Good advice

An amusing e-letter from Investment U today. Its strapline is "What no books, no schools, no brokers will teach you".

With good reason, if the content is anything to go by - it seems that all you have to do for a comfortable retirement is invest in stocks that go up like rockets. And it gets better: the best way (it seems) to choose those stocks is to look at how they've done in the past.

The figures are great, too. To create $100k per year in 10 years' time, they say you'll need a fund of $2 million. Apparently there's no such thing as inflation. Because if there is, and it rolls on at a sedate 2.5% compound per year, you'll need 28% more in 10 years' time.

In actuality, assuming you want your retirement income to be inflation-proofed, your fund will have to be not 20 times the planned income you want, but closer to 40. Partly it's because we're living longer (and retiring earlier), but mostly it's because the life insurance companies have cottoned on to the fact that our governments are (a) losing control of our finances and (b) lying heroically to us about it.

So maybe we're aiming at a fund of $5 million.

The rate of return shown is wild - a mere 29.6% per year. One would have to be "in denial" to postulate a steady 30% a year in America's train-wreck economy, when the great Warren Buffett has been sitting on billions in cash for years and has recently started to hedge against the dollar. Doug Casey has something that he says is "going to the moon", but that's gold - a speculation if ever there was one.

Here in the heavily-regulated UK, the maximum pension growth that can legally be illustrated is 9%, but that's including fund management charges. "Stakeholder" pensions have a maximum annual charge of 1%. So let's assume an (optimistic) annual growth rate of 8%.

Using our revised end-point, our legally-restricted growth rate and working backwards, as in the example provided, we need to start with a lump sum of $2,315,967. Not $194,400.

The article does make some serious points:

• baby boomers are facing a retirement crisis (Richard Bookstaber mentioned that in his interview with Jim Puplava, and thinks it'll be one of the drag factors on investments for many years to come)
• longer-term investments can afford to be riskier than short-term investments
• in the long run, we normally expect equities to outperform bonds
• investing earlier reduces the required rate of return to achieve your end-point target, so start early

But please, don't think that returns over the last 5 years are anything to rely on. "The Legg Mason Opportunity Trust (LMOPX), for example, has a 5-year annual return of 20.74%," say these not-your-brokers. The Dow itself has risen 60% since August 2002, but you have to remember where we were then. So Legg Mason's fund has returned an average 10.7% p.a. above the Dow.

How did it do that? Much depends on the type of fund you're in - a fund whose name includes the word "recovery" or "opportunity" is usually one that concentrates on smaller companies, the shy, creeping things that are the first to emerge from the undergrowth after the storm. These are also damaged more easily than the big beasts by economic downturns. So the real lesson is, be in the right type of asset at the right time. Getting into a recovery fund in '02-'04 was a good choice, then.

And how about highlighted stocks? "Starbucks, Franklin Resources, General Dynamics, Amazon, Citigroup… These companies have posted average returns in excess of 30% a year, for more than a decade."

...I'm now reading Benjamin Graham, the man who taught Warren Buffett, and a note to the latest edition points out that in 2000 and 2001, Amazon. com lost 85.8%. If you'd been one of the victims and had to re-start with 14.2 cents for every dollar you had originally, you'd have to post a 704% gain just to get back where you started (and even then, you'd still be behind inflation, and interest earned safely on deposits). The first principle of investing is not to lose your money.

If you're going to risk a fortune on individual stocks, maybe you should blow your wad at the track instead - it'll be more fun. A nice day out, a bit of champagne, and you can sell your binoculars for the fare home.

There's an adage in law: "Free advice is worth what you pay for it". If you want advice, seek out a broker and pay for it. The poor sap is then liable for all your losses, while any gains are down to your wisdom in picking him.

Seriously, though, read financial newsletters with caution, and read the disclaimers first.

Poll: how would you hedge against a dollar fall?

...and for extra marks (especially if you're putting your money on it!), let's see what currency or precious metal looks like the best store of the value of your dollars.

Warren Buffett recently revealed he's hedged against the greenback, and gold and silver bugs are contesting the merits of their respective hoards. If your preference is for currency but you wonder about the backing, remember that Germany has the world's second-largest stock of gold, whereas Switzerland and the UK have been persuaded to get rid of about half their gold holdings since 2000.

Meanwhile, Japan and China are both struggling to hold their currencies down, to protect their export markets. Russia seems keen on claiming half the Polar region and is already able to use its energy supplies as an economic weapon. India is developing fast, and may turn out to be an interesting rival for China.

Here's our starting point today, using the figures from the Currency Converter widget on the sidebar. $1,000 will currently buy:

729.74 Euros
1,427.25 German Marks (there's a glitch in the currency converter, so I've done this in two stages)
119,080 Japanese Yen
7,581.23 Chinese Yuan or Renminbi
492.40 British Pounds
40,383 Indian Rupees
25,548.20 Russian Roubles
1,203.70 Swiss Francs

An ounce of gold costs $665.03
An ounce of silver costs $12.92

Where would you hold your savings until the New Year?

Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Dow survey update

One more day and we'll stop - thanks for your responses. We've seen a little bit of a rally in the last 36 hours and so far (12.35 New York time) the Dow is down 2.55% from its 25 July close. Pessimism is also down a bit - less than two-thirds expect the Dow to be below 13,000 at year end.

Any more votes?

Dow value afterthought

...and if we remember the heady close of December 1999, before tech stocks burst, the Dow was then at 11,497.12. We've had 7 years and 7 months elapse since, with an average growth of just under 2% compound per year. Adjusted for inflation (or available bank deposit interest rates), we've actually fallen behind; or, from a different point of view, we're not so wildly overvalued.

Actually, what I suspect has happened is that the balloon has a tear in it, and has been kept from falling to earth by massive amounts of extra monetary hot air; but "in real terms" we're still stuck somewhere in 1999. In short, we haven't yet faced up to the problems of our economy.

To use a different analogy, we're still drinking, in order to put off the hangover. But maybe there's lots more "booze" left (i.e. the Fed's printing press, aped by the Bank of England and others) and our "livers" (the real economy of production and jobs) will hold out a while longer.

It's not a strategy I'd recommend. I wonder what you think.

What should the Dow Jones be worth?

The Dow closed yesterday at 13,358.31; ten years before, it stood at 8,254.89. That's a compound annual growth rate of 4.93% (less, when you adjust for inflation).

Or if you take it from the big, big scare of Monday 19 October 1987 (close: 1,738.74, down 508 points from the previous Friday!), it's an average 10.88% compound per year. Does that seem too hot a pace? Unsustainable? But remember that we're starting that run from a real panic. If we took it from the happy close of the Friday before, the average becomes 9.53%.

Still too hot? If nearly 20 years isn't enough to establish a sensible long-term trend, let's look at an even longer period: 30 years from 30 July 1977. Then till now, the Dow's capital growth averages out at 9.45% compound per year. The market's folly can outlast your wisdom.

"Two views make a market", and that's it. Mr Market is making his wares available to you - will you buy at today's prices? (I wouldn't - but obviously others will, or the market would be lower.)

You can play with the figures yourself, on this fine page from Yahoo! Finance.

And please click on the poll opposite, to give your prediction for the year's end.

Have I got my sums wrong - or right?

Bill Bonner, in The Daily Reckoning Australia yesterday, quotes Paul van Eeden as saying that gold has kept pace almost perfectly with inflation since the 1920s.

My post of 29 July did some figures with US gold stocks, the price of gold and the money supply, and came to an arresting conclusion. A kilo of gold costs x dollars, yet at that price, all US gold could be bought for 1/66th of all US dollars. There'd be a huge pile of spare paper money left over, completely unrelated to gold.

From one point of view, the current gold price is not surprising, if gold is merely one tiny part of the overall economy governed by the dollar system. Yet the ratio in the previous paragraph - 1:66, which is the same as 1.5 cents to 1 dollar - is almost exactly what The Mogambo Guru (Richard Daughty) said is the difference in purchasing power between one modern dollar and one 1913 dollar. According to him, the modern dollar is worth two 1913 cents.

Perhaps Doug Casey is right: if trust in the dollar collapses, gold could be "going to the moon".