Lies, Damn Lies, and Statistics

“There are three kinds of men. The ones that learn by readin’. The few who learn by observation. The rest of them have to pee on the electric fence for themselves.” Will Rogers

The Truth about Diversification

 My favorite scientific journal, People Magazine ran a story about a couple in Philadelphia in the 1970s that saw the first Rocky movie. Sly Stallone beat all odds in the boxing match of a lifetime gaining fame, Adrienne, and investments in condominiums (which he claimed to never use). People said the couple sold all of their possessions and put it all on the lottery. Everything. They showed them waiting for the results, sitting on the floor in their apartment with no furniture, no TV, and weary smiles on their faces. They did not look comfortable. They never ran a report on what happened. Since that would’ve garnered a lot of attention and magazine sales, I think I know what happened.

Most of us don’t wake up wondering how to risk losing our stuff. We like stuff and we like predictability. We drink the same coffee, use the same toothpaste, and read the same newspaper.  We build things up over time in life’s journey. Life toppled is unexpected and undesirable. We would rather make money and everything about it absolutely guaranteed. Why then is it that financial advisors keep telling us they have the answer to lower risk. If there was an absolute answer, the entire investment industry would not exist. Instead, we are told we can lower risk through diversification and just holding the same investments no matter what. It’s easy to buy into. We hear logic like “I have enough time until I retire. It will all work out ok. If the market is down, I have plenty of time to recoup the loss. I will have enough money in the nick of time just before I retire.”

This is called TIME diversification. It is considered the first level of diversification.

Time diversification explained, demystified, and debunked.

Time Diversification Explained and Demystified

Let’s say that you have $50k to use for a home purchase down payment in six months. You would likely invest this in a very safe, low yielding account because you really need the money to be there. Conversely, imagine that you have 20 years until your child is off to college. Chances are you would invest in more risky assets for it because you have more time.

·         For the six month need, you would tend to use a risk-free asset. It makes sense. If you were to put the down payment in the stock market you run the risk of loss causing you to forgo the new home.

·         For the twenty-year college need, you might tend to use the stock market (risky) because over a 20 year period you expect stocks to have a higher return and you also expect poor performance to be offset by great performance and generate returns close to the long-term averages.

This is time diversification. Higher returns offset lower returns over a long time and converge to the average long-term return. Part of this is the mathematical truism that over time risk (measured by standard deviation… Please don’t start yawning) decreases by the square root of time. Yep, that’s mathematically true. Here is the other truism.

Time Diversification Debunked

While your average risk is declining and converging to a long-term average, your wealth diverges from an expected average.

1. You are less likely to lose money over a long time horizon than over short one, 
2. But the magnitude of your potential losses increases with time through compounding,
3. Number two exceeds number one.

An example shows this: Suppose you have the opportunity to invest in a risky venture with $10k. You decide it’s too risky for you and you decline. Next, you are offered 10 of these ventures for an investment of $100k total. This lowers your risk compared with the previous $10k investment opportunity by spreading your nest egg across 10 different investments. Because this diversifies you, you should be less resistant to invest. The magnitude of your potential loss is now $100k. Your risk has declined but the magnitude of your potential loss has increased.

So, in this case the statistics make honest the lies and damn lies. Ultimately, in order to make retirement really happen in the way that you want it with low risk, you need to choose the risk with which you are comfortable from the get-go and stick with it until you retire, because the magnitude of your potential losses increases over time. Once you retire, you need to reevaluate your risk because your retirement nest egg will need a reboot to produce income.

You might just find that a guaranteed account for 3% beats the pants off of your long-term stock market investment. We’ll talk about that in the next installment of  "The Truth about Diversification".

Please feel free to call us at Private Wealth Counsel of Minnesota, LLC, at 952-230-1340 if you have any questions or would like to talk.

Regards,

Chris

Diversification cannot guarantee the protection against a loss nor guarantee a profit. All investing involves risk.

Securities offered through LPL Financial. Member FINRA/SIPC.

No Time for Substance

         National unemployment is down to 5.8%!                                        Yahoo!!

Substance seems to be expensive nowadays. Its rarity makes it a particularly valuable commodity.

I remember banging my head studying for the CFA exams. For study breaks I began researching the Civil War. The library, where I spent many nights studying, had a microfiche (remember those?) of the New York Times starting from the 1850s. The stories were incomprehensible by today's standards. They used large words, complete sentences, and btw like way proper English, like. Detail had value then. That led to further study elsewhere.

I was intrigued reading about the Lincoln Douglas debates lasting hours at a time for people who really wanted to know for what they stood. Now, sound bites and statistical darts fly by completely out of context. It’s hard to know what they really mean. The Wall Street Journal did an enlightening story today, citing the Bureau of Labor Statistics regarding price increases during the years 2007-2013.

Here are some of them that apply to “middle America” where wages range from $18k-$95k per year before taxes. Once again, this is only 6 years later:

• Income increased less than 1/2%
• Rent increase to 26%
• Food eaten at home rose 12.5%
• Women's apparel spending at age 16 and above fell almost 18%
• Sales of major appliances, entertainment, alcohol, restaurants, and furniture all fell
• Overall spending rose about 2.3%
• Inflation totaled about 12% BUT from a previous blog entry you might recall that the government inflation calculation was changed in 1980. If not changed, average Social Security check would be about twice what it is now. So, this inflation statistic is questionable.

Inspiration

This inspired me to open the Bureau of Labor Statistics website and do some of my own research. I looked at the change in several basic food prices from January 2007-October 2014. Once again, this is only 6 years later:

• White bread per pound: +49%,
•  Ground chuck per pound: +66%,
• Fresh whole chicken per pound: +46%,
•  Eggs, grade a large per dozen: +24%
• Milk per gallon: +31%,
•   Orange juice, canned 16 ounce: +33%
• Coffee per pound all types: +74%,
• Average US city electricity per kilowatt hour: +49%,
• Average US city natural gas per therm: +0.39%
•  Employment Cost Index -37%.
•  Yes you read that right. From 2007 through December 2, 2014 shows that total compensation for all workers in the United States has fallen 37%. Because this seems almost incomprehensible, I've included a copy of the graph and the data:

Employment Cost Index

Series Id:     CIU1010000000000A (B,C) Not seasonally adjusted Series Title:  Total compensation for All Civilian workers in All industries and occupations, 12-month percent change Ownership:     Civilian workers Component:     Total compensation Occupation:    All workers Industry:      All workers Subcategory:   All workers Area:          United States (National) Periodicity:   12-month percent change

These are real statistics that you can take in context. Middle America is largely not participating in the “improvement” in our economy. Perhaps this is why Fannie Mae and Freddie Mac are once again willing to purchase loans at up to a 97% loan-to-value ratio from mortgage lenders. History repeats itself, just faster. 

Regards,

Chris 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future.

This research material has been prepared by LPL Financial. 

The economic forecasts set forth may not develop as predicted.

Securities offered through LPL Financial. Member FINRA/SIPC.