Planning and Investing in an Uncertain Economy

Reader Benjamin sent me this query, and I thought I’d be so bold as to hazard an answer, and anticipate that others will have valuable perspective to contribute:

I read NC on a regular basis, and would like to see some macro advice for your younger readers, like myself. If I’m parsing commentary correctly, I may be graduating (2011, 2012) at the tail end of a big depression. Could you spare a few paragraphs of prediction or caution for younger readers at some point this week? Most of your commentary tends to favor an older and more savvy investing body but I venture that a look at a bigger picture targeted at my demographic would be fun to write (and hey, at least I’d read it avidly). Topics to consider: buying in at the housing market’s bottom; alternate routes to building equity (’cause now I’m leery of the housing market as a vehicle); and traps that unsavvy investors like recent college grads might fall into.

You didn’t ask for advice on the career front, but unless you have a trust or are likely to inherit a substantial amount, your ability to support an investment strategy will depend on the level and stability of your income. I think the biggest change your cohort faces, and one mine is confronting with considerable pain, is lack of not merely job security but of obvious career paths. There are some exceptions; white collar careers such as medicine, law, and accounting that have managed to restrict entry via professionalization (education, licensing, ongoing requirements to maintain one’s standing) are ones where you have a good shot at using the same fundamental skill set for your entire career. But for many in those fields, the earnings potential is not what it used to be.

McKinsey requisitioned a study from Yankelovitch around 2000. It said that the average college graduate would have 13 jobs before he retired. A more recent study (can’t recall the source) claimed it would be 11 jobs by age 38. The latter doesn’t sound credible, but it’s may be reasonable to assume the level might have risen from the 2000 estimate.

So the cliche about developing a portfolio of skills, sadly, is good advice. One thing I now recognize in retrospect is high flier career paths are a double edged sword. While they offer a certain level of credibility (“oh you did/worked for so and so?”),The problem is that people early in their careers look at the upside, and often fail to consider what their options are if they are not as successful as they hope to be or discover they really don’t like the work all that much.

if you continue on these tracks beyond a certain level, you often wind up with very narrow skills (for instance, what happens to people who structured CDOs? The dot com bust similarly saw a lot of people having to find work in fields new to them). Some who go this route nevertheless are able to move from one “track’ to another (some investment bankers have become CFOs at large companies, for instance; law firm partners can be hired by their clients as general counsel), but moves like that include an element of luck and good personal chemistry.

That is a long winded way of saying most people underestimate employment risk. So most people (yours truly included when I was young) do not put away enough money to carry them between jobs. For someone in their twenties, six months of expenses; that amount has to go up as you get old, both because it takes longer for more seasoned people to find work and older people tend to develop higher fixed cost levels, This disaster money should be invested VERY conservatively.

The above probably doesn’t strike you as novel, but I’d be remiss in not saying it.

In planning, it is also important to know yourself, both in terms of possible career choices and investing, You are less likely to do well at something if you don’t have an affinity for it. Again, that no doubt seems pedestrian, but people can do an amazing job of talking themselves into career and investment choices that don’t suit them because they are swayed by what people around them are doing. For instance, I had convinced myself at the start of my career that making money was what motivated me, but that was because it was the right answer in interviews for the sort of job I had set my sights on. After gong down other paths based on acting out of surface motives, I got a better understanding of what really did and didn’t work for me, and it was very different than what I had believed.

The more you can do to get an understanding of your own MO –  can you tolerate frequent, intense intraday pressure? How much autonomy do you need? How good at and tolerant of politics are you? Are you good at functioning in chaotic environments or do you like structure? Most people spent a lot of time thinking about their skills and strengths, when understanding what sort of environment they prefer is often given short shritf.

To your immediate question: it is well nigh impossible to give advice on how to think about investing in 2010 or 2011, beyond some genearlizatoins. By then, it should be clearer what the trajectory for the US and world economy is. That will make it easier to think about who winners and losers might be.

By then, the idea of “house as investment” might have been wrung out of the American psyche. Your home is first and foremost where you live. Real estate is always local, You may see opportunities that are attractive, but be very strict on looking at the after tax cost of ownership versus rental, Robert Shiller determined that the real returns to residential real estate were 0.4%. The first apartment I bought was cheaper after taxes than renting, and that was in Manhattan.

The other question is how much do you like investing? You can be a reader of this blog and actually not like investing, I write this blog and I hate investing (despite doing well via a risk-avoidant strategy, which BTW in this case does not mean a high allocation to cash, although that is tempting). The markets are too irrational and volatile for my taste (and Benoit Mandelbrot, the French mathematician, has shown that markets are far riskier than standard theories lead us to believe. His and similar work is acknowledged in theory and ignored in practice). And how much risk can you take, really? Standard recommendations are for young people to invest heavily in stocks, and reduce their allocation as they get older, But in a bad bear market, stocks can fall 50% (if memory serves me right, the S&P fell 47% peak to trough in the dot com bust). Can you take that?

Diversification by asset class is important, but a lot of things are touted as asset classes by clever fund managers, In a crisis all correlations move to one. Commodities are considered to be a good addition to a model portfolio because they have positive skewness (although they are also hugely volatile, and those markets are far smaller than securities markets, so new cash inflows can have a big impact), Income averaging is a good idea. Vanguard funds are a very good idea. Fees will eat away at what seem to be promising investment returns.

The big argument for holding stocks as opposed to investment funds is if you are investing in a taxable account. Mutual funds trade with sufficient frequency that they are tax inefficient. If you hold stocks, you can do better after tax, but you have to be prepared to leave them alone for years.

Ben Grahman’s little book, The Intelligent Investor, is very much worth reading. It gives some commonsensical guidelines (you’d need to update them for the existence of index funds) but the most important is either spend very little time on investing, do a few simple things with your money or make it your second job. Anything in the middle is worse, for you will overtrade and reduce your returns.

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  1. Steve

    Yves’ advice is very sensible. In terms of pitfalls, I’d add: avoid credit card debt; learn that risk and return are correlated; develop a calibrated bullshit meter; don’t expect anything for free.

    If you’re not sure what you’d like to do, but you have talent, consider taking a degree in applied mathematics.

  2. Dave F

    the environment in which you feel most comfortable working is underappreciayed and it is hard to discern that before having a few years of experience under your belt. One thing I would caution against is relying on professors or parents for advice. With the former few professors understand the word world, even if they are econ or finance professors. Perhaps an organizational psych professor could give you some good ideas. As for parents their experience is not really germane to yours. They may have your best interests but will not really have advice that fits your situation.

  3. eh

    Could you spare a few paragraphs of prediction or caution for younger readers at some point this week?

    From the looks of it now, if you put every penny you’ve got into the market, you’ll have a bundle when you graduate, and might not have to worry about working at all. Recession, depression, or no.

  4. Anonymous

    First, plan to work for yourself. If you have to get a job first to get some money together, do it, but save every dime you possibly can to get out on your own as fast as possible. Working for somebody else for your whole life is for suckers.

    For one thing, tax law is terrific for people who work for themselves, and horrific for employees. Second, unless you’re one of a very small minority who makes it to the very top, remaining an employee virtually guarantees job insecurity from middle age onwards. And forget about pension security, which used to be one of the primary benefits of employeehood. Pension security doesn’t exist anymore. Work for yourself so you can shelter a larger amount of retirement savings from taxes and control it yourself for your retirement.

    Understand that there is a major energy crisis developing, and that it is going to affect the economy for a long long time. The growth model may be over.

    If the growth model is over, and the energy crisis persists, conventional investing is going to be a very very bad choice. Energy shortages will mean a steady rise in consumer prices no matter what the Fed does, so keeping your savings in cash or low interest rate T-bills will mean guaranteed loss in real terms. Likewise, the energy crisis will squeeze corporate profits, and make even most energy stocks a bad investment. (The cost of new drilling is skyrocketing, refining is a losing proposition, etc.)

    I’d place very small bets on a wide variety of alternative energy stocks. Think of these as purchases of lottery tickets–you’re hoping one of them will hit it big enough to pay for a lot of losers.

    I’d also invest in oil and natural gas, but avoid stocks where a lot of money is going into exploration, refining, and high management costs. What you’re really buying is the reserves, so you want to pay as little for the side fluff as possible.

    I would probably delay buying a house, because you’re probably going to have to be very nimble for what’s coming.

    Moe Gamble

  5. Anonymous

    Yves is right. You can satisfy your intellectual curiosity in any number of different jobs, it’s the environment that determines whether or not you are happy.

    The key is to remember that you are paid in proportion to the unique value you add to whatever you produce. Monopolistic professions are great for keeping the unique part high. In the absence of an employment monopoly you need to either own the means of production or be a superstar at what you do.

  6. russell1200

    I was in a very similar situation in the early 1980s.

    What I did not do was work towards building up a network of people who I could use as a resource. It was harder to do then in the pre-internet days, but I had no clue that it even needed to be done.

    The other idea I considered was entering the military. College graduates generally get to start as officers. The military is not as picky (for obvious reasons) as it was a short time ago. When you look in the classified ads and see the only job openings are for door-to-door vacuume cleaner salespeople it is an option to consider.

    And as someone said above: avoid debt like the plague.

  7. eh

    …it’s the environment that determines whether or not you are happy.

    Happiness — whatever it is — comes from inside. You have to make an effort every day to ‘be ‘happy’. Happiness does not have a green card — it does not come and take up permanent residence in you. I don’t think it has much to do with externalities (in particular, no one can really make another person ‘happy’, despite all those gushy songs). At least not in the US, where pretty much everyone gets enough to eat.

  8. Anonymous

    Russell1200 said: “And as someone said above: avoid debt like the plague.”

    I would third that.

    It’s important to remember the purpose of having money is not to buy fancy cars and big houses, but to have peace of mind and to be captain of your own ship.

  9. Anonymous

    I agree with much of what has been said so far. I will add my 2 cents and stress that you should have 6 months salary in cash at a minimum, 2 years is better.

    Screw the house, fancy cars, and expensive vacations until you have a big wad of cash, in T-bills.

    Remember real estate brokers, stock brokers, etc are all sales people that want your cash.

    Not having a big, big financial cushion early in life was my biggest mistake. All it took was one recession and some health problems to find myself flat broke.

    One of my mentors tried to convince me of this when I was in my 20’s but I knew better. Then again he also told me that a real business person had to go broke twice in their life to really know how to make money. The first time you go broke is because of what “they” did to you. The second time is when you accept the fact that it was your decisions that were to blame.

    So take some advice and save your nickels, dimes and dollars until your mattress is bulging. Then go out and live your life with comfort.

  10. Darcy

    the world is going to change so radically over the next 5 to 10 years i would suggest learning to grow some basic crops and living off the land as the number one priority.

    Start preparing for an energy & food scarse world.

    Local energy sources and local food supply. You can forget equities and the financial world it will vapourise as rapidly as Bill Gates wealth.

    I am sorry my perspective is so bleak but the older generation has already spent your inheritance, and your childrens and your childrens children

  11. Anonymous

    Career-track tip – if it’s something/anything done on a computer it can and will be outsourced. I’d have had a much more stable (and lucrative) career had I been a licensed plumber…

  12. S

    I can second Yves advice though I don’t think (?) I have his tenure. Don’t let his point about following your passion, whatever it is, get wasted on the young. When you find the thing you love money is an after thought. I can rely a story about a friend who had just completed his surgical residency after the long slog of med school and residency only to enter business school the day he completed his oral boards. He woke up one day and realized it simply wasn’t for him. He is at McKinsey and loving it.

    Don’t be afraid to fail. I listened to a talk a few years ago at the nadir of .com by a guy who had been been fired from 4 I-banks that matter. He started his own firm eventually in the alternative space and prospered. His message was simply: don’t give up.

    Don’t be afraid to change. Nothing is forever. Don’t be guilted into staying with something because you think it is the right thing to do. Would you hold a losing stock if you new it was going to zero. Of course not; you sell and redeploy -behavioral finance aside (maybe Yves will post on loss aversion /risk seeking tendencies sometime). Loyality is an anachronism.

    Second point about working for other people.

    I took a great class in business school where a whole range of entrep. lectured – from multibillion dollar enterprises to small struggling companies. The former head of a major advertising agency, now in his 60s, said if he new how rewarding it would be to do something hismself, he would have done it 30 years ago.

    Monmey matters but happiness/fulfillment hmatters more. 300 hitters score more runs.

  13. cdulan

    Well done Yves.

    I am a person who loves investing and informed speculation, but is not attracted to workaholic environments. I think your points are really well grounded.

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