Archives For Stocks

What is the Impact of High Inflation on Stock Returns?

October 1, 2022 — Leave a comment

Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data
In Inflation, Investing, S&P 500, Stocks, Value Investing , , ,
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Does a High Dollar Lead to Poor Emerging Markets Returns?

July 30, 2022 — Leave a comment

Quiz!

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns.
  3. There is no correlation between a very high dollar and future emerging markets returns.

Does a High Dollar Lead to Poor Emerging Markets Returns?

I’ve seen articles explain how a high dollar hurts emerging market (EM) economies. With the dollar recently reaching the highest level since late 2002, some articles gave concerning messages related to emerging markets investments.

Historical evidence for the opposite: The history of EM investments shows opposite results. When the dollar reaches high levels, future returns of EM tend to be stronger than when the dollar is low. For example, the recent time we had such a high dollar (2002) was around the beginning of phenomenal 5 years for diversified EM stocks.

Explanations: Once the dollar is at unusually high levels, the negative effect of the dollar is priced into EM stocks, with lowered valuations (price/book and price/earnings). Given that the dollar is cyclical, at some point we got a reversal, with a declining dollar. Some of the logic of the articles can be used to explain the benefits of the declining dollar, helping EM stocks.

Caveats: This quick read shows counter evidence + logic to many articles you may read in some prominent sources. There are still big unknowns. The dollar may have just peaked, or it may go up further. The goal of this article isn’t finding the exact peak, but looking at odds for further increases vs. decreases. When a cyclical measure is above average, you would expect higher odds for the measure to go lower than higher.

Quiz Answer:

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns. [The Correct Answer, but read explanation]
  3. There is no correlation between a very high dollar and future emerging markets returns.

Explanation: A rising dollar lowers the value of emerging markets (EM) returns as measured in dollars. So, the past EM returns leading to the dollar highs are hurt. Future emerging markets returns depend on the future movement of the dollar. From a level above average, the dollar is more likely to decline in the future. That would lead to above average returns. A caveat is that this simply reflects odds, not guarantees or specific timing.

Disclosures Including Backtested Performance Data
In Currency, Investing, Stocks, Value Investing , , , ,
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The Anatomy of a Lost Decade

June 1, 2022 — Leave a comment

Quiz!

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings.
  4. Extreme economic distress.
  5. Euphoria.

The Anatomy of a Lost Decade

In the 2000’s, the S&P 500 experienced a 10-year decline, on a total return basis (including dividends), and much worse after counting the negative effect of inflation. This was not the first time – the decade ending in 1974 had +1.2% return per year, while inflation averaged 5.2% per year. This article describes what may lead to such long declines, and how they look.

What led to lost decades? A diversified portfolio of companies that produces products and services for entire countries is not likely to shrink its production for 10 years. What led to the 2 recent lost decades was high valuations (high price relative to the earnings of the companies or book values) of the companies. During the decade, the valuations declined by more than 50%, to correct (and typically overcorrect) the unusual pricing.

How did they look? The two most recent lost decades involved a series of gain periods followed by big declines, erasing substantial gains.

Can you avoid lost decades? There is no way to perfectly time the market, since turning points vary between cycles, with highs sometimes (but not always) leading to higher levels. There are various approaches with varying levels of success, involving getting out of diversified investments that did far above average for 10 years, or selling when valuations reach extremes. The easiest one is to diversify and include investments with lower average growth. While it involves a sacrifice to the returns, it gets around so many strategies that fail.

Why most people fail at timing? Once you find a strategy that stood the test of time, and has sound logic to it, you still have a major obstacle to overcome. Selling high and buying low involves going against the grain. It involves selling the most loved investment of the time, that people believe will just keep going up, and buying battered investments that underperformed for many years.

Can you avoid lost decades? While it is very difficult to time the market, or at least soften the blow of tough stretches, there are several principles that can improve your odds:

  1. When you hear gloomy news, along with scary predictions, and the investments are very low (low valuations / low 10 year returns), get excited about the investment.
  2. When you see euphoria all around you, with the most positive news, and the investments are sky high (high valuations / high 10 year returns), have the ability pull the trigger and sell and switch to an investment that most people hate.
  3. Whatever strategy you choose, make sure that it passed 2 tests: the test of time & the test of logic. While these are not enough, I would not move forward without these in place.
  4. Don’t expect to successfully time within one day, week, month or even year. Short-term timing strategies are far more difficult than long-term ones.
  5. Have a very robust risk plan, accounting for cases much worse than experienced in the past, allowing you to stick with the plan in some of the toughest times.

Quiz Answer:

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings. [Correct Answer]
  4. Extreme economic distress.
  5. Euphoria. [Correct Answer]

Explanations:

  1. Wars end up leading to increased economic activity. Declines tend to be far shorter than a decade.
  2. Pandemics tended to create short-term shocks, not very long lasting.
  3. High valuations typically get corrected. When valuations reach extremes, such as x2 the typical or more, it takes a prolonged period of poor performance to correct those.
  4. Extreme economic distress can lead to declines, but without high valuations, they tend to get resolved in far less than 10 years.
  5. Euphoria tends to lead to very high valuations – see #3 above.
Disclosures Including Backtested Performance Data
In Investing, S&P 500, Stocks, Value Investing ,
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S&P 500 10-Year Returns if The Past Repeats

December 1, 2021 — Leave a comment

Quiz!

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6%
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1%

S&P 500 10-Year Returns if The Past Repeats

The S&P 500 enjoyed strong returns averaging 16.2% per year in the past 10 years. 10 years look like a long track record, enough to entice investing in the S&P 500 today, based on this data. Let’s evaluate this theory:

1. Actual book-value growth calculated at a mere 6%: What was the growth in the book value of the S&P 500 companies in the past 10 years? We can calculate it as the difference between compounding the 16.2% price increase per year and about 9.6% price/book increase per year (x2.5 going from under 2 to nearly 5), which is 6% per year. It turns out that the past 10 years were not very exciting for the S&P 500 companies.

2. Valuations declined 9.6% per year: From the most recent cycle when valuations reached today’s valuations (year 2000), they declined from about 5 to about 2 in 10 years, which is equal to -9.6% per year.

3. If the past repeats itself, we can get -3.3% annual decline for 10 years = -28% total: If the companies do as well as the past 10 years = 6% per year, and valuations revert to normal as happened last time we reached today’s valuations = -9.6% per year, we get an annual decline of -3.3% per year, and a total decline of -28%.

We don’t know what the future will actually be. But, if you are projecting the past to the future, you should prepare for material declines for the S&P 500 over the next 10 years.

Quiz Answer:

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6% [Correct Answer]
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1% [Correct Answer]

See article for more explanations.

Disclosures Including Backtested Performance Data
In Investing, S&P 500, Stocks, Value Investing , ,
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Sales up 27%, Profits up 47%, Stock Down 7%! What Gives?

July 30, 2021 — Leave a comment

Quiz!

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low.
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Sales up 27%, Profits up 47%, Stock Down 7%! What Gives?

On 7/29/2021, Amazon reported spectacular Q2 sales growth of 27%. Profits grew even faster, at 47%. Yet, the stock declined 7% after the announcement. This is could be unsettling for investors that chose Amazon, given it’s amazing profitability.

What happened? These growth rates were below prior growth rates and the expectations. Stock prices move in response to changes in the company’s performance – a relative measure, as opposed to the absolute company performance. Once the bar is set very high, gains could be tough to achieve, and declines can be very rapid.

Did we get any warning signs? Yes, glaring ones. It’s P/E (stock price relative to earnings) was 69, and it’s P/B (stock price relative to company value or liquidation value) was 17. These numbers are huge, and reflect a company that is 100%’s better than other companies.

An extra difficulty: Stocks of successful companies sometimes go up far above their intrinsic value. It is partly the result of people choosing a company based on its success or even solely based on recent stock growth, while ignoring the stock price. You can do the same, and do well for some time, as people do in various pyramid schemes, or you can join at the peak and experience steep declines. The peak may come during a phenomenal quarter for the company.

How can you use this information? Whenever analyzing whether to buy a stock, look for companies that are underpriced relative to their performance. These include phenomenal companies that are underappreciated, as well as mediocre companies that are priced too low. If you find a company that you love and believe in, analyze how much of its value is already reflected in the stock price, before investing.

What is the future of Amazon’s stock? This question is outside the scope of this article. There are many positive and negative factors, and it’s not a trivial task to combine them to reach an answer. Here is a sliver of the factors: Will the company manage to revert back to its phenomenal growth of prior quarters, or even beat it? Will enough investors continue to bid up the price because they love the company, or because the stock price went up in recent years? Will competition eat into Amazon’s market share, or will Amazon gain even greater market share? Will interest rates in the US go up, hurting Amazon’s borrowing costs? The full list is very long.

Quiz Answer:

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low. [Correct Answer]
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Explanations:

  1. If the company is priced appropriately, the next step is to check the odds of a turnaround towards profitability. Trusting a turnaround can be risky, and should be done with caution, based on strong evidence.
  2. The combination of profitability & underpricing is the ideal one. Underpriced profitable companies have the potential for extra returns compared to the average company.
  3. A phenomenally profitable company is a great start. If you can’t live without it, and others feel the same, it’s another positive sign. The missing part is whether the stock price reflects more or less of all these positives.

See article for more explanations.

Disclosures Including Backtested Performance Data
In Active Investing, Investing, Stocks, Value Investing ,
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What Happens When Interest Rates & Inflation Rise?

February 27, 2021 — Leave a comment

Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

Look for the answer below and read this month’s article for a discussion.

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data
In Inflation, interest rates, stocks, Pandemic, Stocks, Value Investing , , ,
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The Surprises & The Expected of 2020

January 2, 2021 — Leave a comment

Quiz!

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter.
  3. It was scarier.
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual.

The Surprises & The Expected of 2020

The pandemic of 2020 was shocking to investors and humans in general. It involved substantial uncertainty, leading people to predict years of pain for stock investments. While the split between surprises & the expected will vary depending on the reader, below is my split.

Surprises:

  1. While the key actions to contain the pandemic were known early on (looking at some Asian countries), the magnitude of unwillingness to take these actions seriously in other countries was greater than I expected, leading to a much worse result than possible otherwise. While stocks recovered rapidly, they could have bottomed higher, with fewer lives lost on the way.

Expected:

  1. The decline was shorter than typical, because it didn’t come from a position of economic leverage and euphoria.
  2. When panic took hold in March, the Fed repeated its 2008 announcement, being prepared to do whatever it would take to support the economy. Other countries operated similarly.
  3. The turnaround came as soon as the level of uncertainty diminished, far before the economy improved, as typical.
  4. While the economy is still hurting badly, it started the turnaround much earlier than in prior declines, thanks to the cause being a shock and not leverage.
  5. Many people said about this decline that it’s different, and will last much longer than past declines. Fortunately, this prediction failed, as typical when made at past times of uncertainty.

The specifics of every market decline are different, creating a need to prepare for declines of varying lengths & depths, worse than we experienced before. While the specifics vary, there are some truths that follow through the cycles, especially some level of correlation between starting valuations (e.g. Price/Book) of risky assets and the severity of the decline. With the right planning, whether cash set aside or low spending relative to liquid assets, there is no need to label any case as “this time is different”. The more prepared you are, the stronger you can be going through scary times, with discipline to avoid panic selling at the depth of the decline.

Quiz Answer:

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter. [Correct Answer]
  3. It was scarier. [Correct Answer]
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual. [Correct Answer]

Explanations:

  1. This decline was shallower than the other two declines.
  2. This decline was dramatically shorter than the other two declines.
  3. While every decline is scary, this was scarier, because we haven’t seen such a widespread pandemic in our lifetimes.
  4. This decline was dramatically shorter than the other two declines.
  5. In most declines, the turnaround comes far ahead of the economic turnaround. It comes from a combination of government & central banks (e.g. the Fed) support along with an expectation for a future turnaround.
  6. Both 2008 and 2020 saw very big government & central bank support, but this year’s support was even bigger.

See article for more explanations.

Disclosures Including Backtested Performance Data
In Investing, Investment Psychology & Stock Declines, Pandemic, Stocks, Value Investing, Volatility , , , ,
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2 Hidden Risks of Selling Stocks Temporarily Now

March 31, 2020 — Leave a comment

Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.

Disclosures Including Backtested Performance Data
In Active Investing, Investing, Investment Psychology & Stock Declines, Stocks, Volatility
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8 Principles for Happiness in the FIRE Movement

November 30, 2019 — Leave a comment

Quiz!

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -8M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left.

8 Principles for Happiness in the FIRE Movement

FIRE stands for: “Financial Independence, Retire Early”. People aiming for FIRE save aggressively, as much as 50%-75% of their income, aiming to retire at a young age. They typically retire once they reach enough savings to support 3%-4% annual spending.

While the result may sound very appealing, the plan can result in an unhappy life or be abandoned, if not done right. Here are 8 principles that helped me in my process, and may help you:

  1. Spend for happiness: Drop all expenses that won’t make you much happier in life today or in the future, but keep and emphasize the expenses that are important to the core of your happiness, or to build a good future.
  2. Experiment and adapt: Keep dropping additional expenses, even if everyone tells you that the expense is as important as drinking water. Question every conventional wisdom, and you are bound to enjoy some pleasant surprises. When needed, reintroduce expenses.
  3. Keep low-frequency & lower-scale expenses: Eating out once a week (or month) instead of never can add to your happiness far more than the 5th weekly meal out. Going on a road-trip to a national park off season, and sleeping outside the park costs a small fraction of a flight to another continent with a stay in a nice hotel. Such a trip still gives you time away, with family or friends, nature, and relaxation – providing the bulk of the happiness.
  4. Save most when your spending/investment ratio is high: You will save more (1) early, compounding every dollar saved exponentially for longer – giving you free extra money, and (2) when your investments are low, and expected returns are higher.
  5. Invest for high growth: High growth helps reach independence earlier. In addition, high growth investments tend to be more volatile, providing excess gains to a consistent saver (read https://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/ to understand). Two caveats: (1) Stay highly diversified across sectors and countries; (2) Be prepared to stay consistent through multi-year declines – something that comes with all high-growth investments.
  6. Aim for a conservative outcome: Aim for a 3% annual spending rate, to support a potential of many decades in retirement. Spending includes non-recurring and surprise expenses, including car upgrades, major home repairs, and healthcare costs, to name a few.
  7. Keep working at what you love: Once you reached financial independence, keep working at something you love. It can be your current job, a new lower- or higher-paying job, or a new business.
  8. Maintain 3% spending: As your investments reach higher peaks, you can raise your spending proportionately to enjoy the fruit of the optimizations leading to that point. You can call this modification the FIRES movement = Financial Independence, Retire Early, then Spend, Save or whatever makes you happiest. Whatever you choose, the compounded growth of investments is expected to grow the benefit exponentially over time.

There are several benefits to these principles:

  1. Maximum happiness gained from every dollar spent.
  2. Enjoying work in retirement from a position of power with no pressure.
  3. Decades of financial independence + growing spending. You are likely to enjoy far greater lifelong spending than the typical person.

Quiz Answer:

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -2M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left. [Correct Answer]

Explanation:

The frontloading of spending created a disadvantage that was impossible to recover from, despite doubling the number of working years. Details:

  1. The extra spending in the first 20 years of scenario #1, led to a balance of 460k relative to 2.3M in scenario #2.
  2. 7 years later, with 13 years of work remaining for scenario #1, the annual spending of 90k was lower than the spending level of the person who retired already 7 years earlier.
  3. By the end of the working career, the 90k spending compares to 173k for the person retiring 20 years earlier. The investment balance grew nicely to 2.6M, but short of the 6.1M of the early retiree.
  4. By the end of retirement, the spending jumped to 196k relative to 460k for the early retiree. The investment balance reached nearly 7M vs. 16M for the early retiree.
Disclosures Including Backtested Performance Data
In Investing, Retirement, Spending, Stocks ,
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Do Stocks Decline after Yield Curve Inversions?

April 30, 2019 — Leave a comment

In late March the yield on short-term bonds (3-month) was higher than longer-term bonds (10-year) for a week. Normally you would expect higher returns for offering a 10-year loan than for offering a 3-month loan, leading to an upward sloping curve of yields of bonds of different maturities. What we saw in late march is called a “yield curve inversion” – longer-dated bonds providing lower yields than shorter ones. This often occurs when the Fed raises short-term rates fast relative to current conditions, and can be a precursor to a recession. It was true in both 2000 & 2008. Should you expect a decline to start soon? No. There is usually a significant lag between the inversion and stock declines. Here are the returns between the inversion and the stock decline for the S&P 500 and Extended-Term Component (ET) in the 2 prior cases of 2000 and 2008:

Inversion 1 Peak 1 Duration S&P 500 Return ET Return
9/30/1998 1/31/2000 16 months +39% +165%
01/31/2006 10/31/2007 21 months +18% +95%

1 I used month-end dates, given better access to historic return data on a monthly basis. The missing/extra partial-month impact on the results should be minimal.

These ET surges that are typical leading to peaks are a reason for you not to be concerned, and even be optimistic. Additional thoughts:

  1. Leading to peaks, ET tends to significantly outperform the S&P 500. It is great for your risk plan to be in a much stronger position in the face of future declines.
  2. The recent inversion was very short-lived, and current interest rates are still very low historically. It is possible that a recession is even further away than typical after inversions.
  3. While the statistics above provide a reason for optimism, I continue to be prepared for declines at any point – there are no guarantees on timing and results in investing.
Disclosures Including Backtested Performance Data
In interest rates, stocks, Stocks , , ,
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