Reinvest Dividends or Take the Cash?

There is a good, easy to understand article in the NYT about the advantages and disadvantages of reinvesting dividends you receive from stocks, ETFs, and mutual funds.  Here are some highlights, as well as some of my own additional comments:

Why You Should

• Automatic dollar cost averaging: by this I mean you are buying into the market over time and rather than all at once.  This helps limit volatility and theoretically attempts to purchase shares at the best average cost.
• No more tax calculation headaches: new tax rules require brokerage firms to track your tax basis.  Thus, they will automatically adjust (increase) your tax basis for dividends.
• Easily comparable rates of return: when you look at your return, you don’t have to add back dividends.  In fact, the Morningstar return assumes dividends are reinvested.
• Commission free purchases: if you pay commissions for purchases, this is a way to avoid them. 

Why You Shouldn't

• You need the income: you are foregoing the income generation that dividends brings.
• Taking earnings off the table: by taking the proceeds in cash, you can potentially reduce the volatility that the market can bring.
• Portfolio rebalancing: taking dividends in cash allows you to re-balance your portfolio with that cash.
• Possible concentration risk: by reinvesting the dividends you are increasing your exposure to that position.
• Phantom income: reinvesting the dividends generates tax, but not the cash to pay the tax.

As with everything else, the correct answer depends on the investor’s goals, objectives and possibly risk tolerance. 

A retiree who needs cash is probably better served by using the dividend income to support his or her lifestyle.  A younger investor who has a long time horizon may better be suited by reinvesting the dividends as he or she likely doesn’t need the cash and volatility is less of a concern given the time horizon.

Afraid Emerging Market Stocks are Too Risky for You? Here is a Solution...

Some investors shy away from emerging market stocks.  While I think it is prudent to invest in emerging markets in investor appropriate degrees, I can see why there is some aversion:

• Unfamiliarity
• More volatility
• Uncertain political & economic climate
• Currency risk
• Increased correlation (i.e. not a great diversifier anymore)

Despite the apprehension, there are positive facts about emerging markets that can’t be ignored:

• High debt levels in and other legacy economic issues in developed nations (see previous posts here, here, and here)
• Better demographics
• Increasing commodity prices, which puts pressure on  a developed nation’s consumption
• Decreased political risk relative to developed markets, an interesting switch from a decade or two ago (i.e. heightened political and social risk in developed nations).

Also, when I look at the Morningstar numbers the SPDR S&P 500 has a higher trailing P/E than the iShares MSCI Emerging Markets Index.  This means that despite having more reasons for higher growth in the future than the US equity market, emerging market equities are cheaper.  I must admit, however, I believe there are greater risks that such high growth is not met.

Still despite all the positive tailwinds associated with emerging markets, many investors still won’t pull the trigger.  There is an easy solution to this – buy domestic equities that have exposure to emerging markets.  This alleviates or lessens many of the concerns I highlighted earlier while still capturing the positives that emerging markets exposure brings. 

Greece – Who is at Fault & Now What?

I used this example with a client earlier this week:

Suppose I have 5 children.  From a responsibility point of view, two of them are great, two are about average, and one is awful.  While the irresponsible kid can’t generally be counted on to make rational responsible decisions, I continue to subsidize his lifestyle.  After years of handing over funds that are no doubt going to unproductive resources, the irresponsible kid finally hits the financial wall and flames out. 

In the example above Germany is the parent and Greece is the irresponsible kid.   So who is to blame?  Certainly it could be argued both sides are culpable.  While the irresponsible kid did not spend money wisely, the parent still could be considered just as irresponsible.

Admittedly who is at fault is of minor importance; however, as I hinted at before the above example illustrates just how Germany’s stance is misguided. 

While the rest of the Eurozone and the world should help, it just seems clear Germany needs to take the lead.  Saying “it’s not our problem or our fault” not only hinders any sort of solution, but is categorically untrue.

With default nearly certain, some sort of action is needed to assure “breakdowns that seemed inconceivable at one moment can seem inevitable at the next.”

Household & Financial Sector: How We Fix It – Part 3

In my previous posts, I have outlined the problem, what went wrong, and how we got to that point. 

So how do we fix it? Below a list a host of things that need to happen, the problem is all of these don’t happen overnight and take time.  How much?  I am not quite sure.

• Consumers and financial institutions need to get back to sustainable debt levels.  Inflation and write-downs can help with this. 
• The consumption economy needs to shift into more production and exporting. 
• Borrow less, spend less, and save more.  Capital saved now can be invested in the future.
• Regulators need to make sure the system that lead to the collapse is no longer in place, and find a way to assure this system or another can’t be recreated.  

It’s not a welcome answer, but it’s the only way we can cure our debt problem.  It’s going to be no easy task, but once the aforementioned items are accomplished we should have a launching pad for more sustainable, steady growth (and subsequently more stable markets).  Balance sheets will be cured and responsible, modest loan supply and demand will return.  The private sector will then be able to be self-sustaining.

That is why I am a proponent of fiscal support.  As the private sector continues to deleverage, that growth will need to be made up somewhere or the economy as a whole will contract.  This is where the federal government can step in. 

Of course, whether or not they will spend wisely and make investments that will lead to future growth is entirely debatable.  

Household & Financial Sector: What Went Wrong and How We Got There – Part 2

I outlined in the last post the problem on the consumer debt level.  So what happened? 

1. Eventually the market realized income levels couldn't support the liabilities.  As a result the loan market dried up.  Fewer loans meant less money flowing into various asset classes, which led to a corresponding devaluation of those assets that were artificially inflated by the excessive leverage, creating a cycle in which it continued to feed upon itself.  It follows that industries, which were dining at the bubble table, began to contract.
2. Aside from purchasing assets, funds from those loans were also being used for consumption.  No new loans meant far less consumption.  Further, the depressed asset values depressed the psyche of the consumer, from one of exuberant consumption to one of saving at best and desperation at worst.

As illustrated above, the aftermath of a “deleveraging” cycle is fewer loans supplied and demanded.  This in turn negatively impacts growth going forward and leads to uneven economic outcomes as households and financial institutions lick their wounds, and repair their balance sheets.

So why did this happen?  There are a multiple of reasons, but my favorites are listed below:

1. Ultra low interest rates from 2001 to 2005 led to a misallocation of capital into various asset classes, artificially inflating their value. 
2. De-regulation of the financial services industry assisted in allowing for higher leverage, opaque markets, and increased risk taking.  Regulators, legislatures, and the Fed made this possible, then fell also asleep at the wheel.
3. Decreased lending standards.
4. Low interest rates had a negative effect on money managers, who given the low rates had to stretch for yield.  This was facilitated by ratings agencies rubber stamping  AAA  ratings on questionable tranches of debt , and the widely held assumption that markets are efficient.
5. Moral hazard and the “Too Big to Fail” mentality.  This can be traced back to Chrysler and LTCM.
6. Psychology of the American Dream – everyone stretching for the next best thing. 

I have outlined the problem, what went wrong, and how we got to that point.  The last post will be how we fix it.

Household & Financial Sector Debt: The Problem We Face – Part 1

I think it’s really important to spell out why I think debt is at the center of the economic issues, which we are facing.

High unemployment, the tepid recovery, and market volatility can be attributed, in large part, to the deterioration of household balance sheets.  Graphs do a great job illustrating this.

Here is household liabilities divided by GDP:

And household liabilities divided by income:

Lastly, household net worth:

These graphs only represent 1990 to the present; however, a look back a few decades indicates that all rose steadily until 1980, where the charts all spiked, then spiked again in 1990; however, none of those spikes came even close to the boom beginning in the early 2000’s.

Here are some takeaways, which have lead to the problems we are facing:

1. Household leverage spiked without a corresponding jump in GDP.  Thus, the spike in leverage was unsustainable as there was not a corresponding jump in production.
2. Further, as leverage rose without a corresponding rise in GDP one could reasonably assume that resources were being misallocated, thus pushing values higher to unsustainable levels (e.g. housing).
3. At the same time, incomes were not rising in line with increase in liabilities.  As such, households were taking on more debt without the cash inflows to substantiate such a rise. 
4. How were they getting loans?  Looking at the rise in net worth, it is reasonable to assume households were ramping up their borrowing due to an increase in their personal assets (e.g. housing).

A parallel situation was present in financial institutions; however, for simplicity I only covered the consumer.  In my next post, I will provide more detail on what went wrong, and how we got there.   

Subjectively, Pain of Losses > Thrill of Gains

Why?  Monumental losses are extremely difficult to make up.  If you have a big loss, in the most basic absolute sense you are much worse off than you were prior to the loss (obviously); however, it is possible that relatively (e.g. vs. the market) your return wasn’t terrible (e.g. S&P 500 is down 50% and your equity portfolio is down 45%).

On the flip side, missing gains may leave you frustrated, as relatively you may have underperformed; however, in absolute terms you are probably no worse off than you were before. 

Here is a simple example:  In a fantastic year let’s say equities are up 50%.  In such a year a well-hedged investor may be up 10% to 25%.  Now obviously getting the whole 50% would have been the desired outcome, but the value of the portfolio is still higher than before without compromising the long-run goals and objectives. 

On the other hand, if equities have a miserable year and decline 40%, a non-hedged investor will be down the full 40%.  In contrast, a well-hedged investor may only be down 5% to 15%.  The non-hedged investor now has a significant uphill battle just to get back to even – a gain of roughly 67%.  A loss of this size can seriously hamper the investor’s ability to reach his or her long-run goals and objectives.

As I mentioned in the title, such a concept is totally subjective on my part.  I just look at losing big on the downside and don’t see how it’s worth it.  As such, for our clients we will build in a variety of hedges to try and mitigate extreme downside risk.  The strategies can be as simple as selling at various targets on the S&P 500 Index or more complicated like using derivatives.

The Housing Double Dip

The Case-Shiller Home Price Indicies track home prices.  There is a 10-City Index and a 20-City Index.  The chart below is updated to show the June results (via Calculated Risk):

As the graph shows, you can see a massive rise starting in the late 90’s, a crash starting in 2006, a rebound in 2009, and another move down in 2010.  This is what you call a “double dip”.

Rather than go over the reason why there is a double dip going on, I want to outline why this isn’t good:

• Hampers future home development
• Further strain on consumer balance sheets
• Increases the odds for default
• Psychological – “here we go again”
• All the above puts pressure on bank balance sheet
• Lower values + increased balance sheet pressure = less loans

The graph and the above reasons point to the fact that housing won’t be snapping back anytime soon.  Housing usually leads the recovery, but now it will continue to be a drag.

The silver lining is that this is not breaking news.  I don’t know of anyone really who thought housing would snap back and the markets have probably priced that in. 

Thus while housing is still a headwind on the economy, it was expected to be and I would hope consumers, banks, and corporations planned accordingly.  

The Lost Decade, Not So Much

When people talk about the lost decade from 2000 to 2010 there is a lot of truth to that, assuming you invested your money entirely in the S&P 500.  After all, the return of that index including dividends was 1.4%.

It’s a good thing for our clients that we don’t investment money entirely in the S&P 500 or any index entirely.  The NYT nicely articulates the benefits of diversification over that decade pointing out the returns of the following equity asset classes:

• Small Caps – 6.3%
• Real Estate – 10.4%
• International (Developed) – 3.9%
• International (Emerging) – 16.2%

The article then points out that with equal allocations to each and no rebalancing the portfolio would have returned 8.35%.

Further, in most all cases it is prudent to have a fixed income allocation for stability or even appreciation in a down stock market.  When a 40% allocation to the Barclays US Government Intermediate-Term Index is added to the evenly allocated equity portfolio the return would have been 7.83% with less volatility.

Although no investment strategy can guarantee a profit or protect from a loss in a declining market and all investments are subject to the risk of loss, being broadly diversified over various asset classes that exhibit low correlation to each other was and probably will continue to be a good way to invest.

Further, I would add that making small short-term tactical allocations and rotating to undervalued asset classes over the long-term can enhance an investor’s already well-diversified portfolio.  

Hard to be Like Warren

I loved this article in Slate because I have been trying to relay a similar message to clients for the last few years – just because a big name investor, the Slate article is about Warren Buffet, takes a position doesn’t mean you should too.

Here are some things you probably can’t do that big name investors with a large amount of capital can:

• Access – They can call up a CEO and get him on the phone almost immediately.
• Terms – They can dictate their terms – preferred dividends, warrants, premiums, etc.
• Clout – They are big names.  The investing public trusts them.  Thus, when they take a position the masses follow.
• The How – Many big name investors might be long or short a position, but not necessarily own or be selling the asset.  They can have products developed or go into opaque markets to make synthetic trades.
• Talk Their Book – They can make a trade, go on Squawk Box, and articulate why they took a position enticing others to do the same.
• Timing – Are they about to get out and just pumping up the position for one last jump?
• Team – They pay very smart people a lot of money to continually do due diligence. 
• Plan – They have a plan.  They know when they are going to get in and when they are going to go out with contingency plans and maybe some hedges.

Maybe outside of having a plan, almost no common investors can do any of the above.  This is in contrast to the heavy hitters who can possibly have all of those items.

Does this mean you shouldn’t invest alongside a big name?  Of course not.  Just make sure you do your own diligence and understand that most of the time they are getting a better deal and/or have built in advantages.