The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
The investing world is chock full of clichés. A recent commercial recited one of the more nonsensical clichés of our industry: “He didn’t plan to fail, he failed to plan.” Come to XYZ financial and we will create a plan that works for you. In the words of Fluffy Watts, what a crock.
Understanding the psychology of the market can be a great tool, especially when added to a scientific approach. Investing is part science and part art; it is not 100 percent either of those things, and do not let anyone convince you otherwise.
I have struggled with what to say in this Quarterly Report. It seems somehow inappropriate to discuss any topic other than the virus. As I was leaving my office one day, I heard one of the CNBC talking heads say, “I’m scared to death of this virus, as I know we all are.” It hit me because I am not afraid of the virus, and I do not believe I am alone.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act is the biggest change in retirement plan law in a long while. Has our federal government made you more secure? I’m reminded of a saying that Ronald Reagan used often: The most feared words in the English language are, “I’m from the government and I’m here to help.”
The word competition comes from the Latin word “competere,” which is best translated as, “to strive together.” When true competitors compete, they make each other better. Today too many people think being competitive is about winning at all costs. Competitors do not compete against one another; they compete with one another. They strive together, and in the end, both are made better. This is why capitalism works, and why so many don’t seem to understand that. Competition makes us all better.
My father was an athlete. He lettered in three sports in college, but football was his favorite. He loves telling the stories from his days playing, and his high school coach had an enormous influence on him. One of my favorite stories comes from a time when they had lost a tough game on the road. They were loaded in the bus ready for the trip back home when his coach, Fluffy Watts, stood up in front to address the team. He said, “They say it isn’t whether you win or lose that matters, but how you play the game…. well, what a crock.”
I have heard that story hundreds of times, and I laugh every time, in fact I’m giggling right now. I laugh because I believe I understand what Fluffy was doing. I played high school football myself, and like every single other person who has ever been part of a team sport, I know what it feels like to lose. It hurts, and the closer the game, the more it hurts. People who have not experienced this may not understand that statement. Many believe it would hurt more to get blown out, but they are wrong. When a team gets blown out, well it just wasn’t our day or they were just better, but when it comes down to the wire and then goes the wrong way, that is the agony of defeat. Fluffy Watts was not suggesting that his team should do anything to win. I never met Fluffy, but I know my father and how he speaks of him. He was a man who demanded good sportsmanship above all else, but he also understood that when someone is in pain, empathy is often better than a speech about holding your head up.
A friend of mine I used to work with used to say that clichés exist for a reason. He is right about that. “It isn’t whether you win or lose that matters, it is how you play the game” exists for a reason. It is better to lose fair and square than it is to cheat and lose your integrity, but it is also correct that, “If winning didn’t matter, they wouldn’t keep score.” Clichés have their limits.
The investing world is chock full of clichés. Recently I was watching a commercial that recited one of the more nonsensical clichés of our industry: “He didn’t plan to fail, he failed to plan.” Come to XYZ financial and we will create a plan that works for you. Well, in the words of Fluffy Watts, what a crock.
I have written this many times, but I have a true dislike for the term financial planning. This lies mainly in the fact that I understand its history. “Financial planning” evolved from the life insurance industry. A few days after Cain killed Able, some neighbor went over to Able’s widow and instead of offering sympathy said, “Wouldn’t it be great if a company showed up at your door with some money to replace your husband?” The life insurance industry was born, and for years that was pretty much how they sold their policies.
Then one day an enterprising insurance agent realized that they could sell a lot more insurance by calculating the husband’s lost wages, as opposed to taking advantage of the heartstrings. Losing a husband was one thing, but losing the household income? Now that was serious. This new strategy was named the capital needs analysis. Instead of simply asking, “How much is your husband worth?”, the insurance agent could say, “How do you plan to replace your husband’s income?”
Capital needs analysis is simple math. If the husband made $50,000 per year and one could invest capital and receive a yield of 5 percent annually, then the wife needed a life insurance policy on her husband of $1 million. The agent would say it using his best Dr. Evil imitation, “One million dollars.”
It is simple math: 5 percent of $1 million is $50 thousand. That is the income that needed replacing. This was great for the life insurance industry. Much bigger policies could be sold by using this needs approach.
Then needs analysis started getting more sophisticated. The simple example did not factor in other assets available to produce income. There could be retirement plans and home equity. Did the widow need all of her husband’s income? After all there would be fewer tee times, and hunting trips. The beer budget could be cut by 80 percent or so and they could cut the cable on the TV. All of this budgeting needed to be done.
What happens if we make it to retirement? We no longer need insurance to replace income because our retirement plan is doing that. Then the insurance agent thought of something. There are three possible futures, one in which we die too soon, one in which we live too long, and one in which we get disabled in the process. He can sell insurance for all three of those outcomes. We can use the needs analysis framework to calculate how much we need to save in order to retire, in addition to both life and disability insurance needs. Financial planning was born.
For years financial planning was code for being a life insurance agent, then stockbrokers got in on it, too. So, I dislike the term financial planning because in its essence, it is a sales pitch.
Please don’t misunderstand. The analysis done in the planning process can be very helpful, and we do that for our clients all of the time. Having a plan can certainly be of great value. However, there is another cliché about that. “No plan survives contact with the enemy.” That is what they teach soldiers during boot camp. Mike Tyson put it more bluntly when he said, “Everyone has a plan until they get punched in the mouth.”
When I saw the commercial for the poor guy who “didn’t plan to fail, but failed to plan,” my first response was, “On what page in the plan did they explain 2020?” The plan covered COVID-19, lockdowns, and civil unrest? I don’t think that was in there. So, for the restaurant owner whose business has been shut down, was it really a lack of planning?
Plans can be very helpful, and I certainly don’t wish to suggest otherwise, but the difference between failure and success in the long haul is not the plan, it is the execution. We have clients for whom we have helped make very detailed plans and they have pretty much executed those plans precisely. We also have clients who have never planned a thing in their life, but they live well within their means and have invested prudently and are financially secure. Just this past month I met – virtually of course – with a client who has been planning to retire in three years for at least five if not seven years now. Guess what she said when we talked? “I think I’ll work just three more years.”
The idea that success or failure is based on planning is just false. Success or failure will be based on our actual actions. For financial purposes, the first action is living within one’s means. One must form the habit of spending less than she makes, period. A plan can be helpful to calculate the degree to which one must save, and it can provide many people with needed motivation; however, at the end of the day it boils down to the habit of relative frugality.
Another line that comes from the insurance industry is that you must pay yourself first. I have known people who planned and then couldn’t do this, and I have known people who did not plan and did this still. The plan is not the magic.
Once one has begun saving money, he then needs to invest that money. Here again, planning can be helpful. A plan can show what rate of return is necessary to accomplish the goal, and that gives some guidance in how to invest. However, ultimately investing success comes from the habit of prudent investing. Prudent investing has three attributes. First, it is always done from the bottom-up. Each investment must be analyzed and judged on its own merits. Secondly, it is absolute return-oriented. In other words, the investor is not making decisions to compete with another investor or an index, but based on her actual long-term goals and needs. Finally, it is risk-averse. There is no glory in taking risk for the sake of risk.
This is where the planning community goes off the rails. The vast majority of people who refer to themselves as financial planners have no background in how to actually build a portfolio to achieve a certain goal. The planners came from product sales and to this day remain in that mindset. Some have departed from the commission-based life and that is certainly a good start, but as the saying goes, “putting kittens in the oven doesn’t make them biscuits.”
Going fee-only is a good thing. Conflicts of interest should be avoided at all costs, and moving away from the traditional commission-based sales approach in the financial world is the right thing to do, but it doesn’t then qualify a person to actually build a portfolio. The real issue with financial planning is that its practitioners spend all their time learning how to plan, and little – if any – time learning how to execute a plan.
This brings us back to ole Fluffy Watts. “Coaches don’t win games, players win games.” There is a cliché I imagine Fluffy would agree with. Coaches can certainly make players better, but their role is to teach and guide. John Wooden thought of himself as a teacher. Dean Smith came from a family of teachers. Show me a coach that has a consistently winning team and I’ll show you a coach who is great at making players better. The players win the games.
I know myself from the years I have spent in youth coaching, that I did not win a single game. Some games I believe I helped on the margin, and those were the good coaching days. Most games I had either no impact or worse I hurt my team. The players won the games. I could plan all I wanted, but ultimately it was up to the players to execute.
No one plans to fail; they fail to develop the good financial habits that lead to success. We are all different as individuals. Some need to plan in order to instill those habits, while others go with the flow. Regardless, it is the execution that matters. John Wooden published a poem of an unknown author. It is a story of a parent speaking to their child before the first game. There is a line in that poem that says, “But winning is not the point, Wanting to win is the point.” When I read that poem it was the first time in my life that the other cliché finally made sense to me. Winning and losing a game doesn’t matter because it is so often out of our control – a ball bounces the wrong way, the ref makes a bad call, the other team makes some miracle play. We only control how we play the game, and we play to win. We execute.
There are many things that we cannot control that can impact our plans, but we can develop those good habits, and if we do so we will be successful, plan or no plan.
Chuck Osborne, CFA
~Failing to Plan, and Other Nonsense People Say
On March 17 of this year, I explained in a client meeting that the market was in the process of bottoming, and the client asked how I could possibly say that. The COVID- 19 crisis was raging with no clear end in sight, the economy was shut down, and the unemployment rolls were filling faster than in any time in history. How could I possibly be thinking that the market was bottoming?
The market, as it turned out, was indeed bottoming then and hit the very bottom just four trading days later. How did I know? After doing this for 28 years, I understand that investing is part rational science and part art.
The science of investing we talk about a lot: analyzing companies from the bottom-up and estimating their actual value; comparing that value to the current market price; asking questions like, What is this company’s competitive advantage? What is the potential for growth? These things can be quantified and put into a model.
The art? That is a different story. The art is about judging where investors are in the cycle of market psychology. It is emotion, not reason, that drives the market on a day-to-day basis. The longer one is in this profession, the better he gets at reading the emotions of the market, and by March 17 this year, the market was just about done with its downward emotional cycle.
One of the best descriptions I have ever heard about the emotions of the market came from a presentation at the 2012 CFA Institute Wealth Management Conference. A gentleman by the name of Greg Davies with Barclays gave a presentation entitled, “Utilizing Behavioral Finance in the Management of Client Portfolios.” Davies showed a chart that reflects the ups and downs of the market and the emotions investors feel at each stage.
The first step for most investors is reluctance. Making an investment takes a leap of faith; everything we can possibly know about any investment is in the past, and our results will be completely determined by what is in the future. The future is unknowable, and while we do everything in our power to put probabilities on our side, anything can happen tomorrow. This uncertainty makes investors reluctant, and when the market pundits start talking about uncertainty, that is a good sign that we are in the beginning of a bull market run.
As the market climbs, investors start to grow in optimism. Maybe their reluctance was misplaced. Events certainly seem better than expected, so confidence begins to grow. The market uptick starts to accelerate and people begin to believe that maybe the future isn’t so uncertain. Things look positive, at least from a market perspective.
This positivity grows until the optimism turns into excitement. The investors who were brave enough to overcome their reluctance are now bragging about their portfolio gains. The news is highlighting record highs for market indices. Everyone starts talking about their 401(k) and how they will be able to retire in two more years if this keeps up. The excitement is contagious. The wealth effect causes people to spend more out of their income, even though rationally their investment market values and their income are two separate items. The economy picks up because people are excited and spending money. Experts say things like, the market forecasts six months in advance and was telling us months ago about this wonderful economy. Those investors were not uncertain at all, they were “right” about this bull run.
Now the excitement becomes exuberance. Exuberance is actually closely related to reluctance; both are forms of fear. Our investor started out reluctant because she feared the unknown, now she fears missing out. All of her friends are making money hand over fist, and she now really needs to get in on this game. This is when the average lay investor finally gets into the market. This is when clients call us and say, “You know what, I think I should be taking more risk than I have been.” This is when experts start saying, “This time it is different. We know the future is bright.” This is the top.
Of course, once we are at the top, there is only one place to go. The market starts heading back down. The first reaction to the downward market is denial. We all know that investing wisely is a long-term activity. We are in it for the long haul, and this is just a market hiccup. There is nothing to worry about; in fact, this is a buying opportunity.
Yet, the market keeps dropping. The denial turns to fear. Could I lose everything? Will I still be able to retire? I know I am supposed to ride it out, but this is really scary. The future is once again uncertain, but I know this is what investing is like, so I’ll ride it out. Ride it right into desperation. I used to have a 401(k) but now it is a 201(k). I’ll never be able to retire. I’m just a really bad investor.
The desperation can go on for some time, or it can be really short-lived, but ultimately what follows is panic. This is when the client who called a few months ago wanting to increase his risk exposure all of a sudden wants to pull the plug. My portfolio is down X amount and we can never make that up. Now the anti-wealth effect hits and people stop spending, even though rationally their investment market value and their income are two separate items. The economy slows and the perma-bears who predicted this market downturn along with the last three and 20 others that didn’t happen (they usually fail to mention those) start talking about how the future is certain and it is bleak.
The lay investor can no longer take it; the capitulation has begun. There is a great washout, every last long-term holder of investments gives up, and the market crashes to new depths. This is the bottom. This is precisely the time the best investors start to buy, and buy aggressively. The market starts to rise, but we have been through an emotional roller coaster and we have landed in the territory of despondency. I have lost all that money. I can’t believe it, this is just horrible. It is all a big scam.
The despondency gives way to depression. The market is quietly ascending while people are still not spending money; the economy is horrible, the market is “disconnected from reality,” life is depressing, and the market is going to go down again. Except it doesn’t. It doesn’t drop in 2010 after the rally in 2009 and it doesn’t go back to the March 23 low today. It keeps climbing.
Apathy sets in: I was never going to retire anyway, it doesn’t matter. Apathy gives way to indifference: Oh, the market is up today, who cares? Just a bunch of Wall Street guys gaming the system, don’t they know how bad it is out here? But, as the market continues to rise, indifference finally gives way to reluctance, and we are back where we started. The lay investor does it all over again.
So, back to the original question: How did I know that the market was bottoming on March 17? First, I didn’t. I thought it was, but I have been doing this for 28 years. If you wanted to talk to me when I “knew” what the market was going to do, you would need to go back in time at least 26 years when I was still young and unaware of what I didn’t know. I thought we were bottoming because market activity looked like capitulation, and capitulation always marks the bottom.
I did not know it would be a v-shaped bottom; in fact that is not what I thought at the time. I thought we would bounce around the bottom a little longer, but I also knew that I could be wrong. We moved forward prudently, but with the idea that the bottom was either here or very near.
Today, I am fairly optimistic as far as the market goes. Why? Because I keep hearing pessimistic voices. I’m not sure exactly where we are on the emotional rollercoaster, but it is somewhere between despondency and reluctance. This gives me confidence.
Understanding the psychology of the market can be a great tool, especially when added to a scientific approach. Investing is part science and part art; it is not 100 percent either of those things, and do not let anyone convince you otherwise. Quantitative approaches that try to make it all science tend to do very well until they completely blow up, while those who think it is just an art and go with their gut tend to blow up even faster. Wise investors understand it is both.
This leads me to the final thought on the subject: Every investor is subject to this emotional rollercoaster. There is no immunity. Being a professional and having 28 years of experience does not make me immune; I feel these emotions just like everyone else. The difference is being aware of how one’s emotions are affecting him at the time. The two important ones are reluctance and denial.
We put various rules in place in our process to overcome reluctance and denial. If an investor can overcome reluctance, then she can take advantage of the sharpest assent in the market; this is very important for long term results. Likewise, if she can overcome denial, then she can be defensively positioned during the worse of the downturns; this allows her to be far more clear-headed while others are capitulating, creating great opportunities for those who can once again overcome their reluctance.
The cycle continues. This is not to say that everything remains the same, or that it isn’t different from time to time. The dot-com bubble cycle took place over at least six years, from 1997 through 2003. It was slow and drawn out. The bubble burst in March of 2000 and the bear market did not bottom until halfway through 2003. The financial crisis hit in early 2008 and bottomed in March of 2009. The COVID crisis went from denial to capitulation in a month. One cannot mark these cycles with a calendar, but in each case, the downturn starts with denial and ends with capitulation.
I understand the human desire for everything to make sense. We want logical explanations. Every day the pundits make up reasons for what the market did. The truth is that the market is made up of people, and people are emotional, not rational. Understanding what those emotions are and how to recognize them helps investors flow with the market cycle instead of trying to fight it. That is the art of investing.
Chuck Osborne, CFA
~The Psychology of Investing
I have struggled with what to say in this Quarterly Report. I have written almost every week since the crisis began, so there is not much new to report, yet it seems somehow inappropriate to discuss any topic other than the virus. Then, as I was leaving my office, one of the talking heads on CNBC said, “I’m scared to death of this virus, as I know we all are.” It happened so fast I failed to even register who said it, but it just hit me. Scared to death of the virus, as we all are.
It hit me because I am not afraid of the virus, and I do not believe I am alone. I am not saying that the virus shouldn’t be taken seriously, nor am I judging anyone who is afraid. I am just telling the truth. The virus does not frighten me. In the same way, sharks do not scare me. I grew up near the ocean, got certified to scuba dive while still in school. There is nothing in the ocean that “scares” me. There are many things, including the water itself which I treat with respect because I am aware of the potential danger, but I am not afraid of it. I am not going to stop swimming in the ocean.
During our first weekend of social distancing, my kids and I built some shelves for our garage. Our 12-year-old son made most of the cuts with a circular saw. This is a serious power tool. Was I afraid to let him use it? No. Did I go over the safety rules? Yes, including the need to be supervised. Our 9-year-old daughter did not use the saw, but she did drive in some screws with the drill. I was not afraid to have my kids around power tools. Am I aware of the potential danger? Of course, but that is not the same thing as fear.
Part of not being afraid comes from knowing how to stay safe in potentially dangerous situations. The most frequent question we have received from our clients during this crisis is, “How are you all doing?” That speaks volumes about the quality of our client base, so thank you. We are all well. I am still coming into the office, which is surreal because it is like a ghost town. Thomas Healy, one of our analysts and our primary trader, is also coming in as trading is much easier to accomplish in the office. Everyone else is working from home.
Would I be afraid of the virus if people were not taking the social distancing seriously? Perhaps, but for the most part, people are taking it seriously. Just like we know how to maximize our safety when enjoying nature or using power tools, we know how to maximize our safety from viruses. Wash your hands and keep them away from your face. We’ve all heard that. I’ll add some. Eat healthily and keep up with your vitamins C and D. Drink a lot of water, I mean a lot. Keep up your exercise, and hugely important for all health but majorly ignored: get enough sleep. Will that stop you from catching a virus? No, but the stronger and healthier you are, the more likely you’ll be able to fight it off if you do get it. How do I know this? More than 50 years of experience catching viruses. We all know this.
I know, I know, this virus is new, and it is serious. Yes, I’m still not frightened. What if I do get it? According to the data, there is a 50 percent chance I won’t even know it. I have no proof, but based on life experience, following a healthy lifestyle probably increases my odds of being in the 50 percent. There is an 84 percent chance my symptoms will be mild. I like those odds. “Experts” claim that between 1 to 3 percent will die. First, they are wrong. How do I know? They are always wrong. They said the same thing about the 2009 H1N1, and after it was all over the real mortality rate was 0.2 percent. Not that different from the common flu, which kills 0.1 percent of the people who get it. I am not a doctor, but I do crunch numbers for a living and I would wager we end up in the exact same territory with this virus.
What if, against all odds, the worst does happen? Sorry, I’m not afraid. That may seem like a false boast, but it is not. There are two reasons for this. First, I know we are never supposed to bring up religion or politics, but I am a man of faith. That gives me great comfort. Secondly, I have been there. Some of our longer-term clients know this, but for those who have not been reading these pages for a decade, I should already be dead. On May 15, 2010, my wife drove me to the emergency room. I had a pulmonary embolism, which is a fancy way of saying I had multiple blood clots in both lungs. The pulmonologist told me that 90 percent of the blood flow between my heart and lungs was blocked.
I spent ten days in the hospital, five days in the ICU. During that time, I kept getting the same stupid question. The doctors kept asking, “You walked in here?” Yes, I did.
I had been suffering from shortness of breath for a month and had been to the doctor’s office three times about it. My wife finally took me to the emergency room because I was getting a strange feeling down both arms. The cardiologist said that I did not have a heart attack, but my heart was, “a little ticked off.”
Every time they asked that stupid question I also got the look; the look that said, “You should be dead.” Throughout that ordeal, for whatever reason, I was never afraid. There was one moment when I saw the urgency in which the ER personnel responded to the description of my symptoms that the seriousness of the situation hit me. My wife was parking. She was pregnant with our daughter and our son was two and a half years old. I wanted the staff to wait for her, but they refused and assured me they would send her back. That was the darkest moment and I had one thought. I prayed, “God, my kids need their father.”
I was not scared of dying, I was scared of not being there for my kids. (Sorry, Honey. I know it would have been more romantic if it had been my wife who came to mind, but I must tell the truth.) The point is that it was not death that I was afraid of, it was being out of relationship with those I love. Life is not about the avoidance of death, it is about being in relationship with one another.
This virus does not frighten me, but there are some things that do. It scares me when people talk about this being the “new normal.” I believe they are just remembering that phrase from the financial crisis. Economists described the slower growth rates following the crisis as the new normal. It was a debatable phrase then, but now it is downright horrifying. We may need to socially distance for a while to flatten the curve, but cowering in isolation is not a permanent strategy. This cannot be normal. We cannot allow this to become normal.
Relationship is too important. That is what we do here at Iron Capital. Yes, we provide investment counsel, but that is just our chosen field. We really deal with relationships. The last in-person client meeting I had before the lockdown was in Chicago. We greeted each other with a hug. I don’t hug every client and I assume the two ladies in question don’t hug every vendor. We hugged because, after 15 years of working together, having lunches together hearing about each other’s children, etc., we sincerely care for one another. That client is in the hotel business, and they are in my prayers every night.
We invest in companies; we do not trade in stocks. Every client has heard me say that. Companies – or should I use the dirty word, corporations – are built on relationships. In fact, it is when large powerful companies forget the importance of relationship that they begin to fail. It is an easy thing to do. Show me a company that is good with relationship and I’ll show you a good business, led by a good businessperson.
My wife has diligently packed more food into our house than it has ever held before, and after she did, I told her we were ordering from a local restaurant. Why? Because we care about the people who run the places we love. Economic activity is not some dirty word, it is proof of life. It is relationship.
Which brings me to the silver lining in this dark cloud. A few evenings ago, the four of us walked our two dogs together. Father, mother, son, and daughter out with the family dogs. Norman Rockwell would have loved it, and as many of you probably suspect, we were not alone. Our neighbors were doing the same. We all made a joke of staying the appropriate distance apart as we passed on the street. One of our older neighbors said, “I love this, it is like the ’50s… all the families together.” Relationship.
This too shall pass, and hopefully, it does not become the new normal. We may, however, learn that the late night in the office should be the rare exception, and perhaps our kids can survive with fewer activities. No one likes a crisis and we cannot wait for this one to be over, but they do remind us of what is truly important. It has been a decade since God spared my life, and seldom does a day go by when I don’t think of the dying words of Captain Miller, Tom Hank’s character in Saving Private Ryan, “James, earn this. Earn it.” Captain Miller had lost most of his men working to find and save James Ryan. What scares me? Not earning it scares me. Not caring for the relationships whose importance is highlighted in times of crisis.
For Iron Capital, that relationship is with you our clients. That is what guides us through this crisis and will continue to guide us. Relationship is what it is all about. I hope and pray we continue to earn it.
Chuck Osborne, CFA
Politics is such a strange thing. With the impeachment circus, one would think nothing could get done in Washington; I guess they understood that and did not want to earn the “did nothing but fight each other” label. Suddenly, free trade deals are getting approved and the SECURE Act has become law.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act is the biggest change in retirement plan law in a long while. Has our federal government made you more secure? I’m reminded of a saying that Ronald Reagan used often: The most feared words in the English language are, “I’m from the government and I’m here to help.”
The biggest change in the SECURE Act for most retirement plans will be the safe harbor for retirement plan sponsors who wish to provide annuities as options in the retirement plan. If you have a retirement plan at work then your employer is the sponsor of that plan. The plan sponsor, your employer, has a fiduciary responsibility to you as an employee and a participant in the company’s retirement plan. That means all the investment options must be prudently selected keeping all the characteristics in mind, including but not limited to fees, appropriateness, and the risk-and-reward potential.
As a result, annuities mostly have been eliminated from retirement plans. This new act protects plan sponsors from their fiduciary liability for putting annuities in the plan. As one can imagine, the insurance industry thinks this is awesome.
So, why is that not so great for you? I very rarely, if ever, use the word never, but an investor should never, ever, ever buy an annuity. Before I just let that statement settle in, I want to make a point: One of the problems in our modern discourse is that we have provided platforms that allow every- one to express their opinion. Certainly, everyone is entitled to an opinion; however, all opinions are not created equal. If one has spent a lifetime studying a certain field, then her opinion should count more than someone who read a tweet.
I started my career working in the insurance industry. I am a Chartered Life Underwriter and a Fellow of the Life Management Institute (“life” here meaning life insurance, not life coach). I was at one point in my career the content editor for the Life Office Management Association’s annuity textbook. When is comes to annuities, my opinion should carry some weight.
In fairness, my opinion has changed over the years. I used to believe, as many academics and consultants still do, that annuities had their place. The reason is, that annuities, in theory, could be very helpful. After all, an annuity provides the consumer with a lifetime stream of income which is guaranteed by the insurance company. In theory, that is very attractive.
The problem is that we do not live our lives in theory. We live in the real world, and in the real world, annuities are outrageously priced, overly complicated traps. Several years ago I met with a client who was an attorney. He had purchased an annuity several years before our meeting and wanted us to review it for him. We went through the contract and outlined the various fees, restrictions, etc. He kept saying, “That isn’t right. That is not what I was told.” We kept showing him the contract. He was growing more and more frustrated and finally blurted out, “I would never have agreed to that.” To which I responded, “You’re a lawyer, didn’t you read the contract?”
There are not enough billable hours in the world for a lawyer, or any consumer for that matter, to actually get through the average annuity contract. In the real world, annuities are just too complicated. All that complexity does two things: First, it makes it difficult to understand what you are actually paying. According to Morningstar, the average cost for an annuity is between 2.18% and 3.63%. The second reason for all that complexity is to minimize how much the word “guaranteed” could cost the insurance company.
Years ago, I reviewed an annuity contract for an institutional plan sponsor client who was considering adding it as an option to their plan. The brochure said that the participant would be guaranteed to retire with the highest balance the portfolio had seen, even if the market had dropped since that point. The contract said that was the number the insurance company would use to calculate monthly annuity payments if the participant chose to that option, which fewer than 2 percent actually do. If they took their money in any other way, they would receive the actual market value. In other words, the “guarantee’ the participant paid outrageously for meant next to nothing.
The fallacy of annuities is that somehow retirement income needs to be “guaranteed.” Safe? Yes. Reliable? Absolutely. But, guaranteed? Well, your income during your working years was never guaranteed. Was that a problem? Firing employees is harder in some states than others, but it can always happen. Even the best companies are not immune to business downturns. During one’s working years the best she can ask for is a good job at a good company. I’m excluding entrepreneurs here because these are obviously risk-takers. However, the type of person who wishes for safe and reliable is the target of the insurance company. Safe and reliable retirement income can be generated at a far higher rate and lower cost than any annuity. Never buy an annuity.
The new SECURE Act does not require anyone to buy an annuity and I doubt many will. Plan sponsors may be more willing than before to offer annuities, but even then, it is only an offer. The participant has the final say.
In return for this giant handout to insurance industry lobbyists, we got a few positives and one big negative. The positives are that the age at which one must start withdrawing funds from one’s retirement account has been moved to 72 from 70.5. Remember, the government allows us to save money into the retirement plan without paying income tax on it. They allow that money to grow without us having to pay taxes on the growth. They eventually want their taxes. We are living longer, and that logically means that we will be working longer and retiring at later years. This change is frankly overdue and likely too little of a move, but it is progress nonetheless.
The act also makes it easier for companies to auto-enroll employees into the retirement plan. While employees can also opt out, many employers have moved towards enrolling employees automatically into the retirement plan. This helps with the very human trait of inertia. Many employees lose out on retirement savings due to a simple lack of action. The downside to auto-enrollment is that most companies do it at very low savings rates. We would suggest that most employees should contribute approximately 10 percent of their income to the retirement plan, and that is low compared to most in the industry (the reason for that is a newsletter in and of itself). Regardless, most employers auto-enroll at 3 percent of income and may increase it to 6 percent.
The tradeoff in all of this comes to people who have inherited a retirement plan from anyone other than a spouse, most typically a parent or grandparent. Historically, when one inherited a retirement plan, the required distributions would begin right away, but they were calculated based on life expectancies. For a young person inheriting such a plan, the mandatory distributions could be kept small and the bulk of the investments could continue to grow tax-deferred.
Well, the government wants their money. Going forward if anyone inherits a retirement plan from someone other than one’s spouse, then he will have 10 years to take all the distributions. The government will get their taxes much faster, and likely at a higher rate as beneficiaries will be taking out larger sums which will likely push them into higher tax brackets. This is a provision that makes sense in theory but will likely not go over well in practice. Time will tell if relief will be given.
As with everything that Congress does there is an endless list of other details, but these are the major points. The two biggest benefactors are the life insurance industry and the Treasury, but there is something in there for us. The obvious solution to the so-called retirement crisis (which we discussed in our 2014 Q3 Quarterly Report, “The Retirement Myth”) is to work longer. Giving us another 1.5 years to let our retirement grow is not much, but it is something. I don’t know if it makes us more secure, but it is a start. +
~Do You Feel More Secure?
I’m a competitive person. There, I said it. I love competition, and I get it honestly. Growing up in my family, almost everything was a competition. My parents both enjoyed watching sports on television and back then there was no cable package that allowed you to watch the game you wanted, which meant often we would watch games we did not really care about. The conversation would go something like this:
“Who is playing?”
“Green Bay and Chicago”
“Who are you pulling for?”
“I guess I’ll pull for Green Bay.” “Okay, then I’m pulling for Chicago.”
We just thought that was normal. If one family member pulled for one team, then you pulled for the other. Otherwise, there was no competition, and what is the point of that?
Today many people seem to look at competition as a bad thing and I guess I can understand why. Many people think they are being competitive when they are not. Several years ago, I read “Changing the Game” by John O’Sullivan. O’Sullivan was a competitive soccer player and a soccer coach on every level from youth to professionals. He tells the story of watching his kids play soccer when they were very young and it was all fun, and right next to their game was a 10-year-old game. In that game there was no fun being had; parents were yelling, coaches were yelling, and the kids were serious as heart attacks. One comment he made hit home with me: he said that having coached for 20 years he knew something about competition, and what he saw on that field was not it.
The word competition comes from the Latin word “competere,” which is best translated as, “to strive together.” When true competitors compete, they make each other better. When great athletes are asked what they miss most in retirement, they usually say the competition; they do not say the winning. Of course it is more fun to win, but the true joy is in the competition itself. True competitors never take short cuts, and this is where the age-old adage comes from, “winners never cheat.”
Today too many people think being competitive is about winning at all costs. Earlier this year, the United States women’s soccer team won the World Cup. During the tournament much was said about the fact they drew a very tough path. Notably, they had to go through France, which many saw as their main rival. Pundits were saying it would be better to have an easy route into the finals. The reaction of the players and coaches was exactly what one should expect from competitors: They wanted to play France. They did not want a short cut, and they couldn’t even understand why spectators thought an easy way would be better.
Many people just do not get it. Competitors do not compete against one another; they compete with one another. They strive together, and in the end, both are made better.
This is why capitalism works, and why so many don’t seem to understand that. Competition makes us all better. I am old enough to remember what American-made cars were like in the 1970s. Then the Japanese cars started becoming popular, partly because of fuel efficiency, but largely due to the reliability; the German cars started eating away at the luxury end of the market for the same reasons. Then, Ford made “quality job one,” and the American cars got better.
Back then many people feared that Japan would surpass us and that we would cease to be the world’s leading economy, which proved to be a false narrative. Today those fears are pointed toward China, and to a lesser extent, the European Union. It is my opinion that this is once again a false narrative. Let’s look at why.
If China is our competition, we need to know what game we are playing. If we are playing football, soccer, basketball or baseball, the high score wins. Then again, if we are playing golf, the low score wins. We are playing international trade.
In my book, when you play trade, the competitor who ends up with the most stuff is the one who is winning; yet many people tend to believe it is the opposite. For years the United States has gotten far more from China then we have given them. Some think that is a problem; to me it sounds like winning, but even then, it is probably overstated. For most of those years, services have either not been counted or under-counted. We are now a service-oriented economy, so we would be winning by far less if we counted correctly.
The more sticky issue with China is its use of intellectual property and so-called forced technology transfers; this is where the current negotiations keep breaking down. As a true believer in capitalism, I have to say that I have mixed feelings here. I certainly do not think someone should steal another’s intellectual property, but is it really stealing? In some cases it may be, but most of the time these were agreements made by American companies who wished to do business in China. Here is one of the great benefits of a capitalist system that often gets ignored: Every single transaction in capitalism is voluntary. No one ever forced Apple to make and sell iPhones in China; Apple voluntarily chose to do so.
If American companies made bad deals that they now regret, why should we bail them out? This is one thing that critics of capitalisms have right: In real capitalism, there is no return without risk. Sometimes those risks come true and when they do, a company and its executives should pay the price. There is no such thing as a business that should not be allowed to fail, and if one drives his business into the ground, then he should have to live with those consequences. True champions are not those who never fail; they are those who fail and get back up. This should be as true in business as it is in anything else.
At Iron Capital, we often tell prospective clients that we have never refused to work with someone because of the size of their portfolio, but we have refused to work with people for other reasons. You see, transactions in a capitalist society are voluntary. We would never dream of spending resources lobbying the government to force those people to be more to our liking. When we really think about the situation, it seems absurd. If we can come up with a national agreement that prohibits technology transfers to China, then that would certainly make individual companies’ jobs easier. However, if these negotiations fail to make such a breakthrough, then we should remember that these companies chose to do business in China. They were not forced.
The trade war with China may or may not pay off in the end; only time will tell. The current situation, however, is clearly slowing our economy. The result is that the Federal Reserve Bank (Fed) has reversed course from last year and begun to lower interest rates. Some suggest that they have not gone far enough. Once again, I am a very competitive person, but even I know that not everything is a competition. Interest rates in the United States are at or very near historically low levels, but compared to places like Germany, our interest rates are high. As of this writing the yield, or interest rate, on the 10-year U.S. Treasury is 1.61 percent, and the yield on the German 10-year is -0.50 percent. This means that if an investor were to loan money to the U.S. government for ten years, then she would get her money back plus interest of 1.61 percent per year. If that same investor loaned her money to Germany, she would get back her money minus 0.50 percent per year.
It has been suggested that the Fed is losing by not trying to match countries like Germany in the race to lower and lower rates. In my opinion, this should not be a competition. Each central bank should be doing what they believe is correct for their country. However, let’s say it is a competition. Once again, with any competition, we have to know how the scoring works. Who wins the high score or the low score?
Let’s give this some thought. What causes interest rates to rise or fall? We know the Fed sets a target for overnight rates, but the rest of the interest rates are set by the market. Investors chose to invest or not to invest in an auction. The prevailing rate is the one that satisfies the most investors. If investors are willing to accept a 1.6 percent return on their investment, it means they believe that return is fair in comparison to what other options they have. In other words, this is a poll on what investors believe the future economy will look like. The higher the interest rate they demand, the more growth they believe will occur in other investments. The lower the rate they settle for, the more they believe other investments will not grow very much. To be willing to accept negative rates is to believe that more money would be lost if one invested in anything else.
With this realization, it sure sounds to me that the country with higher interest rates is the one who is winning. Just to check that theory, look at the current Gross Domestic Production (GDP) growth. In the second quarter of this year the U.S. economy grew at 2 percent. The German economy, on the other hand, shrank 0.1 percent. Germany is on the brink of recession if not already in one. Again, it isn’t a competition, but if it were, we would be winning.
Competitive games are zero-sum. This means that there is a winner and a loser. My daughter loves to play Candy Land and Chutes and Ladders. Anyone who has ever played these games knows that they are actually the same game with different graphics. However, if we are playing one and I win a few times in a row, then we must switch to the other game. In Candy Land and Chutes and Ladders, there is one winner and everyone else loses; there is a plus one and a minus one for a zero-sum.
Life is not like that; life is not a zero-sum game. Life is more like a marathon. Sure, there is some professional athlete who wins the race, but what every serious marathon runner is interested in is their personal best. They compete mainly with themselves, striving together with the other runners to achieve their goals. This is a far better representation of the competition of life.
This is what we try to explain to our clients: When we talk about prudent investing being absolute return-oriented and not relative return-oriented, we are talking about focusing on reaching your goals. We do not want to focus on beating some artificial benchmark or, for that matter, your neighbor. Real competitors know that competition is not win-at-all-costs. Sure, we want to win, and it is that desire that drives us to strive. In the end, however, the striving together is what it is really about. Hopefully our representatives negotiating a better relationship with China and Europe understand that. “Iron sharpens iron, so one person sharpens another.” Competition can make all of us better if we understand what it is really about.
CFA, Managing Director