Category Archives: Wealth

Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

 

Understanding How Fund Performance Comparisons Overstate Returns

May 13, 2014

Every investor has, I hope, read the standard disclaimer on mutual fund and ETF performance documents that ‘past performance does not predict future performance,’ or other text to that effect. Still, when you read a fund company’s statement that ‘x% of our funds have out-performed their category average’ or that ‘x% of our funds are rated 4- and 5-star by Morningstar,’ this seems meaningful. Similarly, if you read that the average small value fund has returns ‘y’% per year over the last 10 years, this also seems significant. There is a major factor that is missing in many of these types of comparisons of fund performance, however, that tend to make active funds look better than they really are (as compared to low-cost index funds) as well as making a mutual fund family’s managers look more skillful than they might actually be.

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Different Perspectives on Home Ownership

The question of whether to buy or rent a home is of enormous economic significance for most families. Home equity represents the vast majority of American families’ net worth (see chart below). In a post in mid-2011, I discussed some of the major economic variables in the decision to buy a home. My conclusion was that buying a home made sense, but not because housing generates attractive long-term investment gains. The long-term data suggests houses have historically increased in value at a rate only slightly higher than inflation. The best arguments for owning a home, I argued, were historically-low interest rates, the mortgage interest tax deduction, and the inflation hedge provided by locking in your costs for shelter for the long-term. Since that time, housing prices and rents have risen dramatically. In the past week I read two thoughtful and interesting articles on the economics of owning a home that motivated me to revisit this topic for 2014.

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How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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Economic Inequality

Income inequality is increasingly acknowledged as a key economic issue for the world.  The topic is a major theme at Davos this year.  Economic inequality is also an increasingly common topic in U.S. politics.

A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously.   The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult.  The numbers have not changed in three decades.

On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale.  The richest 1% of Americans now own 25% of all of the wealth in the U.S.  The share of national income accruing to the richest 1% has doubled since 1980.  In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.

Why is this happening?

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Estimating the Real Costs of Investing

One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio.  In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small.  Over long periods of time, however, the ups and downs of the market tend to average out.  The effect of those costs  however is persistent and continuous. 

There are a range of costs associated with investing in funds beyond the stated expense ratio.  In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds.  Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising.  He has written similar pieces in the past.  In this article, he provides updated numbers, backed up by a range of academic analysis.  His summary of costs is provided in Table 1 of his article:

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There are three types of expenses, in addition to the standard expense ratio.  First are transaction costs, which are simply a fund’s trading costs.  This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses.  Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds.  He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio.  The second source of additional cost for active funds is cash drag.  Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash.  To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance.  Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year.  The final additional cost that Mr. Bogle includes is sales charges / fees.  This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees.  Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate. 

When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year. 

The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference.  The ICI also reports that the most expensive funds can have much higher expense ratios.  They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%. 

Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year.  This number is highly uncertain.  The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%.  A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%.  Because of compounding, the long-term impact of these costs increases over time. 

The average costs from Mr. Bogle’s article are not unreasonable.  There are probably many investors paying this much or more.  On the other hand, there are plenty of investors in active funds paying considerably less. 

Where does all of this leave investors?  First and foremost, it should be clear that costs matter a great deal.  There will always be expenses associated with investing, but they vary widely.  Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings.  Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio. 

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A ‘New Era’ for Bonds?

The Wall Street Journal recently published an article titled How You Can Survive a New Era in the Bond Market.  The article suggests that investors adjust their bond allocations to tilt more towards high-yield (aka junk) bonds (both corporate and municipal) and global bonds, which tend to yield more than U.S. bonds.  This advice resonates with an Op Ed by Burton Malkiel, famed author of A Random Walk Down Wall Street, at the end of 2013.

The case against bonds is straightforward.  The best estimate for the expected future return from bonds is their current yield.  If you hold a bond until maturity, your total return will be very close to the current yield.  There are nuances to this rule.  With high-yield bonds, you should expect a total return that is a bit less than the current yield due to the fact that some of these bonds will probably end in default.  With bond funds, you don’t necessarily end up holding individual bonds until maturity, so the correspondence between current yield and expected return is a bit weaker.  Nonetheless, with current yields as low as they are, bond investors should not expect attractive returns from most bond classes.

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