INFLATION ROSE JUST 0.1% over the 12 months through June, as measured by CPI-U, the most popular inflation measure. But that tiny increase is a bad guide to the future, because it’s held down by the 15% plunge in energy prices over the past year.
So what should we expect? A better guide is CPI-U with food and energy excluded, which rose 1.8% over the past 12 months. Better still, take your cues from the Treasury market.
If you take the yield on the 10-year Treasury note and subtract the yield on 10-year inflation-indexed Treasurys, you have investors’ collective guess for inflation over the next 10 years. The reason: Like investors in conventional Treasury bonds, holders of inflation-indexed Treasurys receive regular interest. But on top of that, the principal value of their bonds is stepped up along with the inflation rate.
Assuming a rational market, both conventional and inflation-indexed Treasurys should be priced to deliver the same return. Thus, with conventional 10-year Treasurys yielding 2.3% and inflation-indexed Treasurys at 0.6%, you have your forecast for inflation over the next decade: 1.7% a year.
While we’re on the topic of inflation, here’s an early warning on one of this fall’s stupidest headlines. In late October, the Social Security Administration will announce how much Social Security retirement benefits will increase for 2016, based on inflation over the 12 months through September. In all likelihood, the increase will be extremely small, and there may be no increase at all, which is entirely justified given the past year's low inflation rate. The media’s predictable reaction? “Social Security Says No Raise for Retirees in 2016,” or some similar headline that suggests seniors are getting ripped off by the federal government.
IF YOU’RE IN NEW YORK on Sept. 26, consider attending the 13th annual Financial Fitness Workshop at New York University. In addition to signing and selling books, I’ll be giving the opening keynote address.
My talk will be devoted to “How to Think About Money,” which is also the title of the new book I’m working on and which is slated for publication in mid-2016. I can’t promise you will agree with everything I say—but I suspect you’ll be amused.
WANT TO FORECAST the stock market’s 10-year return? You might start by estimating the economy’s growth rate, consider what that would mean for corporate earnings, and then ponder what value investors will put on those earnings. Problem is, with this approach, you begin by making reasonable estimates—and end up engaging in wild speculation.
The first step doesn’t seem so tough: estimating the U.S. economy’s growth rate. If you look back over the past half century, the real (after-inflation) GDP growth rate has been 3% a year. The worst year was a 2.8% contraction in 2009 and the best was a 7.3% spurt in 1984. Still, 36 of the 50 years were above 0% but below 5%. That’s moderately reassuring: It tells you that, most of the time, GDP growth hasn’t been that far from the 3% long-run average. Moreover, 11 of the 14 outliers occurred in the first 20 years—and just three in the 30 years since.
The not-so-good news: GDP growth has been slowing over the past 50 years. Since 2000, it’s averaged just 1.8% a year. Partly, that reflects the Great Recession. But it also reflects slower growth in the labor force—a trend that will continue as the U.S. population ages. Taking that into account, we might assume the economy expands 2% a year faster than inflation over the next 10 years. If inflation is also 2%, that would put nominal GDP growth at 4%.
Will corporate earnings also grow at 4%? That question triggers three others. First, will earnings per share grow slower than overall corporate earnings, as companies sell shares to finance growth and issue stock options to employees? Historically, earnings per share have lagged behind overall corporate earnings by two percentage points a year. But over the past 10 years, shareholders haven’t suffered any dilution, as companies use spare cash to buy back stock.
Second, will profit margins contract from today’s historically high levels? We can only guess at the answer. Third, will earnings of U.S. multinationals get a boost either because they snag a larger share of foreign markets or because foreign economies grow faster than the U.S.? Both are possibilities, but—once again—we can only guess at the answer.
The upshot: We might assume that corporate earnings do indeed grow at 4%, but accept that it could easily be somewhat faster or slower over the next decade. Tack on today’s 2% dividend yield, and you would be looking at an estimated 6% annual total return, or four percentage points a year faster than inflation.
But this assumes that stock prices climb along with earnings per share. Will they? Share prices today are richly valued relative to corporate earnings, which is worrisome. But they’ve been richly valued for much of the past quarter century, so maybe investors shouldn’t be concerned.
Vanguard Group founder Jack Bogle likes to distinguish between the market’s investment return—corporate earnings growth plus dividends—and its speculative return, which is changes in the value put on earnings, as reflected in the market’s price-earnings ratio. The dilemma: To come up with a prediction for 10-year returns, we need to speculate on how speculative other investors will be.
But don’t despair: As we lengthen our time horizon, changes in P/E ratios become less important and instead the market’s return is increasingly driven by the combination of earnings growth and dividend yield. In other words, if you have a truly long time horizon, you have a reasonable shot at notching something close to 6% a year, and that 6% should be comfortably ahead of what you could have earned with bonds.
IF YOU STILL BELIEVE PAST PERFORMANCE is a good guide to future results, check out the latest S&P Persistence Scorecard from S&P Dow Jones Indices. The study tracks top-performing mutual funds from one 12-month stretch to the next, to see whether they were able to hold their position among the better-performing funds.
No large-cap, mid-cap or small-cap stock fund managed to remain among the top 25% of performers over the five consecutive 12-month periods ending March 2015. In other words, if you take the top 25% of funds over the 12 months through March 2011, none held that position in all of the four 12-month stretches that followed—those though March 2012, March 2013, March 2014 and March 2015.
If, instead, you look at funds that managed to remain consistently in the top 50%, the numbers are better—but not much. Only 4.82% of large-cap funds, 3.45% of mid-cap funds and 7.77% of small-cap funds were always among the top 50% of performers over the five consecutive 12-month stretches that ended March 2015.
Such consistency is a sign that a manager may be skillful rather than lucky—and yet, based on S&P’s study, it appears such skill is in short supply. The study also highlights a crucial problem for investors hoping to beat the market with mutual funds. Yes, there are funds that beat the market. But can you identify them ahead of time? The usual starting point is past performance. But it seems that strong returns—at least over 12 months—are no guarantee of future results.
THE FEDERAL TAX SYSTEM punishes the middle class, who have earned income and fund retirement accounts. Meanwhile, it favors the wealthy, who are more likely to have substantial sums in taxable accounts and then bequeath those assets.
Okay, now I need to explain myself.
First, there’s the question of earned versus unearned income. Tax rates on wages are higher than those on long-term capital gains and qualified dividends, plus workers also have to pay Social Security payroll taxes. The latter is especially rough on the self-employed, who have to pay the full 15.3% payroll tax, because they don’t have an employer to pay the other half.
Defenders of the current system will say that we need lower tax rates on investments to encourage folks to save and invest for the long haul, and that those who pay Social Security taxes are eventually rewarded with retirement benefits. But along the way, aren’t we discouraging people from working, a bad idea in an economy where the ratio of workers to retirees is shrinking? On $100,000 in income, a single self-employed individual might lose more than 30% of his or her income to federal income and payroll taxes, or quadruple the 8% paid by someone who lives off qualified dividends and long-term capital gains.
Second, there’s the issue of what gets taxed after your death. Today, if you die with less than $5.43 million ($10.86 million if a couple) in a taxable account, you’ll owe no federal taxes. But if you died with a comparable sum in a traditional retirement account, your heirs would owe a massive amount of income taxes. There’s even talk of forcing heirs to empty retirement accounts within five years of the original owner’s death, which would make the tax bill especially massive.
Again, defenders of the current system would argue that the traditional retirement-account dollars have never been taxed, so the federal government should still get its money. But arguably, that’s also true of the embedded capital gains in a taxable account, and yet those capital-gains tax bills disappear upon death, thanks to the step-up in cost basis that occurs.
As you can tell, I’m well aware of the rationale behind the current system. And while perhaps the current system shouldn’t be scrapped, it seems like we need to tweak the incentives somewhat—so that people have a greater incentive not only to work and to launch their own businesses, but also to save in retirement accounts both for their own benefit and with their heirs in mind.
FINANCIAL FREEDOM is the ability to spend our days doing what we love—and, with any luck, it will come with age. As we amass more wealth, we should become less motivated by fear of layoffs and hopes of a bigger paycheck. Instead, our motivation should come from within, because we’re increasingly free to focus on the things we’re passionate about.
In the psychology literature, there’s much discussion of so-called extrinsic vs. intrinsic motivation. Being self-motivated is celebrated as crucial to mental well-being and fulfilling our full potential. This seems reasonable: Wouldn’t you rather spend your days doing what you want, rather than what others want you to do?
To be sure, some folks love their job. That gives them the best of both worlds, because they can devote their time to something they’re passionate about, while also getting paid for it. But for those who aren’t so crazy about their work, amassing wealth should allow them to focus less on the extrinsic motivation of the workplace—and eventually, with retirement, to leave behind the world of pay raises and layoffs. Instead, they can focus their energies on the things they love doing.
But here’s the surprise: While it seems like older workers ought to become more intrinsically motivated—and certainly it seems desirable—it doesn’t appear to happen. Studies suggest many older workers are just as extrinsically motivated as younger workers. Why are older workers still worrying about keeping their jobs and earning more money? I suspect bad financial habits have a lot to do with it. Many folks put off saving for retirement, so they desperately need to stay in the workforce to amass a decent-size nest egg. That creates financial stress that could have been avoided if they’d started saving at a much younger age.
MEIR STATMAN, a finance professor at California’s Santa Clara University, argues that financial decisions—like everyday consumer purchases—have three benefits: utilitarian (what it does for me), expressive (what it says about me) and emotional (how it makes me feel).
As we manage our finances, we insist our goal is strictly utilitarian, and that all we want to do is make money. But in truth, we often make decisions for expressive or emotional reasons—and these other motivations can hurt our stated goal of greater wealth, as Prof. Statman explained in a recent Wall Street Journal article (subscription required).
For instance, we’re proud to own a hedge fund or hire a private money manager, despite the high fees that make it unlikely we’ll earn market-beating returns. We get a thrill out of trading and we enjoy spending money, though high trading typically leads to lower returns and spending means we save less for retirement. We’re proud to sell our investment winners, even though it can mean paying capital gains taxes. Meanwhile, we regret our losers—and we don’t want to make the regret worse by selling and abandoning all chance of recouping the loss.
This, alas, is one area where knowledge is unlikely to set you free. You may know intellectually that you ought to spend less, dump your losing stocks and get rid of your high-cost actively managed funds. But you don’t change your financial ways, because emotions often trump rationality. My advice: Try talking to your spouse or a friend about your finances. It’s easy to convince yourself that you’re being logical when it’s just thoughts rattling around in your head. It’s much harder when you have to articulate those thoughts to others.
MEB FABER’S “GLOBAL ASSET ALLOCATION,” available free this week through Amazon.com if you buy the e-book, offers a look at the historical performance of a fistful of portfolios, such as those recommended by Rob Arnott, Harry Browne and Ray Dalio. It’s a quick read, with just 129 pages, much of it consumed by charts.
The book’s biggest surprise? How unsurprising the results are. “As long as you have some of the main ingredients—stocks, bonds, and real assets—the exact amount really doesn’t matter all that much,” Faber writes.
Over the 40 years analyzed, the difference between the after-inflation results of the best- and worst-performing portfolio was just 1.84 percent points a year (though, compounded over four decades, that modest annual gap would mean a huge cumulative difference).
Which brings us to what Faber says “is the main point we are trying to drive home in this book.” Suppose you guessed right and bought the best-performing portfolio at the start of the 40 years, but then implemented the strategy using a financial advisor who invested your money in the average mutual fund. Result? The fees you paid would have wiped out the advantage you gained—and your results would have been worse than the return, before costs, of the poorest-performing portfolio.
As Faber writes, “Ultimately, smart investing requires that we not only monitor asset allocation, but of equal weight, we focus on the advisory fees associated with the investment strategy.”
MY LATEST COLUMN for The Wall Street Journal—and also my last—is about how costly it is to be self-employed. You have to buy your own health and disability insurance, fund retirement with no help from an employer, and pay Social Security payroll taxes as both an employer and employee.
All this has been driven home for me over the past 15 months, since I left fulltime employment at Citigroup. But there is an upside to being self-employed: You have a wonderful sense of autonomy.
How do I use this autonomy? Yes, I’ve developed a fondness for afternoon naps. But I also find I’m working harder than ever. To economists, this would be no surprise: If you’re self-employed, you have a much greater financial incentive to put in long hours. But it’s more than that: Work is far more enjoyable when you know success is almost entirely within your control, with no risk that surly colleagues will drop the ball or an ornery boss will kill the project. Result: Greater happiness. A 2009 Pew Research Center study found that 39% of self-employed workers said they were “completely satisfied” with their jobs, versus 28% for salaried workers.
MY FINAL ARTICLE for The Wall Street Journal appears this week—and, ironically, it’s about self-employment. The Journal recently announced major cuts, including shrinking both the staff and space devoted to personal finance. I decided it was the right time to be moving on—and, while I never heard one way or the other, I’m not sure there would have been a place for my column in the new, smaller personal-finance section.
What’s next? Even without the Journal column, I probably have too much on my plate. I’m in the middle of updating the Jonathan Clements Money Guide for 2016. This fall, I’ll be teaching personal finance at Mercy College in Dobbs Ferry, NY. I’m working on a new book, “How to Think About Money,” which I hope to publish mid-2016. I plan to put out a free email newsletter every few months, starting in September. If you want to receive a copy, shoot me an email. I also have various other projects in the works, as well as a few speaking engagements—something I’d like to do more of in the year ahead.
MONEY BUYS LIMITED HAPPINESS because of so-called hedonic adaptation. We’re sure that the new car or the next pay raise will make us endlessly happy. But instead, we quickly get used to these material improvements, and soon we’re hankering after something else.
Is there a way to counter adaptation? One strategy recommended by experts: Pause occasionally, and admire your car or think about your larger paycheck. This act of focusing can help you to recall how happy you were when you got the car and the pay raise, and it can remind you how fortunate you still are.
You can also get yourself to focus by moving things around. At dinner, get everybody to sit in a different place. That’ll allow you to see your house from a different angle—and also your spouse and children.
Similarly, try rearranging the furniture and the pictures on the walls. Suddenly, you’ll find yourself looking with fresh eyes at paintings you had stopped noticing, and admiring the antique end table you had almost forgotten about.
“MONEY IS AN OPPORTUNITY for happiness, but it is an opportunity that people routinely squander because the things they think will make them happy often don't,” write Elizabeth Dunn, Daniel Gilbert and Timothy Wilson in an article for the Journal of Consumer Psychology that appeared April 2011—and which, needless to say, I only just got around to reading. It’s arguably the best academic article on money and happiness for the general public, because it’s chock full of practical lessons, plus it has the added virtue of being written with a wry sense of humor.
So how can we buy happiness? The authors mention a number of counter-intuitive notions. We get greater happiness if we spend our money on others rather than on ourselves. We’ll likely get more pleasure from frequent small purchases than occasional big expenditures. We also get more pleasure if we delay purchases rather than buying items right away, because the delay brings with it an enjoyable stretch of anticipation.
The authors suggest that, when assessing the impact of a purchase or event on our lives, we focus less on the big picture—wouldn’t it be great to own a vacation home?—and more on the mundane details, like dealing with maintenance and repairs, because those are a big part of day-to-day happiness.
In addition, the authors note that comparison shopping can lead us to focus on features that aren’t that important. For instance, when house-hunting, we might be drawn to bigger, more expensive homes. But there’s a good chance our home’s size won't prove all that important to our long-run happiness—and yet we could find ourselves spending far more than we should.
IF YOUR INVESTMENTS CLIMB in value, hold the champagne—until you figure out whether it’s a onetime gain or a repeatable performance.
Suppose your foreign stocks post gains because the dollar weakens. Or your bonds climb because interest rates fall. Or stocks rise because price-earnings ratios head higher. Or corporate earnings increase because profit margins expand. Or stocks jump because the capital-gains tax rate is cut.
You won’t necessarily give back these gains—and, indeed, the dollar could weaken further, interest rates could drop even more, P/Es might rise yet higher, profit margins could widen further and tax rates might be cut again.
But each of these is a road you can only travel once. For instance, since the early 1980s, the yield on the 10-year Treasury note has fallen from roughly 16% to 2% and the S&P 500 has climbed from seven times earnings to 21 times earnings. Treasury yields can’t fall from 16% to 2% again and the S&P 500’s P/E can’t climb from seven to 21 again—unless we first saw a dramatic market reversal. In other words, these are truly onetime gains.
Moreover, in some of these cases, there are limits to how far these developments can run. Theoretically, the dollar could continuously weaken and P/Es could continuously rise, though neither seems likely and that certainly hasn’t happened historically. But interest rates are unlikely to spend prolonged periods below 0%, profits margins can’t expand so that all of GDP goes to corporate profits and taxes rates can’t be any lower than 0%.
So what would count as a repeatable investment performance? It’s reasonable to expect that bonds will continue to pay interest at their stated yield until they mature. It’s reasonable to expect that, over time, corporate earnings will rise and dividends will be paid. And that’s pretty much it.
THIS PAST SATURDAY, we visited my daughter in Philadelphia, where she just bought her first home. The trip included moving furniture, heading to Lowe’s, spackling walls and fixing a toilet seat. We also stopped by Ikea, where Hannah bought two sofas, one for $399 and the other for $379.
Think about that: less than $400 for a sofa. In a major city, for that same $400, you might get a 90-minute visit by a plumber. Or dinner for eight people at a moderately priced restaurant. Or an hour with a lawyer. Put that way, the Ikea sofas were a bargain. They might not have been top quality. But my wife and I agreed that we’d happily have them in our living room.
All this highlights the yawning gap between the cost of mass produced goods and the cost of items that involve personalized service. For $99, you can buy a 7-inch Kindle Fire HD tablet with 8GB of memory that’ll allow you to cruise the web, play games, watch videos, listen to music and more. That $99 would have covered just 0.3% of the commission I paid last year when a real-estate agent sold my Manhattan apartment.
There’s an unfortunate aspect to this: As I’ve noted in other pieces, research suggests we get more happiness from dollars spent on experiences rather than possessions. We quickly adapt to material improvements in our lives. But experiences—a vacation, dinner out with friends, a concert—offer not only enjoyable moments, but also weeks of eager anticipation beforehand and fond memories after.
Problem is, because of the personalized service that’s often involved, experiences can be costly. I love eating out. It’s a great way to enjoy time with friends and family without the distraction of cooking and cleaning dishes. But it’s also expensive.
What to do? Two pieces of advice: First, if you’re going to buy possessions, with the limited happiness that they deliver, favor cheap ones and be leery of expensive choices, with new luxury cars topping the list. Second, plan for experiences far ahead of time, so you have months of pleasurable anticipation, and try to make the experiences memorable, so you’re likely to recall them for a long time after.
I LOVE CORRESPONDING WITH READERS, because I find out what’s on ordinary investors’ minds and hence what might make for a good column. And, occasionally, I learn something unexpected.
This week’s lesson: The potential return on EE savings bonds is much higher than I thought. If you look on TreasuryDirect.gov, you’ll learn that the current interest rate is a meager 0.3%. After 20 years, that would give you a cumulative total return of just 6.2%. Factor in 2% inflation, and the spending power of your money would shrink by almost 29%.
But check out the fine print. On EE bonds, the Treasury guarantees that—if you don’t double your money after 20 years through the regular interest payments—it’ll make a onetime adjustment at the 20-year anniversary, so your cumulative return leaps to 100%. That’s equal to 3.5% a year.
A guaranteed 3.5% a year sounds pretty good. But remember, your annual return will be just 0.3% if you cash in before 20 years, and even lower if you sell in the first five years and pay the penalty equal to three months’ interest. Still, EE bonds aren’t quite the atrocious investment I imagined and, for super-conservative investors, could even be a reasonable choice.