Saturday, July 30, 2011

You and the Debt Crisis

By and large, I have told readers that it's important to avoid paying too much attention to the headlines and instead employ a long-term approach when looking at investments and the financial markets. Our collective will in executing that has been shaken lately by dire news reports ticking down the hours and minutes to when the United States may potentially miss its first debt payment and in effect, will be considered in default on its financial obligations to its creditors. 

While this news is indeed scary, it's not something that should shake your confidence too much for two reasons. First, if the market was taking such a prospect as seriously as the media makes it out to be, then the major market indices would have shed much more of their value in the weeks leading up to the August 2nd deadline. I look at it this way: based on the efficient market theory, everything that can be known about an investment or the market in general is already priced into it because of the speed and efficiency of information flow. Even the bond market, while under plenty of pressure given the uncertainty, has not seen the types of wholesale declines that would indicate a default was imminent. 

Secondly, we must not kid ourselves. Lawmakers in Washington know how much is on the line and how disastrous a default would be, and while there has been much political grandstanding and theatre throughout the process, at the end of the day, a deal will be cut, especially if it means preserving re-election chances for many of the incumbents. Unfortunately, this is how Washington works and the media likes to capitalize on the uncertainty. Don't fall victim to the circumstances which don't seem that dire after all. 

Saturday, July 16, 2011

Weekend Reading: Gen Y's Conundrum

A July 11th blog post at the WSJ's "Real Time Economics" blog caught my eye as it noted that most of the income growth in the United States from 1975-2009 was achieved not through wage increases, but through overtime (i.e. working longer). This conclusion was reached by the Brookings Institution's Hamilton Project which noted the following:

"Although median wages for two-parent families have increased 23 percent since 1975, the evidence suggests that this is not the result of higher wages. Rather, these families are just working more. In 2009, for instance, the typical two-parent family worked 26 percent longer than the typical family in 1975."

This news is especially sobering for Generation Y for two reasons. First, since the data was taken from 1975-2009, it does not include the last year and a half of dismal unemployment data which further suggests that a recovery might take awhile to form. Since an extra year and a half of work data was not included, the results are likely even slightly worse than the 1975-2009 data indicates. Secondly, Michael Greenstone, the MIT economist who runs the Hamilton Project notes that, "The long-run decline in wage opportunities has put lots of pressure on families. People are adjusting, but they’re adjusting in ways that we might not like very much. All of that points away from a vision of the American dream where each generation is doing better than the last." 

Unfortunately, that last line should serve as a wakeup call to Generation Y. While it's common to see each successive generation better off financially than the last - this new data suggests that such progress may skip our generation entirely. 

As scary as that sounds, it simply means that as a generation, we need to alter our expectations, especially from an investing perspective.  On this front, my number one recommendation to Gen Y investors is to use a 7% long-term average rate of a return in all investment calculations so as to avoid any type of unreasonable optimism and to build a cushion into all assumptions. The worst feeling in the world is building an investment plan that assumes a rate of return that is much higher than what actually happens. A 7% return is reasonable since the 10-11% long-term average rates of return that we used to see seem to be a thing of the past; now, more than ever, it's better to be safe than sorry!

Friday, July 8, 2011

Building Wealth Can Be a Slow Process

One of the toughest things for many Gen Y investors to accept is that building wealth is exactly what its name implies: a process, sometimes slow, that starts with something small and ultimately grows to something much bigger. Much of the time, we're put out of a touch with reality when we hear stories of instant wealth being "made" either by investors, company founders or the like.

This all highlights an important principle: it's easier to make money when you already have it. However, do not fret! Just because you're not starting off with a billion dollars does not mean that it's impossible to become wealth; just the opposite, in fact. Just because building wealth can be a slow process does not mean it's the wrong process. Being cautious but at the same time well-calculated, meaning you have an asset allocation that fits your tolerance for risk but also allows you enough flexibility to enjoy the here and now, will ultimately make you a better person and investor.

Many readers know that I like to use examples to illustrate why even though building wealth may seem "slow" it ultimately pays off. Consider an investor who begins with $5,000 at at age 22 and is able to earn a 7% return without adding any additional capital. Of course, 99.9% of investors reading this blog will actively add to their nest egg over time, but this example proves that even if our investor doesn't, the magic of compounding still works. After 40 years, our investor would have $74,872. Now, some people might ask what the point of investing and saving is if we can't enjoy today. My response is simple: give yourself enough flexibility to enjoy today - set aside a comfortable amount of discretionary income per month so you can go away on a trip, buy a new TV or do whatever else you'd like to do - and by investing the rest today, you'll ultimately ensure a much earlier retirement than age 62.