What I’ve Learned About the Stock Market

Anyone who has a retirement fund or personal investments has an interest in the stock market.  I have an additional interest because I am the fiduciary in charge of trust funds and describe at this site.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”).  I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next.  I am starting out with what I’ve learned from this debacle.  As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1.  Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate.  Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay 14% for financing).  Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example.  Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high.  I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies.  For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way.  The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example.  The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail.  In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market.  Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together.  One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time.  Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

4. Liquidity can evaporate, and if you depend on liquid markets, you are in trouble – Not only did the risk premium (see #1 above) go up quickly, liquidity in the market evaporated, meaning that if you counted on liquid markets, you were in big trouble.  Illiquid markets mean that you can’t “roll over” debt and if you do have to sell, you will receive a distressed price for those assets (a big loss, in real terms).  One of the first items to fail were the “auctions” in the municipal area which were a sign of bad tidings to come

5. Real estate is no bulwark – For individuals, there was often an assumption that real estate is a “safe” investment, but real estate values have proven to be anything but.  Real estate losses for individuals were semi-spared because the government has set a very low rate for mortgages and nationalized Fannie and Freddie – without that floor mortgages would be illiquid and subject to #1 and #4 below.  Now, however, the mortgage market is basically subject to government fiat – see #2 above.  If the government decides that condominiums are too risky and pulls back on guaranteeing mortgages on half built condominiums, those investments will fail.  For real estate companies that specialize in building new homes, those stocks are basically dead, since demand won’t catch up with supply for years.  The government is definitely working to prop up the home market, with tax incentives for the new buyer (and likely no more talk about not making home interest deductible)

6. Complexity is dangerous – Another early warning sign was the fact that Citicorp and others had to bring in “off balance sheet” entities onto their balance sheet when liquidity failed (see #4 above).  Those companies were incredibly complex, and their financial statements were incomprehensible even to me, a financial professional.  These counter-parties, off balance sheet entities, and WAY too much leverage made a toxic stew.  In general, companies that have a very complex “story” will likely have a harder road to travel when trying to show their value to the equity community, since people have been burned by what they don’t understand

7. Dividends provide little shelter – over time a significant portion of the total “return” from stocks is driven by dividends paid to stockholders.  Many companies paid dividends at a steadily growing rate for decades, and constantly re-emphasized the importance of dividends to their strategy (giving investors confidence that these dividends would continue in the future).  However, virtually everyone gave up on their dividends, from the financial companies that are sliding to the edge of oblivion to GE (who really is a financial company anyways) to many other industrial companies.  There are exceptions to the rule (companies that are not facing dire straits) but the fact is that strong companies can pay dividends and weak companies cannot, so betting on a dividend independent of the underlying financial structure is a fools errand.  The dividend is nice to have (and starting from a solid one is better), but counting on it in the future has proved to be devastating

8. For the most part, no one (who talks) knows anything – yes you can point to the occasional seer who cried doom and certainly many, many smart and rich (and tight lipped people) made tons of money shorting the entire market all the way down, but for the most part the conventional wisdom was completely and utterly wrong.  There are people or firms that understand the market well and can profit in down times, but you aren’t getting their thoughts from Jim Cramer on CNBC or in the WSJ or Barron’s or anywhere else, much less the popular magazines like Time, Money or your local paper columnist.  Look at how their stock ratings performed, and generally it was terrible.  A lot of this is institutional bias because those magazines and paper can’t just tell you to short everything and get out of the market because those same companies buy advertising and those sorts of negative messages frankly sound un-American when explained out loud.

9. Timing IS important, as is re-investment risk – I resisted timing in favor of “buy and hold” for years but then I moved into selling stocks when I thought that they had peaked on the upside, or they had huge down side risk (financials).  Buy and hold really hasn’t done anything for anyone in the last decade or so except rack up huge losses.  That doesn’t mean that I have a better strategy, but it is a fact that the central issue is timing.  Tied to timing is re-investment risk – which basically hits you in that even though you sell at a gain, you have to re-invest in something else that has increased in price (due to strong correlation) and you don’t mitigate your risk that much by selling one overvalued stock for a gain and trading it for a new one.

10. If it seems too good to be true, it probably is – I am not a seer but I think that all these people piling into municipal bonds for the tax benefits and historically low default rates are in for a rude awakening when bad things start happening to the states.  I know that there are many ways to bail out a state including the Federal government but it just seems like the municipal financing is going to fall apart and I don’t want to be holding the bag.  This applies to “free lunches” everywhere…

Now with all these “lessons”, what is a forward looking investor to do?  The stock prices are down, and this could be an historic time to “buy in” to the market, rather than sitting on the sidelines licking your wounds.  I am trying to figure that one out now, but thought it made sense to take stock of what, if anything, I learned so far.

Cross posted at LITGM and Chicago Boyz

My “Lost” Purchase

Virtually all of us have been touched to some extent by the decline in stock prices and asset devaluations (houses). I recently was talking to someone and they mentioned this thought experiment:

What if you had spent all the money that was lost in the recent market declines instead of watching it fall in value?

I was walking through River North last weekend when my personal answer sat on the curb right in front of me – a brand new Nissan GTR, valet parked by a high-end restaurant and club. Sure it has a sticker price above $70,000, but it is about the fastest thing on the road and has a great control layout and is a Nissan, to boot (so it likely won’t end up being a rolling pile of junk after a few years).


Of course, this is now fantasy-land, since reality binds me to the GTR’s all-too-practical sibling, a 1999 Nissan Altima, nearing a decade in service but still reliable and practical for the almost no driving I do in the city.

Not that I am encouraging this type of thinking (spend it now because it is falling in value), because it is critical for everyone to keep a long term perspective and to plan for the future. These market losses are discouraging but this is life and we need to keep marching ahead and learn from our failures. It is likely that high government spending and large deficits will mean that relying on social security, always a bad plan, will become even less viable, since all the other spending will crowd out this benefit.

But it is a fun thought experiment, especially when it is sitting on the curb, right in front of you…

Cross posted at LITGM

Negative Net Worth


The Chicago Tribune business section has a series where readers write in with their financial issues and the columnists seek professional help and recommendations and publish the results. This column is titled “Law Degree on Her Side” and shows the plight of a woman under 30 who is a lawyer but is struggling under a mound of student debt and is considering bankruptcy.


A big element in our economy’s struggle is the fact that the analysts and “experts” were focused on the income statement and not the balance sheet. An income statement view focuses on profits, or the difference between earnings (in her case, salaries) and expenses (rent, living expenses, etc…) and what remains each year. Companies often report earnings EBITA which stands for “Earnings Before Interest, Taxes and (depreciation) and Amortization”. In this model, you become a lawyer because you can make a lot of money (top line revenue) and use it to support the rest of your living expenses.

However, this “income statement” model ignores the debt needed to finance education and expenses related to education. This debt keeps piling up and is a negative item on your balance sheet, which is the long term debt that you owe others, along with the annual interest that you need to pay to service this debt. In an analogy to the stock market, it is the debt payments, along with the fact that companies can’t come up with the cash to pay off principal (or roll-over debt) that is causing the liquidation of companies like Circuit City, Linens & Things, Mervyns, and soon to be many others.

In this lawyer’s case, her balance sheet is “negative” meaning that she is insolvent or has a negative net worth. She has a tiny amount of assets (a bit of retirement savings, some cash on hand, and maybe equity in a car or something) which is all she can show to offset a mountain of debt.

I don’t have exact statistics but I would venture that most Americans have a negative net worth nowadays. By this I mean that the value of their debts exceeds the value of their assets. I also run a site called “trust funds for kids” and I often tell my nephews and nieces that even the relatively small amounts that we put aside ($10,000 or so), as long as they don’t accrue debt, will make them better off than most Americans who have worked their entire lives, since they will have a positive net worth. Obviously some of this is tongue-in-cheek since you need a steady stream of income to pay minimal living expenses but there is much fundamental truth in that analysis in that if you pile up debt you will never accrue enough assets to offset this debt. And if you have a negative net worth, you can never stop working (retire) unless you have a guaranteed string of income high enough to offset your living expenses, interest costs and principal repayments.

These debts cost money to finance, and this cost is in the interest rate. The woman in this article is drowning because $200k of debt will mean that interest payments of $14k ($200,000 * 7% or so) would be needed just to service the debt, without putting ANY sort of dent in the principal. Likely the principal is going to be due over a certain amount of years – let’s say 20 years – so she needs to pay $10,000 / year in principal plus $14,000 in interest (the interest will go down in future years as the principal is paid down) on the current balance. If her income is below certain thresholds (her income, at $75,000, is for now) then she can receive a tax deduction of $2500 based on the interest component (see IRS publication 970). Thus (using this relatively simplistic analysis) of her $75,000 / year salary, $24,000 (or almost 1/3) would go for debt principal and repayment (the tax deduction would likely offset this for about $1500 in cash, depending on her tax bracket).


One very unfortunate difference between companies and this student is that companies can eliminate debt through bankruptcy (if they are cash flow positive on an EBITA base and can obtain interim financing), but the student debt can NEVER be discharged. I remember when I was studying for my CPA exam (20+ years ago, so maybe it isn’t an exact quote) that they had a section on bankruptcy and they mentioned that the discharge of student loans through bankruptcy was eliminated because

Doctors, who require mounds of debt to pay for medical school as well as finance living expenses while they are interns and only modestly paid, used to accept the diploma with one hand and declare bankruptcy with the other. Tiring of this tactic, the schools lobbied and changed the laws so that student loan could not be discharged through bankruptcy

Thus taking up student debt is serious indeed; unlike your house (which you can walk away from or short-sell to the bank) or auto, you can NEVER discharge this debt, and have to either pay it off or have this debt hanging over your head for the rest of your life (essentially meaning that you can’t accumulate any assets).

If you read the article, not only did the woman take on student debt, she also took a vacation and put it on her credit cards, which have a much higher interest rate (maybe 20% or so) and need to be paid off before she can make a serious dent in the student loans, unless she wants to declare bankruptcy. And even if she does declare bankruptcy, given her level of income, it is likely that the court will make her repay at least some of these obligations.


When you incur tens of thousands of dollars in debt to get your degree (or $200,000, in this unfortunate case) you need to ensure that your degree will pay enough to not only support you going forward (and your family, if you intend to have one) but also to pay off the student loan debt and interest accrued on that debt.

In the case of this woman, she has a law degree. However, one item that wasn’t advice in this article is that she has to leverage this degree to make a lot more money. She needs to work for a firm with high billing rates and she needs to put in a lot of hours. Traditionally law firm employees had to bill 2,000 hours / year – note that this is BILLABLE work so everything that isn’t billable has to go into the rest of the week (or weekend) after you are done with a full days’ work, including what shred of a social life you’d like to have.

Given all the taxes and costs of living in Chicago (remember that the sales tax is over 10%, property taxes are high, and Federal and state tax rates are going up) if she increases her income to pay down debt effectively almost 50% of every dollar is going to be taken away from her between social security and taxes of all stripes. So she needs to increase her income by $50,000 to come up with the extra $25,000 which would allow her to pay down this debt sooner.

My uncle (now deceased) was a man who fought for the little guy. He was a lawyer with his own firm and he represented the poor and often did death penalty cases for the state (as a defender). He summed it up to me that

You can either represent poor innocent people or rich guilty people

I suggest that she find some major companies with problems and burn up a lot of billable hours helping them. Her $75,000 / year job will never pay enough.


The other more subtle point in this article and overall in finance is that the implied rate of return for investments has been decreasing. Anyone who hasn’t been fully invested in gold and treasuries has seen the value of their investments plummet, possibly by as much as 50%. Various articles come and go about how the DOW is now back to 1992 or prior – although this is kind of specious unless you were heavily invested all this time – sadly enough most people bought into the market much nearer its peak, so they took big losses on actual cash put into the market (and didn’t just lose gains from prior years).

If the markets are down 50%, it will likely take YEARS of sustained 15%+ growth, for instance, just to get back to where we were in 2007. Thus while those returns might be prominently featured in advertisements, essentially for the average investor those returns are needed just to get you back to zero, and then you need to make returns BEYOND this in order to increase your asset base.

Why does this matter? Because while the implied return on YOUR investments has declined (is frankly negative) and banks are paying about 1% in interest (BEFORE taxes), a loan at 7% is very pricey. In the old days when people put in 10% / year return in their model, they figured that a 7% loan was cheap money. Now with negative returns or puny returns in the risk-free market, 7% means that your loans are outpacing your gains and that your problems increase every day that you don’t pay off that loan. I won’t even go into the impact of a 20% credit card loan (plus the fact that consumer interest isn’t even deductible).


ANY students who are considering taking out debt to finance their education NEEDS to understand the gravity of the situation:

1) these loans can NEVER be discharged through bankruptcy
2) the interest rate you are paying is likely higher than the return that you will make on your own assets
3) you need to earn enough money to pay off the principal and interest, as soon as possible
4) as you earn more money and try to pay off these loans, high taxes and cost of living eat up the value of each dollar earned so that you essentially have to earn $2 to get $1 to pay towards your obligations
5) you need to live as cheaply as possible and get this done as quickly as possible – in this case the woman worked as an unpaid intern which just let her interest accrue and she took expensive overseas vacations which caused her to add credit card debt
6) based on all of the above items, it likely isn’t worth accruing debt for a degree unless your degree is extremely marketable (law, medicine, finance, engineering) – that doesn’t mean that you can’t follow your passion, but it does mean that you need to pay-as-you-go or find a way to do it through scholarships or at your local community college
7) if you incur debt, you need to make money ASAP and forgo other social options, expenses and fun – else you will never escape the debt trap. You spent all this money for the degree, so now you have to leverage it to the hilt and make as much money as possible

Cross posted at Chicago Boyz


One of the features of the stock market lately is that stocks tend to move in unison.  On a given day when the stock market goes up, it seems like almost every stock is buoyed in price.  On the other hand, if the market has a bad day, then everything seems to do down.

Above is a snapshot of the day’s results from Friday, February 6, 2009. You can see that every single stock in portfolio one and portfolio two increased in value during the day (portfolio three has a subset of the same stocks as portfolio two, so showing it was redundant for the point I was trying to make).

The covariance in the market is far more pronounced than it used to be in the past. This may be linked to the fact that the market is making more large percentage moves on a given day. Per Harper’s magazine February issue:

Number of times in 2008 that the S&P 500 closed up or down 5 percent in a single day: 17
Number of times between 1956 and 2007 it did this: 17

The fact that the stocks tend to move in unison makes selecting individual stocks more difficult. When you are selecting an individual stock, you are generally doing analysis on the performance prospects of that unique company. However, the fact that market moves are pushing all stocks in one direction or another (unfortunately, they have been mostly downward) no matter what the rationale for your stock may be, it is buried by the overall market moves.

Some items logically cause the entire market to move on a GIVEN day – for example, this day the market was up primarily due to the fact that the stimulus package appeared to be resolved. Other factors, like changes in interest rates, can make equities more or less valuable overall because they are often an alternative to debt instruments. As the interest rates rise, debt instruments become more attractive and stocks less attractive, all else being equal. Items like attacks on the US or foreign countries can also cause one-day (or longer) shocks to the market, or increase “systemic risk”.

In any case, covariance is definitely increasing, meaning that more and more of the return on an individual stock is due to what is happening across the entire market and less and less due to the story of a particular company. Nowadays company specific research should mainly focus on the downside risk – companies that have to refinance debt at unfavorable rates, for example, which could cause their value to go to “bagel-land” or zero.

One of My Favorite Investing Books in Context

I was reading a Wall Street Journal column by James Stewart recently. He has a column called “Common Sense” which outlines his approach to selecting stocks and investing.
His strategy involves buying when the stock market drops 10% and then selling when the stock market rises 25%. This type of investing (which looks at relative market levels) is a type of “technical analysis” as opposed to “fundamental analysis” which looks at the merit of individual stocks relative to financial metrics. To be fair, Mr. Stewart’s model is a mix of technical and fundamental analysis, but the “buy”and “sell” signals are pure technical analysis (in my opinion).
The headline of the article really caught my eye, however:

When bad times get worse, it’s best to stick to a system

That quote reminded me of a line from one of my favorite investing books titled “A Random Walk Down Wall Street” by Burton Malkiel. On p146 he discusses his opinions of technicians which rings eerily familiar:

I personally have never known a successful technician, but I have seen the wrecks of several unsuccessful ones. Curiously, however, the broke technician is never apologetic. If you commit the social blunder of asking him why he is broke, he will tell you quite ingenuously that he made the all-too-human error of not believing his own charts

In my mind, sticking to a system and not believing his own charts are one and the same.
As far as the book by Malkiel, I like to pick it off the shelf from time to time and read it again. The book is 30+ years old (it has been updated), but the main thesis is the same; a broad basket of stocks, best in an indexed fund, will typically beat active management when fees and taxes are considered. While this idea is pretty much accepted as common sense nowadays, when this theory first came out it was seriously attacked by the investment community, since it undercut their validity and high costs (relative to indexing, which can be done cheaply in a transparent manner).
I also like the book because the author acknowledges the thrill of individual stock-picking, and allows that some people are good at it, and that it can be “fun”. While he doesn’t recommend it for the whole portfolio, he notes the lure and that doing it with part of a portfolio or not “rent money” is also understandable. This to me sums up my plan in the funds I run for my nieces and nephews; I invest in individual stocks because the funds are relatively small and not needed immediately to pay for rent and food, and because investing in individual stocks allow for much greater interaction and teaching opportunities about the market relative to a simple index fund (or ETF).

I heartily recommend Malkiel’s book and am a bit worried about the normally staid and on-point Stewart… don’t ride that system to the end.

Cross posted at Life In the Great Midwest

Actively Managed Mutual Funds

In the “efficient markets” hypothesis, all available information is factored into the stock price, making attempts to “beat the market” by selecting your own stocks a fool’s errand. Index funds, which were originally stock mutual funds, such as those at Vanguard, not only attempt to mimic rather than beat the index, they also sport much lower expenses. Thus even if the performance was the same for an index as a stock picker, the index would win with costs as low as 0.2% / year as opposed to 1% – 2% / year for managed funds. One advantage that remained of a stock selection methodology over mutual funds was related to taxes – individual stocks were definitely more tax efficient if handled correctly; now index ETF’s have erased that lead.

Of course, theories don’t always work in the real world, as the recent financial meltdown attests, when AAA rated financial instruments took significant losses. In a similar vein, those in favor of active stock selection could always point to a few candidates to make their cases. One candidate was Bill Miller, head of the Legg Mason Value Trust, who beat the S&P 500 for 15 consecutive years.


While Bill Miller may have been the “poster boy” for those that point to active stock pickers, he was a reticent candidate. He even said that a lot of his “streak” was due to timing on the calendar and didn’t strut around like a world-beater. Thus I didn’t take much pleasure in the this article…

Bill Miller, whose Legg Mason Value Trust achieved the unlikely feat of beating the S&P 500-stock index for 15 consecutive years, has become the fund world’s punching bag. So far this year, the fund is down a devastating 56 percent on account of bad bets on stocks including AIG, Washington Mutual, and Freddie Mac. This horrific year (combined with lackluster results in 2006 and 2007) has banished Legg Mason’s crown jewel to the ranks of the worst-performing mutual funds not only for the year, but for all standard periods of measurement.

Actively managed funds did terribly in the current stock market environment, and index funds also fared poorly. The delta between the two is the “negative alpha” of active management (sorry, not everyone will get that, but I find it a bit funny) as well as the increased expenses of the actively managed fund over the index (it may be up to 6x bigger, as they say in the Vanguard adds, but unfortunately that is only a small percentage of the overall loss).

Due to the way that ETF’s are structured, there are basically no “actively managed” ETF’s. And ETF’s are more tax efficient than mutual funds. Thus when you pick an “actively managed” mutual fund, you are losing three times:

1) you probably are going to come in worse than your index performance
2) you will almost certainly pay higher fees
3) by selecting a mutual fund over an ETF, you are sacrificing tax efficiency

Bill Miller is among the last of the “index beaters”. The marketing departments for actively managed mutual funds are going to have to think hard to make this one shine…

Cross posted at LITGM

Larger Investment Topics

This blog is focused on practical advice for someone starting out in investing, setting up a smaller trust fund for a relative, or wanting to manage their own performance of a reasonably sized portfolio.

The author of this site also writes on larger topics, really ones that aren’t “actionable”.  Here are a couple that you might find interesting.

Here at Chicago Boyz I write about “Private Equity“, which mainly consists of 1) leverage buyout funds that take public companies private 2) venture capital funds that invest in early stage enterprises in hopes of taking them public for a big profit (those few that typically make it).  The general gist is that these types of financial professionals are supremely well-compensated for their efforts which haven’t warranted these big paychecks recently.

Here at Chicago Boyz I wrote about “Hedge Funds“, which also discusses their relatively vanilla strategies that seem to be easily replicable (note the pages and pages of hedge fund performance statistics in a recent issues of Barrons’) and also not worthy of the big 2% / 20% cuts.

I will try to focus this site on practical tips on a smaller scale that are actionable.

Re-Directing To This Site

For several years I have run a site at http://www.certificationhelp.net called “Trust Funds For Kids”.  Over time I have been moving from that web site to a word press blog run at this address http://www.certificationhelp.net/blog.

I re-directed the URL “Trustfundsforkids.com” to this site but as it turns out very few people got here through that URL; they got here because the text had been embedded in the search engines and they found it through search words.

Just today I changed the code at the Front Page site so that everyone who goes there, searching for something that was in a search engine, gets redirected to this blog, instead.


I realize that many people are skeptical about what people write on the Internet and rightly so.  This blog is run by someone who has financial experience in setting up a trust fund, with selecting stocks, and other financial areas.  You don’t see any links to other dubious sites or get rich quick schemes.  Also no ads (maybe someday, but not now).  The only two links are to other sites that I also post at (recommended, by me at least) and likely I will add some other useful sites to the blogroll (the IRS, etc…).

I will be posting about various investing topics and how to set up a trust fund, select stocks, and related taxation issues.  Hope you enjoy the site and find it useful.


Recently I have been writing about investing in secure securities (i.e. where you can’t lose money, except in extremely unlikely scenarios). I focused on purchasing CD’s that are insured by the FDIC and constructing a “ladder” of varying maturities through your brokerage account. The return on these CD’s is much higher than is currently being offered by US Treasury securities and has other advantages such as convenience and simplification of statements.

There is another form of safe investing that is easy to do and risk-free (assuming the US Government does not collapse). This is called an “I Savings Bond” or “iBond”.


iBonds are issued by the US Government. iBonds can be purchased at www.treasurydirect.gov after you set up an account and provide appropriate information, at zero charge. The iBonds are issued electronically and the money moves electronically which makes them very convenient, as well.

Unlike virtually all other types of bonds, the iBond interest or “coupon” rate is tied to the inflation rate as measured by the US Government. Virtually all other bond instruments either adjust their coupon rate according to how interest rates move (short term rates mainly determined by the Federal Reserve, long term rates a combination of short term rates and market sentiment) or the price adjusts (i.e. if you have a bond paying 6% interest and the market price moves to 5%, you could sell that bond for a gain in the market and it would be priced “above par”), depending on the type of bond.

The iBond has 2 components; a “fixed” interest rate that has varied between 0% (low) to 3.4% (high) over the last several years and a semi-annual interest rate component tied to the rate of inflation that changes every six months. ONCE YOU BUY AN IBOND THE FIXED RATE NEVER CHANGES, but the semi-annual component tied to inflation adjusts every six months (thanks to an alert reader for catching this error in a previous post). iBonds have a thirty year maturity.

The “fixed” interest rate component has had different base rates since the iBond program was started in 1998. The “fixed” component was 3.4% in 1998 and then dipped as low as 0% for bonds purchased between May 1, 2008 and October 31, 2008. The current fixed rate component on iBonds is 0.7% for bonds purchased between November 1, 2008 and April 30, 2009. If you buy iBonds today that “fixed” component will stay the same until you cash them in or they mature, 30 years from now.

The “variable” interest rate component is determined by the inflation rate, divided by 2 (the semi-annual inflation rate). The current semi-annual inflation rate is 2.46%, or 4.92% for the year. Thus iBonds purchased between November1, 2008 and April 30, 2009 pay about 5.64% (it is slightly higher than 0.7% + (2.46% * 2) because of compounding interest).

Note that if you buy different issues (i.e. $5,000 / year) of iBonds, your fixed rate may vary by year, but the “variable” component will be the same for each issue over every six month period. I realize this is confusing (it confused me, for what that is worth) and here is a link to the government site where they try to explain it.


An individual can purchase up to $5,000 / year in iBonds. If you are married and want to go into details 2 individuals can purchase $10,000 / year in iBonds under 2 SSN’s, electronically. You can also go physically to a bank and buy “paper” iBonds up to that same limit (this can be done at a bank). You can also purchase iBonds for kids (i.e. for college or a trust account) under their SSN up to the same limits.


You can’t sell back your iBonds in the first year after purchase (unless there is a natural disaster or some other unique circumstance in your area); thus they are not “cash and cash equivalents”.

If you sell back your iBond within 5 years of purchase, you lose one quarter of one years’ interest. After 5 years you can redeem your iBond with no penalty.


The advantage of iBonds is that you can defer Federal taxes on iBonds until they are redeemed, and they are immune from state and local taxes. Deferring taxes in this manner is useful because the interest that would have been taxable grows at a compound rate for the life of the bonds. In some circumstances (using them for education), the interest isn’t taxed at all when the bonds are redeemed (you should read about these at the government site, I am not an expert on the various criteria, but they seem pretty generous). Overall, iBonds receive very favorable tax treatment. IBonds might be considered as part of your college savings solution; they essentially have the same treatment as 529 accounts (you aren’t taxed on your earnings, assuming they are used for qualified education purposes). If you wanted a guaranteed portion for college you could use IBonds and get a guaranteed (albiet low, if the markets are booming) return.


iBonds provide protection against future inflation. If you own a bond with a fixed coupon at, say 6%, and inflation moves from 3% (current rate) to 5%, it will significantly erode the value of your bond (the price in the market will be lower if you want to sell it prior to maturity; you will receive your same coupon payments in the meantime). For iBonds, however, they automatically adjust to the inflation rate, and thus they provide a “hedge” against changes in inflation. For this reason it may be good to have them in your portfolio, because they are not correlated with your other investments (this is a good thing in “portfolio theory” terms).

Note that inflation as computed by the Treasury may not match actual inflation; they measure a basket of goods and don’t count services like college costs nor do they count real estate (an asset). Thus YOUR rate of inflation could be much higher (or potentially lower) than the rate quoted for your iBond.


You may want to look into iBonds, especially if you are in a high tax bracket or the AMT. iBonds have very favorable tax treatment, more so if your state has a high tax rate. iBonds are also attractive if you are saving for college for yourself or your children; the interest may be non-taxable if used for certain purposes.

iBonds don’t come with any expenses and are easy to buy and sell. You don’t have to deal with a broker, you can just do it all online at the Federal government site.

IBonds are currently paying VERY competitive rates – 5% – 6% depending on when you made your initial purchase – but this could easily go down if inflation slows with the cooling economy. CD’s are paying 4% or so for a couple year maturity. The brokerage CD’s have an advantage in that they can be sold in the open market while the iBonds are “stuck” for one year. Money market (which is paying below 2%) is immediately available (but less well protected, in extreme cases).

The 1 year “lock up” and 5 year “interest penalty” of one quarter means that you shouldn’t use this for your emergency fund. They might be a good component of a balanced investment program, especially if inflation rises which will erode your other bond and fixed rate investments.

Cross posted at LITGM

Treasuries vs. Certificates of Deposit


Recently I wrote a post about how CD’s can be purchased through your brokerage account (Fidelity, Schwab, Vanguard, etc…) and how easy that it is to do so.

Recently I built a “ladder” by taking the amount that I wanted to invest and breaking it into 4 equal groups and buying CD’s as follows:

one year interest rate 2.75%
two year interest rate 3.95%
three year interest rate 3.9%
four year interest rate 4.1%

I called my brokerage account and they read the rates & banks over the phone and I was able to make these purchases in about 15 minutes. The process is simple because they only offer FDIC insured CD’s, so there really isn’t much to differentiate each issue except for the frequency of payments (my 1 year CD paid out at maturity, the rest pay out either semi-annually or monthly, as I noted in my other article all things being equal the more pay outs you get each year, the higher the “real” return).

These CD’s are very easy to administer because they were purchased at face value (no discount or premium) and when the interest payments are made they will just show up in my brokerage account rather than compounding with the CD, which makes taxes (a bit) more complex later.

The reason I built a ladder is because I am not smart enough to “guess” the yield curve and which way interest rates are going. As each component of the ladder matures (i.e. a year from now), I will repurchase a CD at the “far” end of the maturity level. For instance a year from now my 1 year CD paying 2.75% will mature and at that time I will buy a 4 year CD at prevailing rates (which could be higher or lower than the 4.1% I received today).


Recently Treasuries have been in the news since the yield on government debt has fallen to extremely low levels. This article describes the situation:

“Due to stampeding demand for safe short-term investments, the US Treasury’s four-week and three-month bills on Friday yielded an effective rate of 0.01 percent — down sharply from 1.515 percent and 1.785 percent, respectively, in early September… the 10-year bond yield fell as low as 2.505 percent and the 30-year bond yield slid to 3.005 percent at one point on Friday. The six-month bond yielded a mere 0.20 percent. The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil. Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default. The panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero…”

To an individual investor, Treasuries and CD’s insured by the FDIC should be viewed roughly as equal in terms of risk. It would have to be near “end of days” when the US Government defaulted on Treasuries, but the situation would have to be almost equally as dire when the government would consider letting FDIC insured bank deposits fail.

For large investors, CD’s aren’t really a substitute for Treasuries because of the limits on government insurance coverage and the comparatively il-liquidity of the CD market. Large investors, who are demanding access to low risk places to put their cash, are driving down the yields on Treasuries as noted above. The ten year bond per above is around 2.5% and presumably 2-4 year yields would be closer to 2%, so you are almost doubling your rate of return on CD’s vs. Treasuries.

For smaller investors it is pretty clear that you are better off with brokerage CD’s than with US Treasury securities for money that you wish to have some return and as close to zero risk as possible.

If you are interested in more information about FDIC insurance here is the official FDIC site and here is a link to Treasury Direct where individuals can purchase US government securities.

Cross posted at LITGM

Certificates of Deposit

If you are looking for zero risk alternatives for cash the only options essentially are US Government securities (Treasury bonds, etc…) and FDIC secured cash which consists of bank deposits (up to the limit) and certificates of deposit (CD’s). The third option is a money market account which only rarely “break the buck” lose money but it did happen recently with a fund that invested heavily in Lehman Brothers paper (other money market funds, such as those at Vanguard, state that they invest only in the highest quality paper and the likelihood of any sort of loss is very remote).

For the purposes of this post I am going to summarize up CD’s and the basics for investing in this type of zero risk security, which has changed recently. Key elements are as follows:

Principal – amount that you are investing with a financial institution – generally ranges from a few thousand dollars up to $250,000 (you can invest more but you start to go past the limits of FDIC insurance with a single institution)
Duration – CD’s range from a month to 10 years. Most common durations are 6 months, 1 year, 18 months, then 2 years, 3 years, and 5 years
Interest Rate – interest rate paid on your investment – for example 4% on $50,000 principal gives you $2000 interest / year (yes, I know it is more complicated than that). This is typically called the “nominal” rate
Payment Frequency – the most common payment frequency is monthly, quarterly, semi-annually, or annually. If two CD’s offer the same interest rate (say 4%) and one makes payments monthly and the other annually, the “effective” rate will be higher on the monthly payment because you can re-invest your interest. At the relatively low rates of interest that we are talking about (4% or so) and short durations (up to 5 years or so) and principal amounts ($100,000 or less) the difference between an annual payout and a semi-annual payout is insignificant over the life of a CD. All things being equal, if rates are the same go for the more frequent payouts
Penalty – for CD’s bought directly from institutions (i.e. your existing bank) typically there is a penalty for early withdrawal. For instance, if you have a 5 year CD and you pull out your money before the 5 year mark, then you would forfeit 3 months of interest (as an example). This process is different for CD’s bought through your brokerage account, see below.

FDIC Insurance has been changed recently. FDIC Insurance coverage has been raised from $100,000 (per individual) up to $250,000 (per individual) through December 31, 2009. This change was probably done because banks are acquiring other banks with all of the mergers and without raising this cap investors would have to pull funds out of banks in order to stay within the FDIC insurance guidelines (which would reduce the incentive for banks to acquire their weaker competitors in the first place).

Note that this change in insurance only goes through December 31, 2009 – thus if you are buying a CD in the near term with a duration longer than 12 months you should assume that this cap will go back down to $100,000 and you want to plan accordingly (i.e. don’t have CD’s > $100,000 in value with a duration past 12/31/09 in the same bank).

Purchasing a CD used to involve physically visiting a bank, transferring the funds into the bank (if your savings or checking accounts weren’t with that institution), and then receiving a statement or piece of physical paper to document your purchase. While this process certainly worked, it could also be time consuming to compare different rates and terms and it could be a hassle to track interest statements from a number of financial institutions (plus all of the extra tax forms at year end).

Today, however, a good way to purchase CD’s is through your brokerage account. If you have an account with Fidelity, Vanguard, or Schwab (for instance, there are many more) they have the ability to purchase CD’s through their “bond desk”.

You can purchase newly issued CD’s or you can purchase secondary CD’s. New CD’s are usually issued at “par” or 100 cents on the dollar. Secondary CD’s can be purchased at either a discount or a premium. Generally the discount and premium cause more complications from a tax perspective so that if all else is relatively equal new CD issues are a better and simpler bet.

For example, here is the summary at Fidelity:

Benefits of a Brokerage CD
1 All new issue CD’s offered by Fidelity are fee free
2 The CD’s Fidelity offers come from multiple sources
3 All CD’s offered by Fidelity are FDIC-insured
4 Brokerage CDs have some important advantages over bank CD’s including the ability to avoid penalties if the CD is sold before maturity

Author’s note – 2) multiple sources are useful because this allows you to select the best rate for different maturities and buy more than $100,000 at a time while staying within the FDIC limits 4) by avoiding penalties, they mean that you can sell your CD at any time at “market” price, which may be higher or lower than the current price. For example, I have a 3.5% CD that currently is priced at a discount, and a 5.3% CD that is priced at a premium. The fact that an issue is at a premium or discount doesn’t matter unless you want to sell before maturity – since I intend to hold them until maturity I am not worried about the discount. However, if you need your money back before maturity and interest rates have fallen since you purchased the CD you could actually make money (nominally) rather than pay a penalty.

Creating a “Ladder”

At the Fidelity site, for example, the new issue CD’s have different rates at different maturities. Unless interest rates are “inverted”, typically a longer duration CD would pay a higher interest rate than a shorter duration CD. From the Fidelity site:

3 month 2.10%, 6 month 2.55%, 12 month 3.2%… all the way to 5% at 7 years (84 months).

By a ladder, you might split your dollars between 1 year, 2 year, 3 year and 4 year CD’s. As each CD matures, you repurchase it at current interest rates. This will give you some protection from changes in rates, and you can protect yourself from getting stuck for a long duration at low rates (if they rise) and you can benefit for some period of time if rates decline.

If you buy this from your brokerage house (like Fidelity, or Vanguard) it is easy to select new issue CD’s from different banks that do not exceed the FDIC limits and take advantage of the best interest rates offered by CD’s at different durations. In addition, all of these CD’s appear on your brokerage statement and you get simplified tax reporting, too.

You generally will need to call the “bond desk” which is where fixed income investments like bonds and CD’s are sold. You can tell them the duration that you are looking for (2 years, for instance) and the amount you want to invest and they will tell you a bank that is offering the best rate – you will want to not put too much in any single institution. The CD’s are usually sold without extra fees (beyond whatever spread the brokerage earns from the bank, which is transparent to you).

From a tax perspective, the interest is taxable and will appear on your brokerage statement. CD’s are not necessarily tax efficient vehicles, but they are risk free. Depending on your tax bracket, municipal bonds may be a good bet, but they are more complicated and there are more risks (although municipal bonds are generally low risk, especially compared to corporate debt).

From an investment perspective, CD’s are not going to make you rich, but they won’t lose money. The interest rate is typically a bit more than the current short term rate, and then they are taxed, and the impact of inflation needs to be factored in. From an “economic” perspective, the net of return – tax – inflation is probably about zero.

Sadly enough, zero has been kicking butt for the last decade or so…

Cross posted at Life At The Great Midwest

Tracking Your Investments

There are many ways to track your investments. I have used a number of free online portfolio tracking tools over the years including the one at the Wall Street Journal and Yahoo. I really like the tool from google because:

1) it is very easy to set up
2) it lets you add cash independently of creating a “cash” account and treating everything as a transaction
3) you can see at a glance, and hide / unhide right off your home page

Updating Portfolio Performance for October, 2008

There are three portfolios that we are currently running.

Thoughts on our performance:

Like all equity investors, we were disappointed by the market downturn in October, 2008.  The S&P is down about 40% from its high mark set about 1 year ago.

This down turn hit pretty much everything except for 1) cash in the bank or money market 2) gold.  If you were in the market in the US or abroad you suffered severely.

None of our stocks actually went bankrupt or had massive declines, although some dropped more than 50%.  Previously, we had taken some gains on stocks that had run-ups like Amazon (AMZN), China Mobile (CHL) and Broken Hill Proprietary (BHP).  We reinvested these funds, but a lot of our new purchases dropped.

Going forward, we will have more analysis, thoughts and recommendations but I wanted to get started at the new blog and update performance and there are a lot of behind-the-scenes items needed to make this happen and I had to get those out of the way, first.

For many years this site was on Microsoft Front Page but Microsoft essentially abandoned that technology and wants users to try a new tool.  I started working with the new tool but found it very complicated.

In parallel, I have been working on a lot of other web sites, as a blogger.  I started on blogger (owned by Google) but since then have moved on to Word Press (although our main blog is still on blogger).  Thus I decided to transform the site into a blog which saves me from having a dedicated email account (since people can just comment) and makes updating easier.  Another advantage of word press over google is that I can upload spreadsheets and PDF files while blogger, for some reason, only lets you use pictures or videos.