Are Bonds Really "Safe" Investments?

A mutual fund company, which shall remain unnamed, has a series of funds which are named based on the year investors wish to retire. For example, the ABC-2025 Fund (pseudonym) is recommended for those who plan to retire around 2025. The company offers several of these and the only thing that differs about them is the relative percentage each fund invests in stocks or bonds. The 2015 fund is 55% stocks and 45% bonds. The 2025 fund is 75% stocks, 25% bonds. And so forth. The idea is that the closer one is to retirement the more one should be invested in bonds over stocks.

This idea, that bonds are a safer investment than stocks, is one that has been peddled for years to investors, but in fact it is very misleading.

First off, let's define the difference between stocks and bonds. Stocks are part ownership in a company. If you own a stock and the company's market value goes up, your wealth increases. If the market value goes down, your wealth decreases. If the company goes out of business, you lose everything.

Bonds are promises from a company (or government) to pay you back for money you have loaned it, plus interest. If interest rates drop, the values of bonds go up, and your wealth increases. If interest rates go up, the value of bonds drop, and your wealth decreases. If the company (or government) goes out of business, you lose everything. But if you hold a bond to maturity, as long as the company (or government) is solvent, you are guaranteed your money back plus interest. Even if the market value of the bond has dropped, if you don't sell it before maturity, you are guaranteed what the bond promised. This is one reason bonds are considered safer, and it is a legitimate reason.

Another reason bonds are considered safer is that their prices just don't move as fast or as much under normal circumstances. Stocks are the rabbit; bonds are the turtle. Sure, bonds will on average lose less money, but they will also gain less.

But here's the important point: If you plan on selling a bond before it matures, then other than its lower volatility a bond is really no safer or risk-free than a stock. The market prices of bonds can fluctuate quite a bit. This is particularly true in this age of economic crises and central bank interest rate manipulation. Below are charts of the stock market and five-year bond market for the last two years. Note that these bonds went down. They went down less than stocks went up, but the point is they lost money. This can happen at any time. So being invested in bonds does not guarantee protection from losses.

But, you say, I'll just hold my bond fund to maturity, that way I'll get all my money back plus interest. But that brings us to the most important point in this article. You cannot hold a bond FUND to maturity. Buying a bond fund is just like buying bonds that you must sell before maturity--its value is based on the market value of the fund's shares. So if you place your retirement money in a bond fund, and interest rates go up and stay up, you will lose money. The safety feature of holding a bond to maturity is not possible with a bond fund, and if you have a typical IRA, 401k or Keogh account, you are probably only invested in stock funds or bond funds. Few investors actually buy bonds directly, though it is possible to do so if you have a broker which offers them.

This is not to say that bonds are not a good investment, or that stocks are better. Both have their place. The point is that both involve definite risks.

Here's a recap:

• Stocks can go up in value.
• Stocks can go down in value.
• Stocks can become worthless.

• Bonds can go up in value (though are usually less volatile than stocks). 
• Bonds can go down in value (though are usually less volatile than stocks).
• Bonds can become worthless.
• Bonds held to maturity guarantee money back plus interest (as long as the issuer is solvent). 

• Bond FUNDS can go up in value. 
• Bond funds can go down in value.
• Bonds funds can become worthless (though highly unlikely). 
• Bonds funds DO NOT guarantee money back plus interest. 

So if you are near retirement and your investment adviser suggests moving your money into a bond fund, ask him what the outlook is for the bond market. If he says it doesn't matter, fire him.


This article is for information only and is not intended as a recommendation to buy, sell or hold any financial instruments.

The Inevitable Minsky Moment

Economist, traveler and general nice guy John Mauldin recently talked about Hyman Minsky, whose theory of economic instability I'd known of, but hadn't thought about in a while. Minky's Financial Instability Hypothesis is one of those ideas which seem to sum up things simply, elegantly and accurately, with an enticing hint of paradox. Minsky's hypothesis basically goes like this:

Stability leads to instability. The more stable an economic trend is, the more people will come to depend on it. The more they depend on it, the more they invest in it. The more they invest in it, the more imbalanced things become. The longer this goes on, the bigger the inevitable crash when it happens. The moment of collapse has been coined as "The Minsky Moment."

Here's an illustration. Imagine you are on a cruise ship with thousands of passengers on board. At one stage of the trip, passengers begin to notice the view from the port side is particularly pleasing. More and more passengers line up on the rail on the port side to enjoy the view. Due to their weight, the ship begins to lean slightly to port, enhancing the view, making it easier to stay on the port side, and less likely to move to the starboard side, since the view there is now obscured. Passengers begin to call their friends and family on board to join them. Even so, the ship, being well-constructed, holds its current pitch. Waiters and stewards now keep mostly to port, bringing food, drinks and deck chairs. The band moves to port side, and its music attracts even more people. As the trend continues, the remaining laggards, not wanting to miss out, join the party. Someone warns that the situation cannot continue. But everyone ignores him, as they are now fully invested in the belief that things will continue the way they are. Just then the ship capsizes. The trend is over. The Minsky Moment has occurred.  

In the analogy, the ship's view is the current promising economic trend. The problem is the more attractive the trend the more people tend to get over-invested in it, and the more inevitable the collapse becomes. This explains business cycles, bubbles, and even the ongoing up and down nature of stocks charts on every time frame. The excesses of the boom are the seeds of the bust. It's built into the nature of things. 

The end of the trend is inevitable. The question is not if, but when. The key then is knowing when to get on board and when to jump ship. 

Are the Markets Self-Regulating?

Recently I watched the movie Inside Job, a documentary about the 2000s housing bubble and credit crisis. It was a bit one-sided, focusing almost exclusively on the greed and corruption of Wall Street investment banks, but pointing few fingers at the Federal Reserve or Washington.

Still, the outrageous swindling and chicanery of Wall Street financial companies, coupled with obscene compensation given out to executives who wrecked their own companies, ruined investors and drove the economies of the world to the brink of disaster was (it seems too little to say) hard to deny or defend. The fact is a bunch of rat finks made themselves filthy rich by exploiting a system which allowed them—no begged them—to pass the risk to others and keep the benefits for themselves.

In Margin Call, a fictional movie about the same subject, the head of an investment firm—played with elegant ruthlessness by Jeremy Irons—sagely notes, "There are three ways to win in this business: Be first, be smarter, or cheat." In the 2000s Wall Street cheated. Risk, as I once wrote, is the price investors pay for seeking profit. Risk can be controlled; but the only way it can be eliminated is to cheat. Wall Street sought to make high profits at little risk. So, being the greedy but craven bunch they were, they cheated.

They were able to cheat because of wrong-headed deregulation, lack of enforcement of laws which did exist, obscurely complex investment creations, perverted incentives, and failure at the highest levels of government to do anything to challenge the problem, including turning off the flow of cheap money that fueled the binge.

It is jaw-dropping, given the abuse of deregulation by Wall Street, that their lobbyists are still to this day chirping the free market song in brazen resistance any to real reform.

Now, I believe in free markets, until they start sending us over the brink of oblivion. But the problem isn't really markets per se. In a pure sense a market is a good thing: An open arena of up-front, transparent buying and selling where deals and profits are sought and the shrewdest traders and investors win. Nothing is wrong with that.

Wall Street, at least as practiced by these major investment banks in the 2000s, wasn't really a market anymore. It was casino where the odds were so slanted to the house that the game wasn't even fair anymore. Here were the rules of the game: Investment firms sought profit by engaging in risky investments. If the investments succeeded, they won. If they lost, they still won because someone else got stuck with the risk. And even if the risk did come home to roost the top players had already pocketed their bonuses and deployed their golden parachutes. Heads I win, tails you lose. These rules have not changed much yet.

A lot of outrage is expressed over the compensation of financial executives. But that compensation doesn't bother me except to the extent that it motivates those getting it to indulge in practices which threaten the rest of us. I don't care how rich someone gets. It's no skin off my nose unless what he does is destructive  Unfortunately, it's more than clear it is. There is so much money lying around that the feeding frenzy threatens to destroy the whole food chain. If that's not a situation that begs for common-sense regulation I don't know what is.


Markets are self-regulating in the sense that if something is a bad investment, eventually investors figure it out and stop pouring money into it. No human organization could manage the millions of actions and reactions which automatically set prices in the market place. The Soviet Union tried, and collapsed under the burden. The beauty of a free market is that much of it actually is self-regulating.

But market participants aren't self-regulating. I'm a trader and I know. There is nothing more unhinged than the average trader or investor wide-eyed with greed or hysterical with fear. The most basic, raw, selfish human emotions can consume those who engage in the financial game. Forget for a moment about regulation to protect the rest of us. They need it to protect themselves.

Why are the Poor Poor?

My church pastor has defined being poor as not having "enough." That seems a good starting point. But it raises the question, What is enough? I would say that enough means having adequate food for health; adequate clothing and housing to be safe and to function in the society in which one lives; and something left over to enjoy. Provision, protection and pleasure. Those are the basic human needs.

But, however one defines "enough," the question remains--Why do some not have it? Why are some people "poor?"

A lot of ideas are thrown around to explain poverty, including lack of education, lack of opportunity, bad luck, laziness, greed, discrimination, exploitation, social unrest, karma, fate, God’s will, etc. All these reasons may play a part, and many do.

But, however "poor" is defined, the economic explanation for it is always the same: The poor are poor because they do not produce enough to either meet their own needs or to trade for the things they need. In other words, poverty is a production problem. 

So it seems that any effort to address poverty, except those done in the very short term, should in some way address this production problem. This isn’t anything new or ground-shaking. However, those of us who feel that helping the poor should be part of our life’s calling seem to lose sight of it.

There is no good reason why any society cannot come to be productive, or why we should expect any society to be destined to be poor forever. Obviously, if someone is starving, correcting his long-term lack of production is not his most pressing need. At the same time, programs which simply address short-term needs and are not complemented with efforts to improve the productivity of those aided should expect no long-term improvement in the problem. In other words, poverty will continue to be a problem as long as the poor do not, somehow, learn to produce enough for themselves. This, of course, assumes a social order where production is even possible. But, eventually, without production, a society is doomed to poverty and dependency, or worse.

This is not to diminish short-term efforts to help the poor, whether secular or spiritual. Immediate needs must be met, and genuine charity enlarges us all. Further, personal attention to the poor can help them in ways money transfers cannot. An aid worker who cares for the health and feeding of a Third World person may be saving the future leader who turns his village around. A missionary who implants values, faith and confidence in those in her care is affecting the future in ways the biggest check written may not accomplish.

But addressing the long-term poverty problem, though it may begin with placing food in mouths, must continue on to place thoughts in minds. A person or society that is not sufficiently productive will always be dependent on others or will never have enough--or both.

Why are Health Care Costs Rising So Fast?

Everywhere you go Americans are concerned with health care costs. It seems like every few months insurance companies raise rates and providers raise prices. What's going on?

Since the late 1960s, increases in health care costs have steadily accelerated to a present rate of 2.5 times that of inflation. This out-of-proportion increase began with the establishment of Medicare and Medicaid in 1965, and with the massive amount of money they began to channel into the health care market.

Why is this? There is one central reason. Economics 101 says when money chases a market, the price of that market rises. This is called demand-push inflation. Since the introduction of Medicare and Medicaid, the huge amounts of money forced into the health care market by the US government has caused health care costs to skyrocket.

Think of it this way. Imagine the US government decided to initiate a major spending program to buy, say, lots of pinwheels for every American. Now you might not want a pinwheel and I might not, but that doesn't matter because the government is creating the market. Say it earmarks $10 billion for pinwheels and increases that amount every year. What do you think would happen to the price of pinwheels? If you said "go up" give yourself a Ben Bernanke gold inflation star. That's exactly what would happen. And that's what has happened with health care costs.

Massive government spending on health care is the main cause of its severe inflation, and all other causes depend on or are related to this main cause.

What are some other reasons? One is the amazing advances in health care technology. Health care is just a lot better than it was fifty years ago. That jump in technology is in part due the profit potential companies see in the health care market. You can bet the one thing every health care company and entrepreneur counts on is that the government is going to be channeling a lot of money into health care. So they go after it. This is a great incentive for innovation. Unfortunately it also wasteful, because companies come up with all kinds of medical technology that is superfluous but that doctors use just because it's there. In fact, doctors feel compelled to use any technology that exists because they feel the need to protect themselves from lawsuits, which, ironically, are also a product of too much money being in play.

Another cause of high costs is inflated physician compensation, particularly for specialists. The Center for Medicare and Medicaid Services, the government body which sets Medicare and Medicaid rates, pays much more to specialists than they are paid in peer countries. This is done, purportedly, to attract top people into specialization. But most likely, in a freer market, specialists would be paid less than they are. The physicians, knowing a good thing when they see it, take full advantage of this arrangement by demanding the wages the market will artificially bear. Are they greedy? You could say that. But they wouldn't have had the opportunity to fulfill that greed if government hadn't thrown so much money at them.

There are other reasons for high health care costs: pharmaceutical pricing, higher administrative costs due to single-payer model paperwork, and hyper-litigiousness and resulting defensive medicine. But all these things have their root in too much money being artificially channeled into health care.

It may seem strange that the more money you throw at a problem the more expensive it gets. But that's the way economics works sometimes.

Dispelling Urban Myths About Income Taxes

Tax season is in full force. So now is probably a good time to dispel some myths about US income taxes. These myths are so regularly deployed by certain political segments that they've become part of the common dialogue. But that doesn't make them any less false.


Myth #1
Americans pay too much in income taxes.

Fact #1
"Too much" is a relative term. But Americans pay an average overall income tax rate of only 11%. It's hard to make the case that is "too much."


Myth #2
The rich don't pay their fair share in income taxes.

Fact #2
"Fair" is a judgement call. But the US income tax is very progressive. The top 1% of taxpayers pay an average overall tax rate of 24%. The other 99% of taxpayers pay an average overall tax rate of only 8.4%. Hardly "unfair."


Myth #3
The rich make out like bandits exploiting loopholes and end up paying less in taxes than the average taxpayer.

Fact #3
Even after credits and deductions the tax system is very progressive. Those who earn over $250k pay an overall rate of over 23%. Those who earn between $100k and $250k average about 13%. From $50k to $100k it's about 8%. From $30k to $50k it's about 3%. Below that people actually pay negative taxes--they get refunds (credits) for taxes they didn't pay

Myth #4
Every year the rich pay less of the tax burden. It's an example of the rich getting richer and the poor getting poorer.

Fact #4
Actually the reverse is true. Since 1986, the rich have paid a progressively higher and higher percentage of the tax burden. In 1986, the top 10% of taxpayers paid 54.7% of the taxes. In 2010 they paid 70.5%. In 1986, the bottom 50% of taxpayers paid 6.5% of the taxes. In 2010, they paid only 2.3%.


Myth #5
More and more people have to pay taxes because the rich aren't paying as much.

Fact #5
Actually the percentage of income tax filers who end up paying no tax is higher than it has ever been. In 2010 42% of income tax filers paid either no tax or got money back for taxes they didn't pay.


Myth #6
The gains of the rich come at the expense of other Americans.

Fact #6
The truth is the fortunes of the rich and those of more modest incomes have risen and fallen together. In booming years, all averages of incomes rise. In bust years, all averages fall.


Myth #7
If we just taxed the richest Americans more we could solve the budget deficit problem

Fact #7
Even if we taxed those who make $1 million a year or more at a 100% tax rate, the budget would still not balance.


Myth #8
US income taxes punish investment and reward consumption.

Fact #8
Unfortunately, this is true.


Source: The Tax Foundation

"Capitalism Without Bankruptcy is Like Christianity Without Hell" (and other financial facts you may not have known)

Most politicians have less understanding about money, finance and economics than the average undergraduate business major. Yet these are the people making laws that affect your financial future.

The prices of oil and gasoline are NOT set by oil companies. They are set by the buying and selling of future contracts by traders in the open commodities market. When gas prices go up it is in reaction to speculators believing that they will continue to go up. When gas prices go down it is in reaction to their believing that they will continue to go down. Speculators cannot manipulate the market--they can simply place bets based on what they think the market will do in the future. Those bets themselves drive the market. However, no speculator can be sure that any bet he or she places will be profitable. The idea that speculators can manipulate the market to make a profit is a myth perpetuated by politicians looking for scapegoats.


Five reasons health care has become more expensive:

1. It’s a lot better than it used to be. Medical technology has made incredible advances in the last thirty years. Those advances cost money. 
2. Prices go up when something is in demand and/or when a lot of money is allocated to be spent on it. The rise of aging baby boomers and the government allocating huge amounts of money to Medicare and Medicaid have increased the demand for health care and thus driven prices up. If less money was allocated for health care, prices would drop. It’s simple economics.
3. Doctors regularly prescribe needless procedures in order to avoid lawsuits and boost profits, because...
4. The health care system is being crushed by required government procedures, paperwork and other inefficiencies. 
5. Somewhere along the line we got the idea that others are obligated to try to keep us alive for as long as possible. Apparently we think it’s okay to bankrupt the nation in order to make this happen.

Ever since governments have coined or printed money, they have found ways to debase (decrease the value of) that money. The word “debase” itself comes from the practice of ancient governments adding base metals to gold and silver coins in order to make more coins—thus lowering their value and creating inflation. Why do governments do this? One reason is because inflation is an invisible tax. It’s a way governments transfer money from people that have it (savers) to people that don’t (debtors). With the development of central banks and fiat (non-backed) currency, governments have perfected the efficiency of creating inflation.


Inflation is not a fact of nature. It is a deliberate practice by governments which control the money supply. In the one hundred years before the creation of the Federal Reserve Bank, the U.S. dollar actually increased in buying power. What cost $100 in 1812 only cost $56 in 1912! But since the creation of the Federal Reserve Bank in 1913, what cost $100 in 1912 would cost $2342 in 2012, a 95% loss of buying power.


Despite what hysterical politicians and central bankers tell you, sometimes deflation is the best thing for an economy. Politicians don’t like deflation because it makes it hard for them to get re-elected.


Fat cat executives should be held accountable when they drive their businesses into the ground. They should not be allowed to escape with golden parachutes. Aside from the rank injustice of it, it’s a matter of applying the proper incentives. Executives convicted of fraud or malfeasance should be allowed to keep a modest retirement, while the bulk of their wealth should be used to reimburse defrauded investors. Those who caused the failure should have to start over like everyone else.


The housing bubble and the ensuing credit crisis was created by banks, financial companies, but mostly the US government. Banks and mortgage companies gave home loans to people who had no business qualifying for them. These lenders did this because they could package these loans into investments and pass the risk onto to clueless investors. However, although the financial community bear some responsibility, the government and the Federal Reserve Bank bear the most responsibility because (1) they encouraged lending to unqualified borrowers (“everyone deserves a piece of the American dream”) and (2), most importantly, they held interest rates artificially low, allowing buyers to buy more house than they could really afford, spurring demand for home loans, driving up prices, and inflating the bubble. When unqualified buyers began defaulting on loans, the bubble collapsed.


As I said, the Federal Reserve’s holding interest rates too low for too long produced the housing bubble and credit crisis. The Fed's proposed solution is to... keep interest rates even lower indefinitely! Got that? This is what Japan has done for over twenty years and it has produced a zombie economy there, a twilight realm where little fails but little grows too.  Japan’s suicide rate is one of the highest in the world.


So what should the US do? Simply put we should allow capitalism to take its course—we should allow failing businesses to fail.  When businesses fail, the losers are cleared out, someone else steps in, acquires the assets and has a fighting chance of doing something better the next time. But by propping up failed businesses, the government is ensuring that the same mistakes will continue to be made and that resources will continue to be misallocated. As former astronaut Frank Borman said, “Capitalism without bankruptcy is like Christianity without hell.” As I noted, it's a matter of incentives.


Motivated people will always find a way to profit from circumstances. This includes the unlikely circumstance of capitalism being dead--and just about any other you can think of. That is the genius of human nature, and an expression of people's right to act in their own interest.