Well, it turns out that our brain is right, our gut is wrong, and past performance offers no guarantee at all. Not only does it provide no assurances but, in fact, past performance is not even a useful predictor most of the time. It is, more or less, worthless in picking stock investments that will appreciate in value. Future results and past performance have little to do with each other.
No One Can Predict the Future
To understand this, we need to think hard about random chance. There are many thousands of people making their living picking stocks, in one way or another, and trying to get you to buy what they sell. It stands to reason that a few of them would be doing extremely well at any one time. A smaller number still would logically have a pretty long string of winnings. And those doing well have very strong incentives to make sure the investing public knows how well they are doing. This small group of winners, though, sits among a vast pool of folks who are having less success. Take a look at the mutual fund page of the Wall Street Journal. If I told you that one of those mutual funds was going to have a truly extraordinary year but didn’t identify which one, the information would be essentially useless to you—there are thousands of them. And last year’s big winner is no more likely to be next year’s champion than any of the others.
It is foolish to invest in a stock or mutual fund because it did well recently. Funds that claim to be among the top performers in a given category want you to assume such success is likely to be repeated. That assumption would be mistaken. If the fund is among the top performers once again, it will be primarily the result of random chance. There is little or no causal effect.
Past performance is not a useful indicator of where investments like stocks, bonds, and mutual funds will go in the future. Knowing what they did yesterday will not help you guess where they will be tomorrow. And there are no bargains to be found. The market already knows what you know and what your financial advisor knows and has taken that information into account.
Economists can show that past performance offers us very little useful information about what is to come. Our most admired scholars have no more insight into next year’s big winners than anyone else—because nobody can know based on past performance.
Chapter Summary
For the most part, past performance is of little use to investors.
A great deal of performance is a reflection of random chance.
Even the most brilliant economists don’t know which investments will do well in the coming year and, thus, it is a certainty that no stockbroker or TV guy does either.
Chapter 28
The Concept of Present Value
A dollar today is worth more than a dollar one year from now. That probably sounds like a recitation of common sense rather than an important concept in understanding finance. It turns out, though, that it is a big deal when we seek to understand many of the investment choices we are faced with.
In its simplest form, we understand present value by thinking of putting $100 into a savings account at the bank. Let us suppose that the bank pays 1 percent interest on such accounts. If you put $100 in today, one year from now you will have $101. If you will permit some rounding to keep the math simple, in our example $100 next year is worth only $99 today. So if someone asked you how much you would be willing to pay for $100 a year from now, you would reply, “No more than $99.”
As you may have intuited, the present value of a future amount is dependent on what interest rate is applied. Indeed, over long periods, different interest rates make huge differences in present-value calculations.
Here is the math, which I give you full permission to skip:
Calculating Present Value
PV = C/(1 + r)n
C = The amount of money you want to have at the end of the period
r = The interest rate
n = The number of periods
So to determine how much money you need to deposit today to have $1,000 in the bank a year from now at 5 percent interest, you calculate:
$1,000/(1 + 0.05) 1 = $952.40
A deposit of $952.40 today, earning 5 percent annual interest, will yield $1,000 at the end of the one-year period. At that interest rate, $1,000 a year from now is worth $952.40 today.
I encouraged you to skip the equation for three reasons. The first is that I know you really wanted me to exempt you from your old high school math. The second is that we all have access to present-value calculators that will do this math for us. The third and most important reason is that what is important to understand is the concept of present value.
Understanding what present value is all about can help us unravel some of the confusing puzzles in our investing lives. Here are some examples.
What Is Tax Deferral Worth?
Why is an Individual Retirement Account (IRA) so valuable? (Or any other tax-deferred retirement account, such as a 401(k) or 403(b) plan.) These plans are an incredibly good deal because they let you keep and invest money that would otherwise be paid to the IRS today. The future value of that money is far greater, and the tax deferral allows you to claim that future value. In other words, the government is making you an interest-free loan of the money you would ordinarily owe in tax today. You get to use that money (as investment capital) until the funds are removed from the retirement plan.
The same principle is at play with a 529 College Savings Plan. Be careful to note, though, that the greatest benefit of tax deferral comes from putting off paying taxes for long periods of time. If the time frame is shorter, such as the difference between today and when your elementary-schooler is in college, the future value is less. While the tax deferral is still valuable, it may not be so great as to offset any fees or added costs of the more expensive 529 programs.
Present Value and Life Insurance
Present value also helps us understand how life insurance works. How can the insurance company afford to insure a 25-year-old man for $1 million for 40 years if he pays premiums of $3,000 per year? If you simply add up $3,000 times 40 years you get $120,000. Won’t the poor insurance company go broke? Nope. If the man dies at age 65, the insurance company must pay his beneficiaries in future dollars, but each year it is collecting far more valuable present dollars. The insurance company invests all the money it takes in and is able to pay claims with plenty to spare. And if the man lives past 65, the insurance company does even better.
Present Value and Money-Back Guarantees
Variable annuity products (and their cousins that are sold by insurance and investment companies under a hundred different names) offer a seemingly irresistible guarantee. If the investment choices within the product fail to grow your money, you are guaranteed your original investment back. You get the better of (1) investment growth or (2) your original money back. It would seem you cannot lose. Perhaps that explains why these terrible investments sell like hotcakes in the present economic climate.
How can the insurance companies do it? The answer, of course, can be understood using the concept of present value. Like insurance, the annuity product is being funded with valuable present dollars, and the guarantee will be paid off with less valuable future dollars. For example, let’s suppose the insurance company is able to achieve a 10 percent annual return on the money they receive under the contract. Let us further assume that it must pay off on the guarantee 15 years after receiving the investment dollars. In this instance, the company would have been able to quadruple the money paid in. Thus, its guarantee would cost it only about a quarter of the value it received. To view it from the annuity buyer’s perspective, the money-back dollars received 15 years later, in a 10 percent interest rate environment, are worth only about a quarter of what the original pay-in dollars were worth. (Pardon me for rounding numbers.) In this example, what was billed as a full money-back guarantee starts to look more like getting a quarter of your money back.
Present Value and Comparing Investments
Comparing two investments can be hazardous if some of the dollars are in the pres
ent and some are counted at future value.
An example of this is my neighbor Irving. This good man will not sell his house at a loss. Rather, he insists on holding onto it until “the market comes back” and he can sell for more than he paid for it. The problem, you may realize, is that he is comparing present dollars with future dollars. So far, he has let the house sit empty for 10 years. Never mind the decay and slow breakdown of parts of the home, let’s just look at the financial numbers.
Let’s assume that Irving sells his house tomorrow for the same amount he paid for it 10 years ago. In his mind, he has broken even. With an understanding of present value, though, we can see he has not done nearly that well. Rather, he bought the place with 10-years-ago dollars and is being paid back in today’s dollars. If the interest rate applied is 7.2 percent (chosen, in part, because the “rule of 72” makes the calculation so easy), the value of his house has doubled in that time. Accordingly, if he sells it today for what he paid for it 10 years ago, we can say that he has gotten back only half of what he paid for the house.
Whenever the returns on two investments are compared, accuracy requires that you account for the time value of money. A dollar today is always worth more than a dollar in the future. Unless you figure out just how much more, comparisons across different time periods will be very misleading. Beware of those people who use deceptive comparisons deliberately because they do not want you to clearly understand what they may be selling.
Chapter Summary
The value of money in the future is less than what that same amount of money is worth today.
Calculating present value can help you compare different investments.
This concept is especially helpful in thinking about tax deferral, insurance products, annuity products, and any sort of financial guarantees.
Beware of sharpsters offering misleading comparisons.
Chapter 29
There Is Really Only One Interest Rate
The statement “there is really only one interest rate” sounds absurd on its face. How can economists say that when we can look in the paper and see dozens of different interest rates listed? Here is what they mean.
Higher Rates Reflect Higher Levels of Risk
At any given time, there is only one rate of interest for lending your money with total safety. All the other rates are different levels of risk premium. In other words, lenders charge a higher rate to borrowers that are less safe to compensate for the increased risk. If we think about it in the context of the previous chapters, this makes perfect sense. If there was more than one interest rate for totally safe debt, I could easily borrow money at the lower rate and then lend it out at the higher one—as could lots of other clever folks. Eventually, the borrowing of the one and the lending to the other would force rates to converge. Thus, it is the rational market that is causing rates to be the same for an equivalent level of risk.
When an investor buys a bond (which is to say, lends her money to the bond issuer), there are two kinds of risks. The first is default risk and the second is interest rate risk. Let’s examine each one in turn.
Default risk is the danger that the borrower will go bankrupt or in some other way not pay back the loan. Clearly, this is of huge concern to a lender. If you buy bonds, either directly or through a mutual fund or pension plan, you are such a lender, and the concerns are yours, too. Some borrowers are considered extremely unlikely to default. As a powerful example, the United States is thought to be incapable of doing so. Some companies and countries, though, could default. Indeed, many companies go into bankruptcy every year. Some countries decide not to pay their debts every once in a while. And Mom’s old Uncle Willy hasn’t made a payment on his loan from Grandma in over 30 years. The financial world has rating services that try to assess the relative risk of different companies’ bonds and other debt instruments. Moody’s and Standard & Poor’s are among the best known. As you can guess, bonds that are judged more likely to default, and thus have lower ratings, must pay higher interest rates to convince anyone to invest in them.
The second risk with a bond is called interest rate risk. It is the danger that if interest rates rise, an older bond will be worth less. This is because the same money that bought the bond yielding, say, 5 percent last year could now buy the equivalent bond yielding 6 percent. Thus, it stands to reason that the bond bought last year yielding 5 percent now has a lower market value. (Of course, interest rates could also fall. The converse of interest rate risk is the potential for gains when rates drop.) The longer the duration (how long until you get your money back) of the bond, the greater this effect. Thus, longer bonds carry more interest rate risk than shorter bonds. (Indeed, longer bonds usually have greater default risk as well, since the longer period of borrowing means there is more danger that it will not be paid back in full.) It follows that if longer bonds carry greater risks, investors will demand a greater return for buying them.
Occasionally, the likelihood of falling interest rates seems so great that longer bonds have lower interest rates than shorter bonds. This is referred to as an inverted yield curve. It doesn’t occur all that often, though; after all, economists know that nobody can reliably predict future interest rates.
There is also currency risk with bonds that are denominated in a monetary system other than your own (for instance, a U.S. investor buying Japanese bonds denominated in yen). To redeem your investment, you must sell the bond and then convert the yen back into dollars. If the dollar rises or the yen falls, your investment will have lost money. Of course, the dollar may fall or the yen rise, in which case you will make extra profit on the currency appreciation. In any case, though, purchasing bonds using currency other than your own involves taking on an additional risk beyond that of the bond alone.
Money lent to the United States (by buying Treasury bonds, notes, and bills) is considered to be the safest debt in the world with regard to default risk. The United States is one country, the financial world unanimously agrees, that will always pay its debts. (One of the biggest reasons for this belief is that the United States figuratively owns printing presses. It can print U.S. dollars, the strongest currency in the world.) Thus, we might say that the interest rate for lending money to the United States for one day is the world’s true interest rate.
The practical consequence is this: You cannot get a higher yield than the one true interest rate without taking on more risk. Savers and investors who don’t understand this are in danger of holding far more risk in their portfolios than is appropriate or that they would be comfortable with if they were aware of it. Parts of the financial services industry seek to take advantage of people’s misunderstanding by doing a hard sell on junk bonds, long-term bonds, and even emerging market bonds. Many clients, over the years, have complained about the return on short-term Treasury bonds and money market funds. On occasion, they propose exchanging into a higher yielding debt instrument by stating that “such and such bond fund is paying twice as much.” Then we have a long talk. . . .
Risky Investments Involve a Danger of Losing Much of Your Principal
A bond with an effective interest rate far higher than what other bonds are paying reflects a much greater level of risk. Those high-yield bond funds are invested primarily in junk bonds, which come by that name honestly. Junk bonds are debt securities that have very low ratings—in other words, bonds that have a very significant risk of default. Emerging market bonds are the debt of countries (and companies in them) with very weak or unstable economies—they are very risky! Even long-term U.S. Treasury bonds have a great deal of interest rate risk, particularly in a time of inflation or when interest rate increases are expected.
The risks are real. One client came to us after working with a stockbroker (although he called himself a financial consultant) with a portfolio full of junk. One bond, though, bore the name of a county in Pennsylvania. At first glance, it appeared to be municipal debt. On closer inspection, it turned out to be an industrial revenue bond that r
aised money for, and bore the risk of, a steel company in the county. That company is now bankrupt, and those bonds are worthless. The lesson is clear: You can lose a great deal of your principal investing in high-risk bonds.
An investor must understand that bonds, like stocks, carry with them different levels of risk. The higher the interest rate offered, the higher the risk. Interest rates are a function of the one true interest rate—what you would receive to lend money to the U.S. government for a very short period.
Financial markets do not afford possibilities for receiving a higher interest rate from one borrower to the next without taking on greater risk. Any appearance of such opportunity is an illusion. Furthermore, the additional danger can be difficult to analyze. While the various rating agencies work hard to assess the risks of various bonds, their conclusions are often wrong. Nobody can ever know with certainty about the future of interest rates, currencies, or inflation. Anybody who thinks that stocks are risky and bonds are safe is laboring under a mistaken impression: There is plenty of risk in bonds, and various bonds have dramatically different risk profiles.
Chapter Summary
At any given time, there is only one interest rate for lending your money in total safety.
Higher interest rates reflect increased risk.
Investments in bonds that pay higher than expected dividends entail substantial danger that you could lose a great deal of your principal.
Bonds are not per se safer. Risky bonds can be just as perilous as risky stocks.
Negotiating Your Investments Page 23