors know they must increase the value of their portfolio at a higher rate than inflation in order to grow their wealth. Any growth rate lower than inflation (such as the interest rate paid on most savings accounts) would still erode the value of the investment portfolio over time. Lets look closer at this balance of growth against inflation.
Overcoming the effect of inflation
As stated above, there are two opposite forces that affect what your long term investment portfolio will end up accumulating: inflation and rate of growth. Any long term investment strategy must consider the effect of both and incorporate a plan for accumulating assets that will increase in value faster than the rate of inflation. To do this, many investors seek assets that have limited quantity such as rare high grade coins, rare art, gold, desirable real estate. Over time, the scarcity of the asset will make them harder to buy so the price usually goes up. In addition, accredited investors have access to other investments that have high risk of loss, but demand high rates of return such as participation in a private placement, special hedge/leveraged funds, providing seed capital for a new or young business/product/service, etc. These investments each carry different levels of risk and expected returns. All of these factors need to be incorporated into a long term investment strategy/plan.
You must have an investment strategy/plan
An investment strategy must have set investing rules and boundaries you will maintain no matter what. Consistently applying a strategy over time will take out emotional decisions that usually go against what needs to be done during times of uncertainty. Your strategy should incorporate your end goal, how long you plan to invest, and what you are going to invest in to get there. You can make improvements in your plan, but only change one thing at a time - don’t make another change until enough time has past to confirm if the change worked or should be reversed. Continuing this refinement process will go a long way toward getting you to your end goal and help refine your investing skills.
Research historical returns on your prospective investment
Keep in mind a general estimate of inflation is about 3% to 4% per year. You want to make sure your entire portfolio gets at least 4% over time just to keep up the same real overall value. Ideally, your return should consistently be higher than the historical rate of inflation to increase your buying power by the time you retire. Maximizing contributions into tax free accounts is one of the best ways to increase compounding of your long term investments by deferring taxes on the gains.
We are currently in a very scary down market. Seems like everything has dropped considerably including “blue chip” stocks, real estate, minerals such as oil and gas, etc. However, if this down turn is like so many others in the past, then these assets will again come into favor with increasing prices along historical averages. Research the historical average of assets you want to learn about investing in. Within those assets, learn what makes some more desirable than others (for example, different locations of real estate have dramatically different historical returns). Chose those assets that provide the historical returns you need to reach your goal as part of your strategy. Diversify enough to decrease the risk of loss to your portfolio, but not too much as to dilute any gains made by each asset. Periodically shift funds from one asset to another to rebalance your portfolio.
Putting it together
In a previous article on compounding interest, I showed how a $1,000 investment in a tax free compounding interest account after 40 years can provide an additional 122% return at 4% interest rate ($2,224 account total minus the $1,000 invested, then divide that difference of $1,224 by $1,000 to get 122%), 394% at 8% ($4,940 balance - $1,000, then divide by $1,000), and 5,759% at 16% ($576,923 balance - $1,000, then divide by $1,000).
In last week’s article, I showed how inflation does the opposite by reducing the buying power of $1,000 over 40 years to only $201 for a consistent 4% rate of inflation. This is a 80% reduction ($1,000 - $201, then divide by $1,000) in buying power. In other words, $201 is only 20% of the value the initial $1,000 after 40 years. In reverse, to maintain a $1,000 buying power after 40 years you would have needed to initially invest $5,000 the first year ($5,000 x 20% after 40 years leaves $1,000). Starting with five times the initial $1,000 investment defeats the purpose of keeping that initial $1,000 investment at the same buying power after 40 years. Therefore, we need to invest the $1,000 at a compounding rate that negates the devaluing rate from inflation. Since we need the initial $1,000 invested to act like $5,0000, we must invest at an annual rate that generates 400% return after 40 years ($5,000 - $1,000 invested means we need to generate the equivalent of $4,000 additional dollars in the beginning over the 40 years or 400%). From the previous paragraph, we need an annual tax free compounding interest rate of 8%. Interestingly enough, this is the historical growth rate you hear that the stock market has grown. That is why many financial advisors recommend investing in a stock index (S&P 5000) to keep up with inflation. Of course, these days that seems like bad advice with the significant drop stocks have taken in only a few months. But, if you believe history will repeat itself again, then you should still include stocks in your investment strategy to assure gains keep up with inflation. As mentioned earlier, there are many other investments that historically have met or beat the historical rate of inflation such as choice real estate, private placements,
Summary
A small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. Your investment strategy/plan must include investing in assets that increase with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.
Next article in this series
Next week's article covers the relationship between the price of gold and value of the dollar during times of inflation and deflation.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -
Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8
INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/
- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.
Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors. This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.
Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content
Subscribe to:
Posts (Atom)