What Chimpanzees Can Teach Us about Convertible Bonds

By Dennis Miller

In a renewed commitment to finally learn Spanish, one of my colleagues spent quite a bit of time this week awkwardly saying, “Qué es eso?” into the headset Rosetta Stone provides with its language learning programs. Translation: “What’s that?”

Here in the US, the 10,000 or so people reaching retirement age each day often find themselves asking the same question—though maybe not out loud—when advisors use terms of art or casually mention sophisticated investment options. What’s that? Most of these folks didn’t earn their living in the financial services sector, so they don’t speak the language—nor should they feel embarrassed about it.

That said, no one—particularly risk-adverse retirees—should ever invest in something they don’t understand. So let me add one more type of investment to your “I know about that” toolbox: convertible bonds. Despite their obscurity, they’re not the least bit complicated.
Put simply, convertible bonds:

• have, as a rule of thumb, two-thirds of the upside of common stock and one-third of the downside; and
• can be an excellent way to diversify your portfolio.

Convertible bonds are bonds an investor (let’s say it’s you) can convert into common stock of the issuing company under certain circumstances. Imagine, for example, that Rosetta Stone wants to finance a new project—maybe it’s doing R&D on how to teach humans to speak the language of chimpanzees (hey, this is purely hypothetical). So Rosetta Stone (RST), which has a current stock price of about $8.80, issues a convertible bond and sets the conversion rate so that it’s not profitable to convert your bonds unless the stock price rises, say to $11.

Then more people start to feel a burning need to learn Spanish—or Mandarin, or Farsi—and RST’s price passes $11. At that point, you can convert your bonds into shares of RST worth more than the stream of payments from the bond alone. You own bonds with upside potential.

If RST’s price goes up, the value of your convertible bond goes with it. If it goes down, the discounted stream of underlying cash flows (the bonds’ coupon payments plus return of the principal at maturity) act as a price floor.

Now imagine that speaking multiple languages goes out of vogue, and instead of rising past $11.00, RST drops to $4.00. You’ll still receive interest and principal—meaning your convertible bonds can’t be worth less than those payments.

Of course, there’s always the threat of default. Say Rosetta Stone goes bankrupt for one reason or another (maybe it overspent on the chimp project, and it failed). The silver lining is that you’ll have a better chance of getting some money back than if you owned common stock.

What You Trade for the Option to Convert

As with any investment, there are trade offs: convertible bonds have slightly lower yields. The company pays a lower interest rate, and in exchange you have the option to convert your bonds. Also, convertible bonds often fall into the high yield/junk-bond category.

What’s more, it’s often only feasible for individuals to invest in convertible bonds through convertible bond funds. And you know what that means: fees. With an average expense ratio of 1.25%, fund managers have to get past that hurdle before they can start making you money.

With that, why would anyone want to buy a convertible bond fund? In a word, diversification. We hold one convertible bond fund in our retirement-specific portfolio for downside protection and the diversification it provides. With a gross expense ratio of 0.4% and one-third of its holdings in investment-grade bonds, this particular fund avoids the major pitfalls of most convertible bond funds.

Less common investments are worth knowing about, but understanding them doesn’t mean you should jump in whole hog—particularly when you’re investing your retirement nest egg. And that’s our focus at Miller’s Money: plain-English financial education and smart retirement investing. Read our free weekly e-letter, Miller’s Money Weekly every Thursday by signing up here.

The article What Chimpanzees Can Teach Us about Convertible Bonds was originally published at millers money

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How You Can Play to Win When Market Makers Are Calling the Shots

By Dennis Miller

The American Legion sponsored a carnival every summer when I was a young lad. My dad was a legionnaire, so each year I had a job. Beginning at age 12, I hauled soft drinks and food to the various concession booths well into the night, which probably violated some labor laws.

Dad warned me about the carnival barkers, telling me to never play games where you try to win a giant teddy bear. They were rigged, he said, and no one ever wins—“So don’t waste your money.”

I questioned Dad’s advice when I saw other boys carrying giant teddy bears to the delight of cute teenage girls. So I quietly watched some of the games. Some people won silly goldfish, but few won the giant teddy bear.

Then I befriended some of the carnival workers and told them what my dad had said. To my surprise, they took his remarks personally. Each one stepped outside his booth to demonstrate just how easy it was to win by pinging ducks or knocking over little stuffed clowns with ease. The guy who shot the BBs told me to ignore the rear sights because they were off center. He also told me exactly where to hit the moving duck to make it go down. Ping, ping, ping! He knocked them down one after another.

He argued that the game was not rigged; if it were, eventually no one would play. But the odds were tilted toward those who practiced. I tried it, lost a dollar (one hour’s pay), and realized it was cheaper to buy the teddy bear than to spend the money to learn how to win consistently.

I think about those carnival games often, when friends and readers ask about market makers, brokers who help keep markets liquid and profit in the process. Do they just hold a unique position, or is something fishy going on?

24 Men Make History Under a Buttonwood Tree

Let’s take a step back to answer that question. The history of what would later become the New York Stock Exchange began in 1792, when 24 brokers and merchants signed the Buttonwood Agreement outside 68 Wall Street—under a buttonwood tree, of course.

The securities market grew, particularly in the aftermath of the War of 1812, and in 1817, a group of brokers established the New York Stock & Exchange Board (NYS&EB) at 40 Wall Street. At that time, stocks were traded in a “call market” during one morning and one afternoon trading session each day. A call market is exactly what it sounds like: a list of stocks was read aloud as brokers traded each in turn.

Whatever the benefits of this seemingly orderly system, it did not foster liquidity, and in 1871 the exchange, which had been rechristened as the New York Stock Exchange (NYSE) in 1863, began trading stocks continually throughout the day. Under the new system, brokers dealing in one stock stayed put at a set location on the trading floor. This was the birth of the specialist.

Designated Market Makers (DMMs), who are assigned to various securities listed on the exchange, have since replaced specialists. DMMs are one type of market marker, which are broker-dealers who streamline trading and make markets more liquid by posting bid and ask prices and maintaining inventories of specific shares.

Since the NYSE is an auction-based market, where traders meet in-person on the floor of the exchange, the DMMs, who represent firms, maintain a physical presence on the floor. Unlike the NYSE, the National Association of Securities Dealers Automated Quotations (NASDAQ) is an exclusively electronic exchange. Plus, it has approximately 300 competing market makers (not physically present at the exchange). Stocks listed on the Nasdaq have an average of 14 market makers per stock, and they are all required to post firm bid and ask prices.

Why Market Makers Matter to Retail Investors

You may be thinking, “That’s great, but why should any of this matter to me?” Well, because the existence of market makers should affect a few of your trading habits—for thinly traded stocks in particular.

Trades are not automatically executed via magical computer elves. When you place a buy or sell order (likely via the Internet), your broker can choose how to execute your trade.

When you place an order for a stock listed on the NYSE or some other exchange, your broker can pass that order on to that particular exchange, or it can send it to another exchange, such as a regional exchange. However, your broker also has the option of sending your order to a third market maker, a firm ready to buy and sell at a publicly quoted price. It’s worthwhile to note that some market makers actually pay brokers to route orders their way—say, a about penny or so per share.

On the other hand, your broker will likely send your order for a stock traded on the Nasdaq, an over-the-counter market, to one of the competing Nasdaq market makers.

And of course, your broker can always fill your order out of its own inventory in order to make money on the spread—the difference between the purchase and sale prices. Or it can send your order (limit orders in particular), to an electronic communications network (ENC), where buy and sell orders of the same price are automatically matched.

With that in mind, there are two steps you should take to make the most of your trades:

Always place orders at limit prices, as opposed to market prices.

As of Tuesday, the price for Coca-Cola is a bid of $41.23, and the ask price is $41.24; the spread is a penny.

If you put in an order to buy at $41.24, a market maker could buy at $41.23 and sell it to you for $41.24, pocketing a penny per share. If you buy 100 shares, they make $1.00. That is their profit for making the market.

If you put an order in at “market,” it can cost you a lot more. The depth of the current bids goes all the way down to buy at $34.01 (there are a couple of orders to buy KO for $22.12 and even one as low as $3.00, but the probability they will be filled is negligible), and the sell side goes up to $53.68 (again, there is one order to sell KO at $88 but this investor won’t find a counterparty in his right mind that would take it). That means there are currently orders sitting with the market maker to be executed at those respective prices.

If the market maker sees a market order, he would buy the stock at $41.23 and sell it at a much higher price. A market order is basically a license for the market maker to steal. You want the best price for any stock you’re trading; entering a market order will ensure you don’t get it.

The spreads for thinly traded stocks are generally larger. If you want to buy, you can offer a lower price than the bid, or perhaps a penny higher. If you want to trade several thousand shares, consider doing so in small tranches, so you don’t show your full hand to the market maker.

Know the role market makers play when executing stop losses.

For the Miller's Money Forever portfolio we generally set a trailing stop loss when we buy a stock. Entering a stop loss order with your broker will automatically generate a sell order should the stock drop to that number. A market maker can see that number and may drop down to buy your stock at the low price and then resell it for a profit.

As a practical matter, I set stop losses for big companies like Coca-Cola that trade millions of shares per day. The stop loss was there for a reason, and I don’t want to risk the price dropping further before I can sell it.

Some pundits think you should never enter a stop loss with your broker. They prefer another method: a stop loss alert, which many brokerage firms offer. They notify you through an email or text message if the stock drops to the stop loss price, and then you can go to your computer and enter the sell order. We always use the alert for thinly traded stocks, so we’re less vulnerable to an aggressive market maker.

If you are concerned about showing your hand to the market maker, by all means, use a stop loss alert. If you think the risk associated with stop losses is minimal for high-volume stocks, you may want to use both stop losses and stop loss alerts, depending on the stock.

Whether any of this means the market is “rigged,” I’ll leave to those $500-per-hour lawyers to hash out. This is the game we’re playing, so it’s critical to understand the rules, whether we like them or not.

Whether you’re a retail investor or just a guy shooting at moving ducks at a carnival, you need knowledge and skills to succeed. My free weekly missive, Miller’s Money Weekly, exists for that very reason. We provide retirement investors with the education and tools essential for a rich retirement. Receive your complimentary copy each Thursday by signing up here.

The article How You Can Play to Win When Market Makers Are Calling the Shots was originally published at Millers Money

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Retirement Investing and Kitchen Table Economics

By Dennis Miller

What is it about retirement that causes confident, successful businessmen and women to lose that edge when they invest their own life savings? Many otherwise dynamic people become virtually impotent in the face of retirement investing. I have many friends who were very effective in business—folks who made sound decisions affecting how millions upon millions of dollars were spent. They would gather the facts, make a plan, and make the right call with confidence. Why was it so taxing for these same friends to manage their personal retirement accounts?


I’m a staunch advocate for gathering around the kitchen table to hash out problems and pass on life lessons. It’s where we gathered as a family to open our mail, pay the bills, and teach (and worry about) our children. I might even say that everything we needed to teach our family about economics, we taught at that kitchen table.

The secret is there is no secret. Investment gurus, stockbrokers, and talking heads like to use fancy words to dazzle. Many would have you believe their university or Wall Street pedigrees give them investing powers outside of your reach. Though many do have a little more knowledge or a little more experience, there is no need to be intimidated by the mystique.

Why? Because you already know most of what you need to know. The underlying principles for protecting and growing wealth during retirement are the same principles that allowed you to make and save that money in the first place.

When former Federal Reserve chairman Alan Greenspan would talk to Congress, many bright people would look at each other and think, “What the hell did he say?” If folks like Greenspan are so darn smart, why couldn’t they predict or prevent the Internet or real estate boom and bust? Why can’t they speak plainly? Don’t let anyone’s “elite” status overshadow your own common sense.

For the last few years, the Federal Reserve has been printing a 100 year supply of money annually. No one needs a PhD in economics to grasp the potential for high inflation. A little knowledge of history and a bit of common sense will tell you where we’re headed.

The key to using kitchen-table economics in retirement is to apply the same fact finding and research skills that made you successful in business. If you are uncomfortable making an investment decision, continue to educate yourself until you are. Of course, it’s sensible to take in input and ideas from experts. Just don’t get caught thinking they have any magic bullets.

If you ask four people to define “rich,” you would likely get four different answers. As we move into retirement, the definition tends to be more practical and realistic. “Rich” is enough money to live comfortably without countless hours of financial worry. It’s also a feeling of pride in the lifetime of work that built your nest egg and an appreciation for each and every trip you get around the sun.

How much do you have; how much do you need to earn to supplement your retirement income; and, how can you invest safely to reach that goal? Retirement investing is no more complicated than that. Simply put, it’s living within your means and protecting what you have.

If I could shout one piece of encouragement to retirees, it would be: Don’t let the fear of losing money immobilize you! Doing nothing can be just as dangerous as risking too much on a speculative or even downright foolish investment.

You may recall the old adage about the banker who never made a loan because he was afraid he might lose money. When the bank went out of business, he claimed it wasn’t his fault. After all, he never made a bad loan during his tenure.

To make your retirement money last, you have to take on some risk. There are, however, proven ways to limit that risk to manageable doses: sector, geographical, and political diversification, trailing stop losses—the list goes on. Good investors will lose money from time to time and learn from their mistakes. You just need to learn and make the right judgment call more often than not.

Don’t fret when others brag about how well they’re doing. Each year financial newsletters, mutual funds, and investment managers like to boast about how much money they’ve made their clients. Accountability is a good thing; we’re certainly proud of our own track record.

Though, when I see the list of top-performing funds ranked by the amount of annual return, my first questions are: How much did they risk to get there? Have they performed that well consistently? How much of those profits were eaten in fees?

Some mutual funds occasionally produce nice gains for their shareholders. I, however, would put my money on the well educated grandfather investing from his kitchen table in Iowa any day of the week. Why? A recent report indicated that 78% of all US domestic equity funds were outperformed by their benchmarks during the past three years. Large caps were worse, with 86% of falling short of their benchmarks.
Benchmarks are the indices in the sectors funds specialize in, respectively. In short, there are countless statistics indicating that you can invest just as well as a fund manager.

Those numbers should embolden you, not frighten you. I shared them to keep things in perspective. There is no magic wizardry, secret code, or special knowledge. All investors gather facts, make an evaluation, and then allocate some money based on what they think the future will bring. Those are skills that can be honed through education and experience by smart folks sitting at their kitchen tables or in their home offices.

I’m happy to report that the most frequent comment we receive is that our newsletter explains investments in plain English. There’s a reason for that: the investments well suited for a conservative investor’s retirement portfolio are not that complicated.

You can overcome retirement impotence. The best way to build your confidence is to learn ways to invest safely. We think teaching our premium subscribers about protective mechanisms like asset allocation, diversification, position limits, trailing stop losses, and internationalization is just as important as the individual picks in the Money Forever portfolio. If you’d like to learn more too, sign up for a no-risk trial subscription today by clicking here.

The article Kitchen Table Economics was originally published at Millers Money

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Not All Debt Is Created Equal

By Dennis Miller

Optimal diversification: We all want it. Diversification is, after all, the holy grail of portfolio management. Our senior research analyst Andrey Dashkov has said that many times before, and he echoes that refrain in his editorial guest spot below.

A brief note before I hand over the reins to Andrey. The last time the market tanked, many of my friends suffered huge losses. They all thought their portfolios were well diversified. Many held several mutual funds and thought their plans were foolproof. Sad to say, those funds dropped in tandem with the rapidly falling market. Our readers need not suffer a similar fate.

Enter Andrey, who’s here to explain what optimal diversification is and to share concrete tools for implementing it in your own portfolio.

Take it away, Andrey…

Floating-Rate Funds Bolster Diversification

By Andrey Dashkov
Floating rate funds as an investment class are a good diversifier for a portfolio that includes stocks, bonds, and other types of investments. Here’s a bit of data to back that claim.

The chart below shows the correlation of floating rate benchmark to various subsets of the debt universe.
As a reminder, correlation is a measure of how two assets move in relation to each other. This relationship is usually measured by a correlation coefficient that ranges from -1 to +1. A coefficient of +1 says the two securities or asset types move in lockstep. A coefficient of -1 means they move in opposite directions. When one goes up, the other goes down. A correlation coefficient of 0 means they aren’t related at all and move independently.

Why Correlation Matters

 

Correlation matters because it helps to diversify your portfolio. If all securities in a portfolio are perfectly correlated and move in the same direction, we are, strictly speaking, screwed or elated. They’ll all move up or down together. When they win, they win big; and when they fall, they fall spectacularly. The risk is enormous.

Our goal is to create a portfolio where securities are not totally correlated. If one goes up or down, the others won’t do the same thing. This helps keep the whole portfolio afloat.

As Dennis mentioned, diversification is the holy grail of portfolio management. We based our Bulletproof strategy on it precisely because it provides safety under any economic scenario. If inflation hits, some stocks will go up, while others will go down or not react at all.

You want to hold stocks that behave differently. Our mantra is to avoid catastrophic losses in any investment under any scenario, and the Bulletproof strategy optimizes our odds of doing just that.

When “Weak” is Preferable

 

Now, a correlation coefficient may be calculated between stocks or whole investment classes. Stocks, various types of bonds, commodities—they all move in some relationship to one another. The relationship may be positive, negative, strong, weak, or nonexistent. To diversify successfully and make our portfolio robust, we need weak relationships. They make it more likely that if one group of investments moves, the others won’t, thereby keeping our whole portfolio afloat.

Now, back to our chart. It shows the correlation between investment types in relation to floating-rate funds of the sort we introduced into the Money Forever portfolio in January. For corporate high yield debt, for example, the correlation is +0.74. This means that in the past there was a strong likelihood that when the corporate high yield sector moved up or down, the floating rate sector moved in the same direction. You have to remember that correlation describes past events and can change over time. However, it’s a useful tool to look at how closely related investment types are.

I want to make three points with this chart:

• Floating-rate loans are closely connected to high-yield bonds. The debt itself is similar in nature: credit ratings of the companies issuing high-yield notes or borrowing at floating rates are close; both are risky (although floating-rate debt is less so, and recoveries in case of a default are higher).
  
  Floating-rate funds as an investment class are not as good a diversifier for a high-yield portfolio. They can, on the other hand, provide protection against rising interest rates. When they go up, the price of floating-rate instruments remains the same, while traditional debt instruments lose value to make up for the increase in yield.

• Notice that the correlation to the stock market is +0.44. If history is a guide, a falling market will have less effect on our floating-rate investment fund.
• The chart shows that floating-rate funds serve as an excellent diversifier for a portfolio that’s reasonably mixed and represents the overall US aggregate bond market. The correlation is close to zero: -0.03. This means that movements of the overall US bond market do not coincide with the movements of the floating rate universe.
  
  Imagine two people walking down a street, when one (the overall debt market) turns left, the other (floating rate funds) would stop, grab a quick pizza, get a message from his friend, catch a cab, and drive away. No relationship at all… at least, not in the observed time period. This is the diversification we’re looking for.

Floating rate funds provide a terrific diversification opportunity for our portfolio. This gives us safety, and that is the key takeaway.

Our Bulletproof income portfolio offers a number of options for diversification above and beyond what’s mentioned here. You can learn all about our Bulletproof Income – and the other reasons it’s such an important one for seniors and savers – here.

The article Not All Debt Is Created Equal was originally published at Millers Money


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10 Ways to Screw up Your Retirement

By Dennis Miller

There are many creative ways to screw up your retirement. Let me show you how it’s done.


Supporting adult children. My wife Jo and I have friends with an unmarried, unemployed daughter who had a child. Our friends adopted their grandchild and are now in their late sixties raising a kid in grade school. The same daughter had a second child, and they adopted that one too. When she announced she was pregnant a third time, they finally said, “Enough! It’s time for a third party adoption.”

Last time I spoke with them, their unemployed daughter and her boyfriend were living in their basement, neither contributing financially nor lifting a finger around the house. What began as a temporary bandage had become a permanent crutch. Our friends love their grandchildren; however, they’ve become bitter.

Jo and I also know of retirees who make their adult children’s car payments. I’m not talking about college-age kids; some of these “children” are close to 50. What’s their justification? “If we don’t make the payments, they won’t be able to go to work.” What I can’t grasp is how these adult children have iPads and iPhones, go on vacations, and do other cool things, but can’t seem to make their car payments.

You are not the family bank. There is generally a brief window of opportunity between children leaving the nest and retirement. Use it to stash away enough money to retire comfortably!

Ignore your health. I served on the reunion committee for my 50^th high school class reunion. We diligently tried to track down our classmates, but many had not lived long enough to RSVP to the party. The number of deaths from lung cancer and liver cancer were shocking. Many of those six feet under had been morbidly obese or simply never went to the doctor for checkups.

I know this sounds obvious, but your health choices really do affect how long and how well you live. Retiring only to become homebound because of health problems won’t be much fun.

Not keeping your retirement plan up to date. In the summer of 2013, the Employee Benefit Research Institute (EBRI) published a survey about low-interest-rate policies and their impact on both baby boomers and Generation Xers, who are following right behind. The bottom line (emphasis mine):

“Overall, 25-27 percent of baby boomers and Gen Xers who would have had adequate retirement income under return assumptions based on historical averages are simulated to end up running short of money in retirement if today’s historically low interest rates are assumed to be a permanent condition, assuming retirement income/wealth covers 100 percent of simulated retirement expense.”

It is a sad day when people who thought they’d saved enough realize they have not. Run your personal retirement projection annually to make sure you’re keeping up with the times. Otherwise you may have to work longer or step down your retirement lifestyle—drastically.

Thinking you can continue working as long as you wish. While age discrimination is illegal, you may not be able to work forever. If illness doesn’t push you out the door, your employer might downsize (we all know who goes first) or buy you out with a lucrative lump sum.

Many companies want older employees off the payroll because their healthcare costs are high; plus, they are often at the top of the salary scale. More than one employer has made the workplace so uncomfortable that an older employee felt he had to quit. Other employers will systematically build a case to terminate a senior employee with their legal team waiting in the wings to help.

Whatever the reason, you may have to stop working even if you enjoy your job, so plan for it.

Not increasing your rate of saving. A surefire way to end up short is to pay off a large-ticket item like your home mortgage and then continue spending that money every month. Start paying yourself instead! Don’t prioritize saving after it’s too late to benefit from years of compounded interest.

Continually taking equity out of your home. Too many of my friends have been duped into taking out additional equity when refinancing with a lower-interest mortgage. If you can secure a lower rate, use it to pay off your home off faster. When you have, start making those payments to your retirement account.

Retire with a substantial mortgage. The general rule of thumb is your mortgage payment should be no more than 20-25% of your income. If you retire and still have a mortgage, it might be tough to stay within those guidelines.

Taking out a reverse mortgage at a young age. Debt-laden baby boomers are taking out reverse mortgages at an increasingly younger age. Just read the HUD reports. Many have very little equity to begin with and use a reverse mortgage to stop their monthly bank payments for pennies in return.

Locking yourself into a fixed income at a young age is a great way to kiss your lifestyle goodbye. Many of these young boomers will find themselves wondering, “Why is there is so much life left at the end of my money?”

Putting your life savings into an annuity. While annuities have their place in a retirement portfolio, going all in is dangerous, particularly at a young age. After all, your monthly payment depends in part on your age.

I know folks who put their entire life savings into variable annuities. They thought they were buying a “pension plan” and would never have to worry again. The crash of 2008 slashed their monthly checks, and they have yet to recover. Retirement without worry is not that simple.

Thinking your employer’s retirement plan is all you need. The era of pensions is gasping its dying breath. We have many friends who retired from the airlines with sizable pensions. When those airlines filed for bankruptcy, their pensions shriveled. No industry is immune to this danger, so we all need a backup plan.

Government pensions are following suit. Just ask anyone who has worked for the city of Detroit! While the unions are fighting the city to preserve their pensions, an initial draft of the plan indicates underfunded pensions (estimated at $3.5 billion) may receive $0.25 on the dollar.

Don’t fall for the trap! If you work for the government, you still need to save for retirement. Contribute to your 457 plan or whatever breed of retirement account is available to you. The federal government has over $100 trillion in unfunded promises, and many state governments are woefully underfunded. That doesn’t mean your retirement has to be.

Reverse mortgages and annuities are often the undoing of many income investors and retirees. They can be used properly, however, if your situation or the opportunity fits with your needs. With all of the misinformation out there about these two products, we decided to pen two special reports to help you decide whether these are right for you. They are The Reverse Mortgage Guide and The Annuity Guide. Check out one – or both – today and learn where, if at all, these fit your needs.

The article 10 Ways to Screw up Your Retirement was originally published at Millers Money

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Learn to Trust Your Own Financial Judgment

By Dennis Miller

Keep this goal in mind as you read on: solid income and growth with minimal risk and no catastrophic losses. Just tuck it in the back of your head.


Subscriber Brian A. wrote sharing a common concern:

"I subscribe to your newsletter for the purpose of diversifying my portfolio as well as taking more responsibility for my investment future. … I look at the soaring S&P and Dow and wonder if both are appreciating from strong fundamentals, or from the Fed's easy money policy. … I listen to my broker who spouts out information of a resurgence of manufacturing coming back to US soil and (says) equities are the place to be for the near future. The other side spouts banks are insolvent, businesses are closing, (and) if it wasn't for the Fed propping things up we would be in a recession. Some say we are in a recession. I would like to see you devote an article on the subject of the 'don't worry be happy' crowd verses the 'doom and gloom' crowd."

Well, Brian, ask and ye shall receive. My recommendation, as always, is to look at the data, decide for yourself which camp you fall in—if either—and invest accordingly.

Folks who think things are turning around generally point to statistics published by the Congressional Budget Office (CBO). These numbers—the unemployment and inflation rates and the Consumer Price Index in particular—are used by the Federal Reserve to make or change policy. Those decisions affect the economy and the stock market.

If you swallow these numbers, you can point to a trend line going up. You may not think "happy days are here again," but you could make a case that we are headed in the right direction.

In contrast, the "gloom and doom" crowd point to data from statisticians like John Williams at Shadow Government Statistics, who make a good case against the accuracy of official government data. Williams' alternatives to the CPI, official inflation rate, and unemployment rate paint a much different picture.

Unemployment offers an easy example. When a person stops looking for work, the CBO no longer considers him unemployed. I guess that means if everyone just stopped looking, the unemployment problem would be solved.

Many in the gloom-and-doom crowd distrust the government and believe its statistics are produced for the benefit of politicians.

The gap between these two camps is wide. We recently published a special report called Bond Basics, offering safe ways to find yield in the current economy. Shortly after releasing our report, I attended a workshop with one of the top bond experts at a major brokerage firm. As I listened to his excellent presentation, I realized we agreed on many points: interest rates seem to be going up, the value of laddering and diversification, etc. We also agreed that investors (not traders) should buy bonds for one purpose: safe retirement income.

This speaker, however, recommended that baby boomers and retirees buying individual bonds only buy investment grade bonds and ladder them over an eight year period. Each year some would mature, and retirees would then replace them with other eight-year bonds. In a rising rate environment, retirees would eventually catch up he claimed. This expert mentioned inflation only once, remarking that it is "under control" and should remain low.

I went to the company's website and discovered that five year AAA bonds were paying 1.92%, and ten year bonds were paying 3.41%.

Then I went to Shadow Government Statistics. The official inflation rate as indicated by the CPI is hovering around 1.8%. However, using the same method used for calculating the CPI in 1990 (the government has changed the formula many times), the current rate comes to approximately 5.5%.
Now, it only makes sense to invest in long-term, high-quality bonds if you truly believe the government's CPI statistics. If, however, you that suspect inflation isn't quite so under control—even if you don't believe it's 5.5%—why would you invest in an eight-year bond that's virtually certain to lose to inflation?

The same logic applies to unemployment numbers. The official number is around 6.7% and coming down. Alternative calculations show a double digit unemployment rate that is rising. Should you invest heavily in stocks now? It depends again on whom you believe.

How should this affect your approach? If you hold the majority of your nest egg in cash or low-yield investments, you are losing ground to inflation. On the other hand, going all in the market if you are uncertain that the economy is improving could be equally disastrous.

A word of caution: do not let fear of getting it wrong immobilize you! It can be a very costly mistake. Keep learning and researching until you find investments you are comfortable with.

Let's look at the best- and worst-case scenarios with long term bonds. If you follow the advice of a bond salesman, you'll buy long-term corporate bonds. Ten year, AAA rated bonds currently yield around 3.41%. Assuming the bond trader is correct and inflation is not an issue, the best you could earn is 3.41%. Is that enough to get excited about when you factor in taxes and the risk of inflation?

In a recent article, I shared an example of a hypothetical investor who bought a $100,000, five-year, 6% CD on January 1, 1977. If he'd been in the 25% tax bracket, his account balance after interest would have been $124,600 at the end of five years. That's a 25.9% reduction in buying power because of high inflation during that five year period.

In that light, 3.41% does not look quite so appealing. Yes, inflation was particularly high during the Carter era, so apply a bit of common sense to the example. Nevertheless, what has caused inflation in the past? In general terms, governments spending money they don't have and printing money to make up the difference. Argentina is a timely example of this folly.

These concerns are why our research team and I paired up to produce Bond Basics. We think there are better risk and reward opportunities than long-term bonds available in today's market.

Investing in stocks is a different story. We cannot keep up with inflation and provide enough income to supplement retirement needs with bonds alone (unless you have a huge portfolio and are willing to buy higher-risk bonds). That's why our team picks stocks with surgical precision. We run them through our Five Point Balancing Test, recommend strict position limits, diversify across many sectors, and use appropriate stop losses.

Our premium publication is named Miller's Money Forever for good reason. We want to help you grow your nest egg in the safest possible manner under any market conditions. Neither the happy days nor the doomsday crowd can predict the future, so we prepare for all possibilities.

You've likely heard the refrain, "Inflation or deflation? Yes." It's a favorite of our friend John Mauldin. With that, baby boomers and retirees are forced to become kitchen-table economists and to sift through statistics that may or may not be accurate.

I haven't been shy about my opinion: I don't think the economy is improving, so retirees need to risk more than they would like in the market. That's why our Bulletproof Income strategy prepares for all market possibilities as safely as possible.

Whom should you believe? Well, is the person speaking trying to sell you something? Stockbrokers trying to garner your business tend to be optimistic about the economy. If someone is trying to sell gold or foreign currency investments, they are likely to cite a history of rising inflation and explain how their product can protect you. It doesn't mean either is wrong. And yes, the same point applies to the humble authors of investment newsletters.

At Miller's Money we share the reasoning behind every recommendation we make. We want our subscribers to know as much as we do about every pick—pros and cons. If you agree with our reasoning, act on our advice. If not, or if you have additional questions, ask us or sit tight for another pick. Never invest in something you don't understand or are uncomfortable with no matter who recommends it.

The bottom line is you have to read, learn, do your own research, and make your own judgments. Listen to all sides of any argument, and then do what you think is best.

What could be more important to baby boomers and retirees than protecting their money? Take the time necessary to teach yourself. In time you will become more comfortable trusting your own judgment. If you were savvy enough to make money, you are savvy enough to learn how to invest and protect it. Give yourself credit where it's due.


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The article Learn to Trust Your Own Financial Judgment was originally published at Millers Money.

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What Is Worse Than Being at Risk?

By Dennis Miller

You may have heard the old adage: “What is worse than being lost? Not knowing you are lost.” In that same vein: What is worse than being at risk? You guessed it! Not knowing you’re at risk. For many investors, portfolio diversification is just that. They think they are protected, only to find out later just how at risk they were.

Diversification is the holy grail of portfolio safety.

Many investors think they are diversified in every which way. They believe they are as protected as is reasonably possible. You may even count yourself among that group. If, however, you answer “yes” to any of the following questions, or if you are just getting started, I urge you to read on.

• Did your portfolio take a huge hit in the 2008 downturn?
• Was your portfolio streaking to new highs until the metals prices came down a couple years ago?
• Do oil price fluctuations have a major impact on your portfolio?
• When interest rates tanked in the fall of 2008, did a major portion of your bonds and CDs get called in?
• Are you nervous before each meeting of the Federal Reserve, wondering how much your portfolio will fluctuate depending on what they say?
• Has your portfolio grown but your buying power been reduced by inflation?
• Do you still have a tax loss carry forward from a stock you sold more than three years ago?

There are certain lessons most of us learn the hard way—through trial and error. But that can be very expensive. Ask anyone who has a loss carry forward and they will tell you that the government is your business partner when you are winning. When you are losing, you are on your own.

The old saying rings true here: “When the student is ready to learn, the teacher shall appear.” Sad to say, for many investors that happens after they have taken a huge hit and are trying to figure out how to prevent another one.

Alas, there is an easier way. Anyone who has tried to build and manage a nest egg will agree it is a long and tedious learning experience. The key is to get educated without losing too much money in the meantime.

Avoid Catastrophic Losses

The goal of diversification is to avoid catastrophic losses. In the past, we’ve mentioned correlation and shared an index related to our portfolio addition. The scale ranges from +1 to -1. If two things move in lockstep, their correlation rates a +1. If the price of oil goes up, as a general rule the price of oil stocks will also rise.

If the two things move in the opposite direction (a correlation of -1), we can also predict the results. If interest rates rise, long term bond prices will fall and generally so will the stocks of homebuilders. At the same time, a correlation of zero means there is no determinable relationship. If the price of high grade uranium goes up, more than likely it will not affect the market price of Coca Cola, ticker $KO, stock. So, your goal should be to minimize the net correlation of your portfolio so no single event can negatively impact it catastrophically.

General Market Trends

An investor with mutual funds invested in Large Cap, Mid Cap, and Small Cap stocks may think he is well diversified with investments in over 1,000 different companies. Ask anyone who owned a stable of stock mutual funds when the market tumbled in 2008 and they will tell you they learned a lesson.

Mr. Market is not known to be totally rational and many have lost money due to “guilt by association.” When the overall stock or bond market starts to fall, even the best managed businesses are not immune to some fallout. While the Federal Reserve has pumped trillions of dollars into the system, there is no guarantee the market will rebound as quickly as it has in the last five years. The market tanked during the Great Depression and it took 25 years to return to its previous high.

If you listen to champions of the Austrian business cycle theory, they will tell you the longer the artificial boom, the longer and more painful the eventual bust. Mr. Market can dish out some cruel punishment.
Diversification is indeed the holy grail, but there are some risks which diversification cannot mitigate entirely. No matter how hard you try to fortify your bunker, sooner or later we will learn of a bunker buster. There are times when minimizing the damage and avoiding the catastrophic loss is all anyone can do.

Sectors

Allocating too much of your portfolio to one sector can be dangerous. This is particularly true if a single event can happen that could give you little time to react. While no one predicted the events of September 11, people who held a lot of airline stocks took some tough losses. Guilt by association also applied here. After September 11, the stocks of the best-managed airlines, hotels, and theme parks took a downturn.

When the tech bubble and real estate bubble burst, the stock prices of the best-run companies dropped along with the rest of the sector, leaving investors to hope their prices would rebound quickly.

Geography

One of the major factors to consider when investing in mining and oil stocks is where they are located. It is impossible to move a gold mine or an oil well that has been drilled. Many governments are now imposing draconian taxes on these companies, which negatively impacts shareholders. In some cases, this can be a correlation of -1. If an aggressive government is affecting a particular oil company, other companies in different locations may have to pick up the slack and their stock may rise in anticipation of increased sales.

Many governments around the world have become very aggressive with environmental regulation, costing the industry billions of dollars to comply. If you want to invest in companies that burn or sell anything to do with fossil fuels, you would do well to understand the political climate where their production takes place.
Investors who prefer municipal bonds must make their own geographical rating on top of the ratings provided for the various services. States like Michigan and Illinois are headed for some rough times. I wouldn’t be lending any of them my money in the current environment no matter what the interest rate might be.

Currency Issues

Inflation is public enemy number one for seniors and savers. One of the advantages of currencies is they always trade in pairs. If one currency goes up, another goes down. If the majority of your portfolio is in one currency, you are well served to have investments in metals and other vehicles good for mitigating inflation.

Tim Price sums it up this way in an article posted on Sovereign Man:

“Why do we continue to keep the faith with gold (and silver)? We can encapsulate the argument in one statistic.

“Last year, the US Federal Reserve enjoyed its 100th anniversary. … By 2007, the Fed’s balance sheet had grown to $800 billion. Under its current QE program (which may or may not get tapered according to the Fed’s current intentions), the Fed is printing $1 trillion a year. To put it another way, the Fed is printing roughly 100 years’ worth of money every 12 months. (Now that’s inflation.)”

It is difficult to determine when the rest of the world will lose faith in the U.S. dollar. Once one major country starts aggressively unloading our dollars, the direction and speed of the tide could turn quickly.

Interest-Rate Risk

The Federal Reserve plays a major role in determining interest rates. Basically they have instituted their version of price controls and artificially held interest rates down for over five years. Interest-rate movement affects many markets: housing, capital goods, and some aspects of the bond markets. While it also makes it easier for businesses to borrow money, they are not likely to make major capital expenditures when they are uncertain about the direction of the economy.

While holders of long term, high interest bonds had an unexpected gain when the government dropped rates, their run will eventually come to an end as rates rise. Duration is an excellent tool for evaluating changes in interest rates and their effect on bond resale prices and bond funds. (See our free special report Bond Basics, for more on duration.)

While interest rates have been rising, when you factor in duration there is significant risk, even with the higher interest offered for 10- to 30-year maturities. Again, having a diversified portfolio with much shorter term bonds helps to mitigate some of the risk.

Risk Categories of Individual Investments

While investors have been looking for better yield, there has been a major shift toward lower-rated (junk) bonds. Many pundits have pointed out that their default rate is “not that bad.”

At the same time, the lure of highly speculative investments in mining, metals, and start-up companies with good write-ups can be very appealing. There is merit to having small positions in both lower-rated bonds and speculative stocks because they offer terrific potential for nice gains.

So What Can Income Investors Do?

There are a number of solid investments out there that offer good return, with a minimal amount of risk exposure and that won’t move because of an arbitrary statement by the Fed. It’s not always easy to find them, but there is hope for people wondering what to do now that all of the old adages about retirement investing are no longer true.

There are three important facets of a strong portfolio: income, opportunities and safety measures. Miller's Money Forever helps guide you through the better points of finance, and helps replace that income lost in our zero-interest-rate world—with minimal risk.

This is where the value of one of the best analyst teams in the world comes into focus. We focus on our subscribers’ income-investing needs, and I challenge our analysts to find safe, decent-yielding, fixed-income products that will not trade in tandem with the steroid-induced stock market—or alternatively, ones that will come back to life quickly if they do get knocked down with the market. They recently showed me seven different types of investments that met my criteria and still withstood our Five Point Balancing Test.

My peers are of having holes blown in their retirement plans. While nuclear bomb shelter safe may be impossible, we still want a bulletproof plan. This is what we’ve done at Money Forever: built a bulletproof, income generating portfolio that will stand up to almost anything the market can throw at it.

It is time to evolve and learn about the vast market of income investments safe enough for even the most risk-wary retirees. Some investors may want to shoot for the moon, but we spent the bulk of our adult lives building our nest eggs; it’s time to let them work for us and enjoy retirement stress free. Learn how to get in, now.

The article What Is Worse Than Being at Risk? was originally published at Millers Money

A Profits Pipeline Starts Here Right Here!

Maximizing Your IRA: An Interview with Terry Coxon

By Dennis Miller

As working folks get closer to hanging up their spurs, it is easy to become overwhelmed. When should you take Social Security? What type of insurance do you need? Should you buy an annuity? Do you need nursing home insurance? Should you roll over your 401(k) into an IRA? The list goes on and on.


Retirement planning requires many irreversible decisions. We each need to get it right; however, what is right for us is not always right for someone else. And, in addition to basic number crunching, we each make assumptions about life and politics—sometimes without even realizing it.

One of my most significant personal decisions pertained to a Roth IRA. Managing your traditional or Roth IRA is an ongoing process, no matter how near or far you are from retirement. And the options are worth investigating regardless of the size of your portfolio. Making sure your money lasts requires much more than picking the right stocks. Owning those stocks—or whatever else you invest in—inside the right type of account can grow your portfolio faster and save you thousands of dollars in taxes, if not more.

I’m not shy about seeking out experts in different investment niches. In this spirit, I reached out to Terry Coxon, a senior economist and editor at Casey Research and principal in Passport IRA.

In the spirit of full disclosure, I want to add that Terry has taken the time to mentor me on occasion, and he’s encouraged me to bring some of my vast life experience to our readers. As Terry has reminded me from time to time, math is only part of the retirement puzzle—the uncertainties inherent to politics and the law are also integral pieces.

Terry travels the world, and I was lucky to catch him upon his return from a recent trip to the Cook Islands.

Dennis Miller: Terry, welcome. Many investors use a traditional IRA or retired with a lump sum from their 401(k). Can you tell us how a Roth IRA differs from those plans?

Terry Coxon: With a traditional IRA, if your income isn’t too high, you get a tax deduction for your annual contribution. But later, the money you withdraw is taxable as ordinary income, except to the extent of any non-deductible contributions you made. In the meantime, earnings accumulate without current tax, which helps the money grow much faster.

A Roth IRA is different. With a Roth IRA, you don’t get a tax deduction for your contributions; but all the withdrawals you later make can be tax free. The only requirements for keeping withdrawals 100% tax free are: (a) the Roth IRA must be in at least its fifth calendar year of existence; and (b) you must have reached the calendar year in which you will be at least 59 1/2 years old. As with a traditional IRA, earnings accumulate and compound free of current tax – which is the special power source of any retirement plan.
Most 401(k) accounts are similar to a traditional IRA in that contributions are deductible; withdrawals are taxable; and while they stay inside the account, earnings go untaxed. However, there is a variant called a Roth 401(k) that is available to sole proprietors and to participants in employer plans whose rules provide for Roths. With a Roth 401(k), there is no deduction for money that goes in; the money is invested free of current tax; and everything can be tax-free when it comes out.

Fleeing the High Tax Zone

 

Dennis: When I retired, I had a 401(k), and then rolled it over to a traditional IRA. As I began to understand the Roth IRA, I realized there were real benefits to putting my nest egg in a Roth. I had a CPA tell me not to do it, and he ran the numbers to show me why.

In April 2012, you published an article, Doing the Roth Arithmetic, which painted a much different picture. Can you explain all the factors and why they are so important?

Terry: Staying with a traditional plan or going to a Roth is a big decision, and it’s not always an easy or simple one. The decision needs to be based on the individual’s current circumstances, which are a matter of fact, and also on his hard-to-know future circumstances. Make the right decision, and you can come out way ahead. Let’s look at two extreme situations—which is helpful because extreme situations point to clear answers.

Situation #1 is the individual who has all of his investments in an IRA or other retirement plan, who is not in the top tax bracket, who expects that his tax rate is more likely to decline than to rise, and who expects to consume all of his assets in his own lifetime. That individual has nothing to gain by going the Roth route and might be walking into a higher tax bill if he takes it. If that description fits you, sit tight with your traditional IRA or 401(k).

Situation #2 is the individual with substantial investments outside of retirement plans, who is in or near the top tax bracket and expects to stay there, and who has more than he needs to live on for the rest of his life. That individual should definitely convert to a Roth. He’ll have to pay a big tax bill now rather than later, but he’ll get the better of the bargain. He will be buying out his minority partner—the government—that in any case will, sooner or later, collect 40% or so of his traditional IRA in taxes.

The money for the tax bill can and should come out of the individual’s non-IRA assets—which live in a high tax zone. That way, the net effect of converting to a Roth is to move capital from the high-tax zone (direct personal ownership) to the no-tax zone (the Roth).

You can get an added bonus by converting to a Roth IRA, and it’s a lot more valuable than a second ShamWow. A Roth IRA is not subject to the minimum withdrawal requirements that kick in at age 70 1/2 for someone with a traditional IRA. Escaping the minimum withdrawal requirements lets money stay in the no-tax zone longer, especially if you won’t need to spend it all in your own lifetime.

Don’t ask why, but unlike a Roth IRA, a Roth 401(k) is subject to minimum withdrawal requirements. However, you can convert a Roth 401(k) to a Roth IRA without tax cost.

Dennis: I have a friend who has a traditional IRA and is of the age where he has to take a required minimum distribution and pay taxes on the income. He is quite a bit older than his wife and would prefer to leave the money in the sheltered account. With a Roth IRA, are there any required withdrawal times or amounts?

Terry: Your friend is a good candidate for a Roth conversion. If he converts, he can stop making the withdrawals he doesn’t want to make. And once the Roth reaches its fifth calendar year, withdrawals he or his wife take will be tax-free. And if his wife doesn’t use it up, the Roth will be available for tax-free withdrawals by their children or other heirs.

Self-Directed and Open Opportunity IRAs

 

Dennis: A lot of folks think you have to have an IRA with a bank or brokerage company. Can you explain the concept behind self-directed Roth IRAs?

Terry: Quite a few people will be knocked over by the news, but the rules written by Congress allow an IRA to invest in almost anything (there are only a few, easy-to-live-with limitations). But when you go to a bank, broker, mutual fund family, or insurance company, you find that you can only invest in… their stuff. So go elsewhere.

“Self-directed” IRAs are available with a number of IRA custodians that specialize in opening doors to the full world of investment possibilities for IRA participants. They don’t promote any particular investments or investment products. Instead, they earn fees by doing the paperwork for pulling whatever investments you want under the umbrella of your IRA. It could be an apartment house or a farm or gold coins or private loans or tax liens or almost anything else. Rather than buying CDs from a bank, your IRA can be the bank.
It can be even better. A few custodians administer a special type of self-directed IRA called an “Open Opportunity” IRA. The idea is as powerful as it is simple. The IRA owns just one thing—a limited liability company that you manage. Since you are the manager, you have hands-on control, and you are free to buy almost any investment you think is right. You don’t need to wait for anyone’s permission or stamp of approval. The hands on the steering wheel are yours.

Dennis: What tips do you have for folks who want to roll their 401(k) over to a Roth? When should they start? Should they pay the taxes from the proceeds or other funds?

Terry: As I said earlier, the decision to convert isn’t simple. The best single indication that it is the right move is that you are able to pay the tax out of non-retirement-plan assets.

Dennis: I recently wrote an article about encore careers. If a retiree decides on a second career, can he start making contributions to his Roth?

Terry: Yes, no, and yes.

The first yes is: you are as eligible to contribute from your earnings from your encore career as you were during your earlier careers.

The no is: if your income is too high, you are not eligible to contribute to a Roth IRA.

The second yes is: Anyone can convert a traditional IRA to a Roth IRA. There are no income limitations. So you can always get to a Roth by contributing to a traditional IRA and then converting. The required waiting period is less than 15 nanoseconds.

Internationalizing Your IRA

 

Dennis: I’ve recently spoken with Nick Giambruno, senior editor of International Man, about international diversification. Can you help us understand our international options if we have money in a Roth?

Terry: This is one more wonderful thing about the Open Opportunity IRA structure. The LLC that lives inside the IRA can invest anywhere in the world. Want a brokerage account in Singapore? The IRA’s LLC can be the account holder. Want a farm? The LLC can buy it in New Zealand. Want gold? The LLC can keep it in a safe deposit box in Austria. Want your IRA to go into the ski rental business? The IRA’s LLC can open a shop in Chile. And the IRA’s LLC can own—or be—a foreign LLC.

Dennis: I have a good portion of my Roth offshore, but it is not inside an LLC. It is invested in traditional investments—stocks, bonds, etc., except on a worldwide basis and in a variety of foreign currencies. Are there times when an LLC might not be necessary?

Terry: Whatever you want your IRA to buy and wherever you want the investments to reside, doing everything through your IRA’s wholly owned LLC is quicker, easier, and cheaper. With the LLC in place, you don’t need to keeping going back to the IRA custodian for every transaction. You avoid fees and you avoid delays. You are in the driver’s seat.

Using a foreign LLC to hold foreign investments may give you two additional advantages. First, some foreign institutions are more willing to deal with a non-US LLC owned by a US person than they are to deal directly with a US person. Second, if the US government ever imposes currency controls or capital controls or undertakes a program of forced gold sales, an IRA’s foreign LLC—depending on the specifics of the new rules—might go untouched.

Dennis: Terry, I want to thank you on behalf of our readers. You have opened up avenues for real tax savings and additional safety.

Terry: People work hard, and it is tough for some to save money. Understanding their Roth IRA options is a good way for people to keep it and make it last. Enjoyed it, Dennis—glad I could help.

Final Thoughts from Dennis

 

With a traditional IRA, you get a tax deduction when you make your contribution, and that money grows tax-free. When you take it back out, it is subject to taxation.

A Roth works in the opposite manner. There is no tax deduction when you make the contribution, but it also grows tax-free. The difference is that when you take it out, there is no tax as long as you follow a few basic rules, which Terry discussed.

I am a strong advocate of maximizing your 401(k), particularly if your employer matches all or part of your contributions. Save as much money as you possibly can during your working career. At the same time, there are many reasons why, as Terry suggested, you might want buy out your business partner (the government) so you can grow your nest egg tax-free and make tax-free withdrawals as you see fit.

As you’ve just read, as the editor of Miller's Money Forever, I often have the pleasure of interviewing my colleagues on a variety of topics to give our subscribers even greater exposure to different investing sectors. Recent interviews include:

• Energy Profits with Marin Katusa, senior economist and editor at Casey Research;
• The Ultimate Layer of Financial Protection with Nick Giambruno, editor of International Man;
• Juniors for Seniors with Louis James, globe-trotting senior editor of Casey Research's metals and mining publications; and
• Other esteemed colleagues.

Gain access to everything our portfolio has to offer, as well as access to these top minds through occasional interviews and input, with your risk free 90 day trial subscription to Miller's Money Forever.

The article Maximizing Your IRA: An Interview with Terry Coxon was originally published at Millers Money.

Make sure you don't miss "What 10-Baggers [and 100-baggers] Look Like"

And the Band Plays On

By Dennis Miller 

Quantitative Easing (QE) is no longer a surprise, but the fact that it's continued for so long is. Like many Miller’s Money readers, I believe the government cannot continue to pay its bills by having the Federal Reserve buy debt with newly created money forever. This has gone on much longer than I'd have ever dreamed possible.

Unemployment numbers dropped in December and the Federal Reserve tapered their money creation from $85 billion to $75 billion per month. Why did the unemployment rate drop? Primarily because people whose benefits have expired are no longer considered unemployed. The government classifies them as merely discouraged, but the fact remains that they don't have jobs.

So, what is the problem? Let's start with the magnitude of money creation. Tim Price sums it up well in an article on Sovereign Man:

"Last year, the U.S. Federal Reserve enjoyed its 100th anniversary, having been founded in a blaze of secrecy in 1913. By 2007, the Fed's balance sheet had grown to $800 billion. Under its current QE program (which may or may not get tapered according to the Fed's current intentions), the Fed is printing $1 trillion a year.

To put it another way, the Fed is printing roughly 100 years' worth of money every 12 months. (Now that's inflation.)"

As Doug Casey likes to remind us: Just because something is inevitable, does not mean it is imminent. Well, sooner or later imminent and inevitable are going to meet. Interest rates are depressed because the Federal Reserve is holding our debt. Eventually those creditors outside the Federal Reserve will demand much higher interest rates.

Currently, 30 year Treasuries are paying 3.59%. If interest rates rose by 2%—still below what was considered "normal" a decade ago—the interest cost to our government would jump by 30% or more. It's hard to imagine the huge budget cuts or tax increases it would take to pay for that.

In the meantime, investors are caught between the proverbial rock and hard place. We cannot invest in long- or medium-term, "safe," fixed income investments because they are no longer safe. They could easily destroy your buying power through inflation.

At the same time, the stock market is not trading on fundamentals. It is on thin ice. Just how thin is that ice? Take a look at what happened when the Federal Reserve stopped propping up the economy with money printing.

Each time they stopped with their stimulus the market dropped. In the summer of 2013, Bernanke made his famous "taper" remark and the market reacted negatively, immediately. The Fed has had to introduce more money into the system to stop the slide.

Investors who need yield know they have virtually no place else to go but the stock market. Most realize it is a huge bubble; they only hope to get out ahead of everyone else when the time comes. And we can't hold cash; inflation would clobber us. So, we've been forced into the market to protect and grow our nest eggs.
It reminds me of playing musical chairs as a kid. The piano player would slow down the tempo. We would all grab the back of a chair and get ready to sit. No one wanted to be the one left standing.

Today the band is playing the "Limbo Rock." Investors are in limbo, knowing the music will stop eventually. We're all going to have to grab a chair quickly—and the stakes are much higher now.

The chart below on margin debt comes courtesy of my friend and colleague at Casey Research, Bud Conrad.

Investors now have a dangerous amount of money invested on margin—meaning they borrowed money from their brokers to buy even more stock. There are strict margin requirements on how much one can borrow as a percentage of their holdings. If the stock price drops, the investor receives a margin call from his broker. That has to take place quickly under SEC requirements. The broker can also sell the holding at market to bring the client's account back into compliance.

Record margin debt, coupled with the thought of traders using computers to read the trend and automatically place orders in fractions of a second, paints an uneasy picture. The unemotional computers will not only sell their holdings, they may well initiate short sales to drive the market down even further.

As the lyrics from the "Limbo Rock" ask, "How low can you go?" When the market limbos down, it will likely be faster and further than we've imagined.

Why is 2014 different? I've been taking stock of 2013 as I prepare our tax filings. Our portfolio did very well last year, thanks in great measure to the analysts at Casey Research. With our Bulletproof Income strategy in place, I am very comfortable with our plans going forward.

At the same time, I am as jittery as a 9-year-old walking slowly around a circle of chairs, knowing that sooner or later the music will stop. The music has played for years now and we are in the game, whether we like it or not. Pundits have gone from saying "this is the year" to more tempered remarks like "this can't go on forever." They place their bets on inevitable, but hedge them on imminent.

What can we do? One of the mantras behind our Bulletproof Income strategy is: "Avoid catastrophic losses." Doug Casey has warned us that in a drastic correction most everyone gets hurt, so our goal is to minimize that damage and its impact on our retirement plans.

Here are a few things you can do to protect yourself.

• Diversify. Not all sectors rise and fall at the same speed. Optimal diversification requires more than just various stock picks across various sectors. Limit your overall stock market exposure according to your age. You don't have to be all in the market. There are still other ways to earn good, safe returns. International diversification will give you an added margin of safety, too, not only from a market downturn but also from inflation.
• Apply strict position limits. No more than 5% of your overall portfolio should be in any single investment. When I look at the record margin debt, I wonder how so many investors can go hog wild on a single investment. Planning for retirement demands a more measured approach.
• Set trailing stop losses. If you set trailing stop losses on your positions at no more than 20%, the most you could lose on any single trade is 1% of your overall portfolio. The beauty of trailing stops is the maximum loss seldom happens. As the stock rises the trailing stop rises with it, which will lock in some additional profits.
• Monitor regularly. As part of my regular annual review, I go over each one of my stop-loss positions. I use an online trading platform to keep track of them. Depending on the stock, you may want to place a stop-loss sell order or use an alert service that will notify you if the stock drops below your set point. Other investors prefer to use a third party for notification.
  
  So, why do I check my stop losses? My particular trading platform accepts the orders "GTC," meaning "good 'til cancelled." But GTC really means "Good for 60 days and then you have to re-enter the notification." Just read the small print.
  
  Also, sometimes stop losses need adjusting. As a stock gets closer to the projected target price, you may want to reduce the trailing stop loss to 15%, or maybe even 10%, to lock in more profits.

We all want to enjoy our retirement years and have some fun. I sleep well knowing we have several good circuit breakers in place. We may get stopped out of several positions and stuck temporarily holding more cash than we'd like. But that means we've avoided catastrophic loss and have cash to take advantage of the real bargains that are bound to appear.

And so the band plays on as baby boomers and retirees continue to limbo.

From the very first issue of Money Forever our goal—my mission­­—has been to help those who truly want to take control of their retirement finances. I want our subscribers to have more wealth, a better understanding of how to create a Bulletproof portfolio, and confidence their money will last throughout retirement.

With that in mind, I’d like to invite you to give Money Forever a try. The current the subscription rate is affordable – less than that of your daily senior vitamin supplements. The best part is you can take advantage of our 90-day, no-risk offer. You can cancel for any reason or even no reason at all, no questions asked, within the first 90 days and receive a full, immediate refund. As you might expect, our cancellation rates are very low, and we aim to keep it that way. Click here to find out more.

The article And the Band Plays On was originally published at Millers Money

Master Limited Partnerships Generate Safe Income for Seniors and Savers

By Dennis Miller

It's time to answer the "who, what, when, where, and why" of investing in master limited partnerships (MLPs)…....


Andrey Dashkov, senior research analyst at Miller’s Money Forever, is the rare person who, when you asked for a hammer comes back with a hammer, nails, staples, and glue. In short, he often comes up with better solutions to tricky problems than I ever thought possible.

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Since Andrey and I are on a nonstop mission to unearth the best opportunities for generating safe income, we have looked to MLPs more than once. Many Business Development Companies (BDCs) and Real Estate Investment Trusts (REITs) also fit the bill. Today, however, we are focusing exclusively on how MLPs can produce a healthy and steady income without exposing your nest egg to unwelcome risks.

The Nuts and Bolts of MLPs

 

By Andrey Dashkov
An MLP is an entity structured as a limited partnership instead of the traditional C-corporation. This allows the company to avoid corporate-level taxes. The limited partners pay most of the taxes, which means that MLPs are essentially pass-through entities.

In the United States, the net effective rate of corporate income tax is 40%. That means a corporation calculates its profit, pays the appropriate income tax to the government, and then pays dividends from what remains. With an MLP all the profits are passed through to the unit holders.

While a traditional corporation can choose to pay a dividend, an MLP does not have that option. In order to maintain their status, MLPs are required to generate at least 90% of their income from qualifying sources and distribute the major portion of that income. In most cases these sources include activities related to the production, processing, and distribution of energy commodities, including gas, oil, and coal.

The government gives a special treatment to these activities to encourage investment into the United States' energy infrastructure.

Limited partners (LPs) own the company together with a general partner (GP). The GP takes care of the day-to-day operations, typically holds a 2% stake, and can usually receive incentive distribution rights (IDRs). LPs, called unit holders, (which we can become by buying shares of publicly traded MLPs) receive dividend-like cash distributions. LPs, unlike traditional shareholders, do not have voting rights.
There are many advantages to MLPs, including:

• Attractive yields;
• Inflation protection;
• Portfolio diversification;
• Tax advantages; and
• Resilient business model.

 

Attractive Yields

 

MLPs pay various yields that average 5-10%. Data for the Alerian Index, which tracks the top 50 MLPs, show that in Q2 2013 MLP yields varied from 3-12%, with an average of 6.5%.Besides the actual yield, MLP investors can count on distribution growth. Dividends per share of Alerian Index constituents grew at a compounded rate of 4.1% over the past five years.

Inflation Protection

 

Several factors hedge against inflation:

• Inflation-adjusted contracts renewed periodically;
• Distribution growth has historically outpaced the growth in CPI; and
• MLP unit (share) prices are weakly correlated with movements in inflation and interest rates.

 

Portfolio Diversification

 

MLPs have a low correlation to other asset classes, including equity, debt, and commodities. However, for a short time they may correlate with any asset class or the market in general.

MLPs are less volatile than the broad market. Currently at 0.5, the average beta of Alerian Index, is quite conservative. This suggests that if the broad market goes down by 10%, we should expect the Alerian Index to drop by 5%. An individual company's volatility may stray from the average, but in general MLPs should be much less volatile than the market as a whole.

Generally, the vast majority of MLPs operate in the energy sector, but usually do not own the underlying commodities; this is part of the reason for the decreased volatility. Their income generally consists of transportation fees. However, some MLPs can be exposed to commodity risk (coal, propane, and oil exploration and production MLPs, among others). Economy-wide consequences of a severe recession may impact the demand for energy commodities and, in turn, the profitability of transportation companies.

Tax Advantages

 

An MLP investor typically receives a tax shield of 80-90% of one's annual cash distributions, which is a very nice feature. This defers tax payments until the unit (your share) is sold.

The tax payment schedule for an MLP is illustrated below. Assume you bought one unit of an MLP for $20 and sold it after five years for $22, having received $2 annually in years 1-5. Assuming your ordinary income tax is 35%, and the long-term (LT) capital gains are taxed at 15%, you can see the breakdown.

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Purchase price	$20.00
Distribution per unit		$2.00	$2.00	$2.00	$2.00	$2.00
Income per unit		$2.00	$2.00	$2.00	$2.00	$2.00
Depeciation expense		$1.60	$1.60	$1.60	$1.60	$1.60
Cost basis	$20.00	$18.40	$16.80	$15.20	$13.60	$12.00
Sale price						$22.00
Taxes:
Earnings per unit		$0.40	$0.40	$0.40	$0.40	$0.40
Depreciation recapture						$8.00
Amount subject to ordinary tax rates		$0.40	$0.40	$0.40	$0.40	$8.40
Ordinary tax rates		35%	35%	35%	35%	35%
Taxes owed at ordinary rates		0.14	0.14	0.14	0.14	2.94
Amount subject to LT capital gains						$2.00
LT capital gains rate						15%
Taxes owed at ordinary rates						$0.30
Total taxes owed		$0.14	$0.14	$0.14	$0.14	$3.24
Source: Credit Suisse

Resilient Business Model

During periods of economic uncertainty, MLPs remain a solid source of income. In 2008-2009, 78% of all energy MLPs either maintained or increased their distributions. In comparison, 85% of real estate investment trusts (REITs) either cut or suspended dividend payments.

Now, a note of caution is in order. Despite the excellent income track record, MLP share prices stumbled as they became more correlated to the general market. However, the investors who held them through the difficult times saw the share price rise again. MLPs returned to January 2008 levels in early 2010; the S&P 500 did not do the same until 2013.

The same plunge could happen again if a severe economic crisis hits. As we said, MLPs may move with a falling market. The fact that more investors are aware of MLPs now than a decade or two ago adds to this risk. As investors have searched for yield, MLPs have become more mainstream; however, they are by no means your average S&P 500 stock.

Also, there are two immediately positive outcomes to the higher investor awareness of MLPs: higher liquidity and access to more capital. In the Money Forever portfolio we look for the best and safest available and then protect our downside with protective stop losses.

Principal Risk Areas

 

With any investment offering a reward, there is a corresponding risk. Here are the key risks of MLPs.
Risk #1: Economic downturns. If the US economy is hit by a severe economic crisis that drives the demand for energy products down, MLPs will take a blow. Like a trucking business that transports products for which the demand is going down, if less product is shipped through a pipeline owned by an MLP, their revenue may decrease.

This, however, is where some investors may get confused. If a pipeline MLP has a contract with an energy company, the price of the transported product may increase or decrease, but at the same time, the MLP may have a fixed-fee arrangement with the energy company. So, if the volume flowing through the pipeline remains steady, its revenue should not fluctuate.

Risk #2: Access to capital and interest rates. As a general rule, MLPs return 100% of their distributable cash flow (DCF), less a reserve determined by the general partner, to the unit holders. Unlike real estate investment trusts that must give away a certain share of their cash flow every quarter, MLP distributions are governed by individual partnership agreements, so the terms vary.

However, the majority of cash an MLP earns will be distributed, so it's only natural that they turn to issuing debt or equity to finance growth projects. When their interest costs rise MLPs that need capital right away will be at a disadvantage. We prefer companies with enough internally generated capital to finance growth, and no major ongoing projects that require billion dollar loans and thereby run the risk of being underfunded or funded at an unfavorable interest rate. We also prefer companies with fixed rate debt to floating rate.

Risk #3: Management and execution. Management should have a track record of successful investment in new assets and cash generation to finance distributions.

We also look for companies that have 5 to 10 year capital plans as part of the write up, and a history of following those plans. They tend to fare better when it comes to keeping capital costs under control.

Risk #4: Sustainability of cash distributions. The above three risks boil down to whether or not an MLP will be able to churn out cash for its unit holders. The distributions should be sustainable, and should grow year after year. The primary reason for buying an MLP is income. We need to make sure the cash keeps coming in.

A company's track record of cash payments is a good, but not perfect, indicator of how it will perform in the future. Variable-rate distributions tend to, well, vary more significantly than those of traditional MLPs.

Distributions in the midstream sector tend to be more predictable; natural gas pipelines and storage generate the most stable cash flows while refining/upstream MLPs do so to a lesser extent. We carefully consider these factors when evaluating our investment options.

The "Taper" Factor

 

When Ben Bernanke uttered the word "taper" on June 19, the markets jittered. Even the traditionally defensive sectors such as utilities took a hit.

MLPs were not immune to the potential implications of the Fed easing up on its bond-purchase program which many believe is helping the US economy. The market panicked, and MLPs dropped in price. Readers will note the index dropped in the middle of 2013. The drop was less steep than those in either the broad market or the utilities sector and MLPs rebounded—in less than a week, while it took approximately three weeks for both the S&P 500 and XLU to get back to their June 18 levels.

When evaluating a potential candidate, a prudent investor will see how they have performed during times of market volatility. Sometimes trading a bit of yield for much less volatility is a smart move.

The IRA Caveat

 

We do not recommend putting MLPs in an IRA account. By placing an MLP in a tax-deferred account, you may lose part of the tax advantage the MLP structure provides. In an IRA account, unrelated business taxable income (UBTI) of over $1,000 is subject to federal income tax. If you earn more than $1,000 annually from an MLP's cash distributions and other sources of UBTI, the excess will be taxable. This becomes more likely over time, since most MLPs increase their cash distributions.

A Peek Behind the Curtain

 

In summary, an MLP gives us a couple of advantages from a tax perspective. There is more money to pay out in dividends. Unlike a traditional corporate dividend, which is paid after a corporation pays income taxes, MLPs do not pay corporate income taxes. An MLP's income is taxed only once, when the dividends are received.

Initially, when you buy an MLP, only 10 to 20 percent of the MLP distribution is considered taxable income. The rest of the distribution is considered return of capital and isn't subject to tax when you receive the dividend. Basically you put off paying some taxes for the short term. When you eventually sell your MLP, the tax is adjusted so the net amount of taxes is the same. The formula is technical, but the information you receive from your broker can be given to a competent CPA and you should be fine.

You can see why MLPs have become so popular in a yield-starved environment. While they have attracted a lot of investors, there are still some great opportunities for those willing to do their homework.

Dennis and I added our favorite MLP to the Money Forever portfolio in October, and we are chomping at the bit to share it with you… But, because of the special relationship we share with our paid subscribers, you'll need to sign up to for a premium subscription at no-risk to your pocketbook to find out what it is. Subscribe to our regular monthly newsletter and take a peek at the MLP we recommended, along with our entire portfolio.

If, after 90 days, you decide it's not right for you, we'll return 100% of your money without a fuss. Click here to get started.

The article Master Limited Partnerships Generate Safe Income for Seniors and Savers was originally published at Millers Money

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