Why we don't need a crystal ball

Nate Crosby |

Weekly wisdom

“Have you ever been able to get directions to a destination on Google Maps without having to enter your current position first?”   -Joseph Brown

 

If the place you are in life is not where you want to be, the first step is to understand where you are and how you got there.  In our planning meetings we often talk about “reverse engineering” our desired retirement income.  By knowing where we are, and where we want to be, we can create a plan that will accomplish the goal – directions, in a sense, to success as we define it.

 

A Strategy for All Times

    Earlier this week the Federal Reserve indicated that it would accelerate the tapering of its bond purchases.  In plain English this means it will slow the pace at which money is injected into our economy.  The sharp increase in money supply over the past two years has led to inflation in the prices of goods we buy.  To combat this the Federal Reserve plans to slow down the purchase of bonds and begin raising interest rates in 2022.  They hinted at potentially three rate increases in 2022. Stocks rallied on the news.  Let me explain why I think stocks rallied and why they then sold off in the following days.

    Stocks rallied upon the news likely because even three rate increases would only put the Federal Fund Rate at around 1%. That is still historically very low and cheap money.  However, there is more going on than just interest increases.  By tapering the bond purchases, the Federal Reserve will begin turning the shut-off valve on the stream of newly printed money. The last time the Federal Reserve attempted to do this it didn’t last very long.  What will happen this time?   Time will tell.

     As the economy changes, different types of investments come in and out of favor. Every day someone asks me, “Nate, what do you think about……(insert an asset class).  Stocks, bonds, real estate, gold…they all have a place.  If your strategy is appropriate for your time horizon those questions won’t come up. 

 Long-Term Accounts-If I have multiple decades ahead of me, most of the account will be invested in stocks because they have a long history of outpacing inflation.  Since I will not access the money in my long-term accounts for several decades, I don’t worry about what I think stocks will do in the next six months.  I’m confident in the next 10 years they will be higher and will have outpaced inflation, meaning my future assets have more purchasing power than they do today. Volatility in this account is a mirage and doesn’t bother me the least.

Mid-term Accounts-These are often brokerage or non-qualified accounts.  These are accounts that have money that I’d like to grow competitively, and they may very well supplement my retirement, but I also want access to the money incase an opportunity comes up.  For this reason, I like these accounts to display a bit more stability. I love our “All Weather Portfolio” for mid-term type of accounts.  It consists of roughly 30% large cap stocks, a laddered investment grade bond strategy to protect against interest rate changes and hedge investments like gold. While the All Weather Portfolio does fluctuate and can lose value, historically it has been a solid performer with it’s worst year being -3.95% (2008) and its best year being 18.33%.  The balance in this account means I don’t get too overly excited about much.  Historically it has displayed low volatility with competitive returns. To learn more about our All Weather Portfolio contact our office.

Short-term- I define short-term accounts as accounts which I may have to access in less than one year.  These accounts typically have no to low stock exposure and are invested in cash or short-term investment grade bonds.  While these accounts will display low volatility, they are not a solution for growing money over multiple years as their real return (return minus inflation) will likely be negative.

     My daughter would tell you there is an outfit for all occasions, but I prefer a portfolio for all time horizons.  If you make sure the strategy is appropriate for your time horizon you won't have to play the guessing game what stocks and other investments will do tomorrow. 

 

Cheaper to Continue Coverage

Recently a client who was traveling abroad for a month called to see if it made sense to cancel their auto insurance policy for the month.  In that short of time, it would be financially detrimental to cancel the policy.  Insurance companies have access to a vast database of information, within that database is information on lapses in coverage.  The insurance company will charge more to a driver who has had a lapse in coverage in the past 6 months.  Their actuarial numbers suggest drivers who let their policy lapse tend to have more claims or are not in a financial situation to continue coverage.  Additionally, if your car could possibly be driven by someone you will want to keep liability coverage on the vehicle as the risk of a lawsuit far outweighs any slight gain you may make in saving one month of premium.  Contact our office if you have any questions about insurance coverage, asset protection or are seeking quotes.

 

Is CPI an Accurate Depiction of Inflation? Part 1

     Consider this a continuation of last week's newsletter, you can read my piece on new CPI data here. To not bombard you with too much technical speak I decided to break it up into two separate articles and we will discuss CPI on an upcoming episode of Dynamic Growth. 

     CPI (Consumer Price Index) is a basket of goods that is developed by the BLS (Bureau of Labor Statistics) to track the increase in prices for consumer goods. This is the stated number that is read in headlines and is typically the standard when people discuss the “rate” of inflation. This number is also typically stated in salary negotiations, in the meeting you would likely say “I'm scheduled for a 2-3% raise, but inflation is at 5% so I need to be compensated with a 5% raise”. If the employer does not compensate you with the 5% raise you are effectively making less money than you were in the previous year because your nominal wages measured in dollars may have gone up 2-3% but everything around you got more expensive by 5% so you have less purchasing power but not necessarily fewer dollar bills in your bank account. It is my belief and the belief of others that CPI does a poor job at measuring your purchasing power and is drastically oversimplification as well as an underestimation for tracking purchasing power over time.

     To begin with the issue of hedonic adjustments, hedonic adjustments basically attempt to capture the difference between a change and price and a change of standard of living associated with a newer version of the item that is purchased. For instance, let's say a flat-screen TV is in the basket of goods, and the price for flat-screen TVs increases by 10% but they go from being 50lbs and a bad resolution to now being 10lbs and have ultra-high 4k resolution. Everybody would consider the added benefit of better technology improving your standard of living more than the increase in price “decreased” your standard of living. In the CPI even though the price went up, it would denote that as a decrease because of a hedonic adjustment, you got more utility per dollar than you did the year before. 

The problem with hedonic adjustment is, for one it's very subjective. How could anybody quantify utility changes on 80,000 items across 200 categories? Even with the most technical statistical analysis, you can't control for every exogenous factor and there is likely bias in the data. I encourage you to be the judge yourself, click here and you can judge if the items that received a hedonic adjustment have improved your life. 

     Another issue with hedonic adjustment is that it's only reflected in the price and quality of the item. Inflation impacts other areas that may negatively impact your standard of living as well. A rhetorical question: should there be a broad negative hedonic adjustment for delays in shipping in 2021? To me, it seems like there are some items that have not increased in price, but there are still long delays on when you can receive the item which would be a net negative that isn't shown in the CPI. Or what if the item you normally choose hasn't been in stock, so you have to switch to another item that is of inferior quality but prices for both items have not changed. That would negatively impact the standard of living yet not be reflected in CPI.

     Another reason I believe CPI underestimates the effect of inflation is that it measures a basket of consumer goods, but that isn't the only thing people buy and arguably isn't the most important thing people buy. Let's say for instance your goal is to become extremely wealthy, then your basket of goods is dramatically different from somebody who has no interest in becoming wealthy. People have different preferences and should be allowed/encouraged to have different preferences; this is not a problem that some people don't want to become wealthy but to not acknowledge it seems like a misstep.

    The categories measured by the CPI are food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Let's take housing for example… housing where exactly? Let's say for instance purely hypothetically you were moving from Orrville, OH to let's say Denver CO. In 2020-2021 everybody knows somebody that has bought, sold, refinanced their house and can tell you that the real estate market is red hot. People are shocked at the prices their house is selling for and are shocked at what a house they are going to buy is selling for. The price increases are much higher in an in-demand area like Denver compared to Orrville Ohio. Let's say you are going from renting a house to purchasing a house, it is significantly more expensive to do this in 2021 than in 2020. The reason for bringing this up is that CPI is inaccurate because it gives an overly simplistic view of a “basket” of goods. Everybody’s basket is different and each person’s basket is supposed to change every year if the standard of living is truly increasing. Simply measuring the percent change of a basket of goods gives very little information about the change in the standard of living, and it potentially becomes dangerous if you develop policy around overly simplistic data. 

Next week I will discuss CPI’s failures because it provides a picture of past inflation and also does not account for asset inflation for those who want to become wealthy or ascend the economic ladder.

It should be noted that this article was written by Derek Ballinger who is moving from Orrville, OH to Denver, Co. This article was not intended to slight the fine citizens of Orrville, but rather a simple factual comparison of differences in property prices in different geographical regions. 😊-Nate

 

Disclaimer: Crosby Advisory Group is a registered investment advisor in Ohio and Florida.  Insurance products are sold through NMD Insurance. This newsletter is for informational purposes and does not replace direct individual consultation. Investing involves risk including the potential loss of principal. Investments mentioned in this newsletter may be owned by Crosby Advisory Group employees.

 

Facebook: Crosby Advisory Facebook         Instagram: Crosby Advisory Instagram      Youtube: Crosby Advisory Youtube