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This is essentially the strategy opposite to Naive Siegelism and the key idea "put all your money in a money market/stable value fund" is also very simple, attractive and wrong. Its main advantage is peace of mind and the ability more or less precisely know the value of 401K many years ahead up to retirement. Cash of course is a king, but king reign usually doe snot last long and often ends with the assassination ;-).
It is important to understand that ultraconservative position (money under mattress, or modern equivalent of this in the form of stable value fund) has its own risks due to weak protection from inflation and some amount of TIPs, gold and short term bonds probably should complement this strategy well. Because you do not know and can't know the level of future inflation ultraconservatism is a bad advisor. We need to understand several basic facts about depression to guide us to the right allocation:
It is true that during real depression cash is the king. After all you lose you job abd it take years to find a new one. So the less leveraged you are the better are your chances of survival.
And, if the previous depression is a template, you saving in the bank are vulnerable. Ino old time it was run on a bank. In new times it might be a run on a dollar. So savings are real saving only if you can get your savings from the bank. That means that some part of savings can (and probably should) be converted into gold if changes of depression are high. Gold and silver, not cash are the store of value during the depression under fiat regime. But it is important to understand that even in dire circumstances of early 2009 it is not clear whether the situation will deteriorate to full scale depression.
It is yet unclear how 2008 economic difficulties will resolve themselves and whether all 2009 will be as bleak as 2008. Moreover depression is somewhat subjective notion: "It is a recession when your neighbor lose the job as saying "it is a depression when you lose the job" suggests.
The key point is that a small doze of other investments can enhance returns on your stable value holdings without violating peace of mind and the level of your protection against depression. I will not talk too much about gold as it is usually not available in 401K plans (but can and should be used in Roth plans). In any case you can find plenty of advice about gold on the Internet. But I would like to make a point that cash (as in stable value funds or CDs) are a good place to park your money, but only in moderation. In January 2008 Vanguard stable value fund returned approximately 3.6% (annualized). That's probably close to the current level of inflation. And it is not clear whether there will be a sharp spike of inflation, but it is a possibility. that's why gold and TIPs are important diversifiers, if used in moderation.
At the same time I would be the last to argue that peace of mind is not a valuable dividend (look at my efforts to write those pages, which were triggered by losses during dot-com bust ;-).
The discussion below I will make the following assumptions which might be realistic or not:
If we assume that those assumption are true using stable value fund to park a substantial portion of your 401K savings has several undeniable advantages:
|If you really are risk averse, you can use combination of 100-your age splitting stable value and TIPS. You still get your tax relief, it’s worth it just for that. Plus you get you company contribution (say, 4% of salary) which can be counted as a return on investment too. And you are partially protected from currency risk which is probably the gravest risk of all.|
There is an additional incentive to adopt this strategy is the your organization uses for 401K bond and stock funds with high expense rations (Wal Mart 401K plans are one such example, they use horrible and expensive Merrill Lynch funds; see Some stock funds can't even outperform lowly T-bills ):
You'd be amazed at how much work it can take to make a stock portfolio give T-bill returns — and how many funds have managed to make the leap from the merely mediocre to the truly dreadful.
A basic tenet of investing is that, over the long term, stocks tend to return more than bonds or T-bills. The past 10 years have borne this out.
• T-bills have gained an average 3.7% a year from November 1997 through November 2007, assuming you reinvested your interest.
• The Lehman Bros. U.S. Aggregate Bond index, a broad measure of the bond market, has returned an average 6.1% a year the same period.
• The Dow Jones Wilshire 5000 index, which measures the returns from virtually the entire stock market, has risen an average 6.6%.
For individuals who can fund their retirement with just contributions and stable value returns worth more than a high return: the ability to sleep at night is priceless. And this is not just a metaphor. As CNN reported pm Oct 28, 2008 (Money worries rob workers of sleep, study shows):
Nine of 10 American workers are losing sleep over financial worries, according to a survey released Monday by a company that helps workers deal with wellness issues.Thirty percent of respondents reported worrying about the cost of living while 29 percent cited credit-card debt.
Keeping up with the rising cost of living and credit card debt were top concerns preventing people from falling asleep, according to the results from ComPsych Corporation, which surveyed employees of companies it serves. Thirty percent of respondents reported worrying about the cost of living while 29 percent cited credit-card debt.
Making mortgage payments and building retirement accounts also kept people awake, with 14 percent and 13 percent, respectively, listing those as their main concerns, the survey said.
How to afford childrens' school tuition and health care costs robbed just three percent of sleep, the survey said.
Only eight percent of respondents said they are not worried and have no trouble sleeping.
The study was compiled and released by ComPsych Corporation, which contracts with companies to provide employee assistance programs.
"As the largest EAP, our increased call volume has been a reflection of the financial stressors faced by U.S. employees," said Richard Chaifetz, ComPsych's chief executive officer.
According to Vanguard approximately 13% of participants in 401K plan had their entire accounts in fixed-income securities. Money market (stable value) funds are definitely preferable to bond funds if yields are less then 5%. They also preferable in time of financial crisis. You can see what happened with bond funds in October 2008; even short term bond funds posted losses close to 10% (for example Vanguard Investment Grade Intermediate fund lost 6.5% or so).
There is some theoretical justification of this strategy: The fundamental cause of any credit crisis is that risk and reward became disconnected. And that can be true not only for stocks but for bonds too. If yields before the crisis are too low (as they were in 2006-2007), corporate bonds can be decimated too. For example LQD, a popular ETF that invests in investment grade bonds in 2008 at one point lost 30% (yes, thirty percent) of its value dropping from 107 to 81.70.
Also people who from Jan 1, 2006 contributed (using cost averaging) all their 401K contribution to stable value fund has had on Oct 27, 2008 65% more money then people who who used cost averaging to contribute all their money to S&P500 based fund (assuming Vanguard stable value fund and 2.5% yearly increase in salary for each calendar year). Just think about it: 65% less money... OK, this was so far the worst day in 2008 but still...
|People who from Jan 1, 1996 contributed (using cost averaging) all their 401K contribution to stable value fund has had on Oct 27, 2008 65% more money then people who who used cost averaging to contribute all their money to S&P500 based fund (assuming Vanguard stable value fund and 2.5% yearly increase in salary for each calendar year).|
But it is clear that inflation protection matters and even is situations close to start of the depression (like in beginning of 2009) this strategy can be enhanced by investing a small amount (let's say up to 10%) in other instruments, which slightly increases protection from inflation without substantial increase of risk (assuming 50% decline in case of 10% investment you will get 5% decline of the total; in case of 20% investment it can be up to 10% decline).
Obvious candidates are TIPs. risk that you lose your TIPs investment are even less then the risk that you lose your stable value fund investment. And returns are pretty similar in low inflation periods. But quite different in high inflation periods. The problem here is that we can run multi-year deflationary period, but with small invesnted amount it matter much less then if you put all 100% into TIPs.
Other possibilities are junk bonds and stocks (if bought at low points like November 2008; same thinking is applicable to junk bonds; never buy either stocks or junk bonds using cost averaging). It's enough to invest say 10% in TIPs and say 3-5% in junk bond or stocks to get some protection from inflation and increase returns without significantly increasing risk.
Again the key recommendation is not to do cost averaging for stocks or junk bonds but patiently wait for the multiyear low and only then invest when dividends for S&P500 are close to dividends of stable value fund (for example when S&P500 returns approximately 3.5% or more). And you should be ready to sell them if there is some "surprise rally" which bring you 10% or more return in less then a year.
In any cases above 5% any investment increase the risk dramatically as most people cannot afford to lose money in 401K accounts and there no guarantee that the year of your retirement cannot be replica of 2008.
But stocks might be faded asset class after the current crisis and returns might suffer for a decade or so like was the case with Japanese stocks. Just, please, do not be greedy, do not pull the trigger buying all 5% at the point you consider "deep dip", buy them in small chunks of, say, 1% ("cost averaging on dips", so to speak ;-). A good timing is impossible and if you bought S&P500 for say $86 on October 24 (which is a good price based on proposed S&P500 metric of 25% decline from 1000 days average) that does not means that it cannot be, say, $75 later the same month or next month (actually in this case in November 2008: the lowest point was $74.34).
|According to Vanguard, the portfolio of 45% cash, 45% bonds (TIPs) and 10% stocks (can probably be replaced a mix of 5% high-yield bonds and 5% international stocks) produced average return 5.5% with best year +21.6%, worst year -4.5% (1931) and 5 years with loss out of 82. I wonder what will a loss of this portfolio in 2008.|
The main danger of "everything in stable value" strategy is not leaving all the money in stable value account. It is the danger of abandoning the strategy in good years in usually counterproductive attempts to increase returns ("greed effect" is fully applicable to stable value investing too -- the lure of bonds with higher returns (say 5% vs 3.6% in stable value fund) and stocks after 20% of annual return can be too much to resist ;-).
|The main danger of "everything in stable value" strategy is not leaving all the money in stable value account. It is the danger of abandoning the strategy in good years in usually counterproductive attempts to increase returns.|
This often happens if stocks produce spectacular returns and the "cash only" investor start moving money to more risky investments due to greed. Unfortunately period of very low stable value fund returns are usually the worst periods for moving money to bond funds as yields are low and risk is very high. Especially dangerous are junk bonds which actually behave like stock and can crash 50% or more.
Usually people move funds from stable value when stable value fund returns became really miserable. But this is a really bad (completely wrong) time as bonds are overvalued at this moment and, for example, the yield spread between junk and high quality usually becomes very narrow. That means taking disproportionate amounts of risk and this is a huge costly mistake that costs some people up to 30% of their 401K saving. For example Vanguard High Yield fond is a toast as of November 2008, dropping from $6.30 to 3.92. Such a drop means that you might recover your money with "stable value" interest (let's say 4%) only in a decade or so ( bonds usually have 5-7 years to maturity in this fund).
We probably should respect those people who are afraid of depression and use "all stable value" strategy but they might consider amending it by adding small percentage of TIPS and even smaller percentage of stocks and junk bonds. There are at least three advantages of this strategy:
|We probably should respect those people who used "all stable value" or all bond strategy: they just refused to play in the Wall Street casino and enrich brokers.|
|Another nice feature of this simple strategy is that you can enjoy life and not to think about recent drop of S&P 500|
As if retirement planning (in general) and faith in equity markets (in particular) didn't have enough working against them right now, it seems a small, but growing, number of businesses are foregoing their 401k matching contributions in order to conserve cash (and jobs).
Having left the confines of traditional employment almost two years ago, those year-end five percent matching contributions are sorely missed.
What is not missed, however, are the restrictions that most 401k plans impose along with the constant prodding to fill up those Morningstar style boxes with more U.S. equity funds.
How's that workin' for ya, as Dr. Phil would say.
It seems that the 401k industry is in a rough patch at the moment with world-leader Fidelity Investments announcing huge layoffs and a growing number of plan participants opting to scale back or stop contributing to their retirement account.
Those stable value funds may be their only saving grace in the period ahead.
News comes in this BusinessWeek story about the growing number of companies that are eliminating their matching contributions.
|According to Vanguard's Center for Investment Research, investors think that there's a 51% chance that U.S. stocks will lose a third of their value in any given year.|
Based on historical returns (which as we all know do not predict the future events), Vanguard calculates that the real probability of that happening is about 2%. Even if we assume 20% risk of the recession with 33% drop in stock instruments, holding all 100% of your money in stable value fund might be an overkill. Some percentage that feels comfortable to you should probably be allocated to more risky instruments that have inflation compensation potential (as I mentioned before regular bonds does not have this potential, only TIPs do).
Here is an interesting comment that I have found in Let's play the blame game again of the The Mess That Greenspan Made blog on Feb 11, 2009:
- I was amazed that you considered changing the name of your blog a while ago.
I found your blog several years ago because I reached the same conclusion you apparently did about Greenspan: He made a BIG MESS of our economy.
I looked up 'Greenspan' and 'mess' on Google, et voila, here I am!
I believe your blog title is part of the reason for your blog's success. (Of course, you're smart, a good writer and you work your tail off, too!)
FWIW, Greenspan will go down in the history books as the biggest villain in the current financial mess and a whole lot of people already see it that way.
It's also galling to picture Greenspan getting a medal from GW Bush. That really says more about Bush than Greenspan.
(It's a lot like "You're doin' a heckuva job, Brownie!" It shows how lame Bush is. But, beware: Obama is not looking any better at this point! It's just more of the same old garbage, I'm afraid.)
While history will show Greenspan is a loser, the top 10 list is correct to point out that people can only blame themselves in the end.
Some of us didn't fall for the 'Good Times' temptations offered by nearly free money.
Some of us were raised to believe "There's No Such Thing As A Free Lunch" and to be VERY suspicious when something (like a half million dollar McMansion with nothing down, 125% financing and interest only payments at 1%) looks too good to be true.
I'm a saver and I've worked very hard and saved very hard for decades to pay off my house and have a wad of cash. I intentionally live way below my means.
My plan was to earn 5-6% interest in bank CDs and retire early and live off the money.
That plan isn't working out so well with interest rates at ridiculously low levels and, to me, the threat of runaway inflation too real.
I avoided the stock market because, as a finance major in college, a former banker and bankruptcy lawyer, I could see that it was a corrupt, Vegas-style, gambling mess with no real substance and huge risk at the ridiculous price levels for almost all stocks.
I had adjusted to the fact that our government encourages borrowing by making the interest deductible and discourages saving by taxing the interest.
I honestly never thought it would go so far as it has to punish savers and reward borrowers. The current 'bailout' fad is simply stunningly unfair.
Greenspan's policies (and now Bernanke's) have made it hard to justify saving money. It's such an insult to get the paltry 1% interest each year and then have to pay taxes on it!
I heard Obama and his surrogates openly state that they want to "get Americans back to where they can borrow money to buy the things they want again."
To me, that is just an amazing thing to admit. You know we're in deep trouble when the new POTUS can say that and almost no one even notices or objects.
Debt is a way of life in America and it will sink us.
I have said for years that I feel as if I'm a 3rd class passenger who is locked below decks aboard the Titanic. I didn't do anything wrong but I'm screwed.
It's a little worse than that because I could see the iceberg coming and I've been yelling to anyone that would listen for years. But no one in power, except Ron Paul, seemed to hear me or agree with me.
That's how I found this blog and I then began to realize that thousands of people saw it coming, too. If all of us 'regular' people could see it coming, how is it that all the powerful geniuses in Washington and on Wall Street couldn't see it coming?
I decided that these powerful people are either liars or wildly incompetent - or BOTH! For that final conclusion, Greenspan is the poster boy.
Obama will still be conducting and his musicians will still be playing as the stern of the USS AMERICA slowly sinks into the dark, cold abyss.
It's a sad story...
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