I’m a big fan of safety margins. When I drive over a bridge, I’m glad it has been designed for several times the weight of the cars on it. Investing strategies should be designed so that you’ll be okay financially even if your returns are lower than you hope. But, we can sometimes make the mistake of layering too many safety margins and lose track of likely outcomes. In his book, The Intelligent Portfolio , Christopher L. Jones does some computer simulations to show that even though the S&P 500 returned an average compound rate of 6% above inflation for the past 40 years, there was a 1 out of 20 chance that the return could have been as low as 1.2% above inflation. This analysis is based on assumptions about the distributions of stock market returns. What happens if we take a look at actual returns over the past century? According to a chart produced by Crestmont Research, in the 58 rolling 40-year periods since 1910, the S&P 500 compound average return has ranged from infl...

Life only follows one path, but we can’t predict which path we will follow into the future. The fact that investments have risk means that we don’t know for sure what returns we will get. What we can do with some analysis is to list possible outcomes and estimate the chances of each outcome. The company Financial Engines uses a technique called Monte Carlo simulation to generate possible outcomes as part of personalized investment advice to its clients. (Disclosure: I have no connection to Financial Engines or its products.) Monte Carlo methods are well-known in the sciences, and it’s not surprising that they are useful in economics as well. Christopher L. Jones, who works for Financial Engines, includes examples of their simulations in his book The Intelligent Portfolio . I found the long-term simulations of stocks and bonds particularly interesting. The way the simulations work is that you start with some portfolio of investments, and the software generates thousands of possible...

We would all like to have investments with high return and low risk. Despite the sales pitches for get-rich-quick schemes, such investments don’t exist. In his book, The Intelligent Portfolio , Christopher L. Jones explains the forces that cause higher-return investments to have higher risk. Given a choice between two investments with the same expected return, investors would select the one with lower risk. Investors “expect higher returns as compensation for taking on the additional risk.” Suppose for a moment that a high-return, low-risk investment existed. Investors would immediately start buying this investment and drive its price up to the point where the returns are lower and more consistent with the risk level. Market forces will always act to maintain the relationship between risk and return. One thing I would add that Jones did not mention is that this relationship is based on our collective guess of the risks and returns of each type of investment. Such market wis...

I have already discussed the forces that led to individuals managing their own retirement money . In his book, The Intelligent Portfolio , Christopher L. Jones explains how this led to product-based compensation for financial advice. For wealthy people, investment advisors traditionally charged a percentage of the total portfolio each year. For this money, advisors were expected to have high levels of expertise over a broad range of financial topics. Investors got personalized attention requiring substantial amounts of the advisor’s time. Now that there are so many small investors managing their own retirement money, this model doesn’t work well. Advisors simply don’t make enough money on $50,000 portfolios to justify the time and effort. Something had to change. Enter commissions. When an advisor sells a mutual fund or insurance product, he gets a commission that is often invisible to the client. The result is, in Jones’ words: “This approach suffers from a big conflict...

In my parents’ generation, most people didn’t need to know how to invest money. They saved modest sums at the bank, but few routinely owned stocks. This question of why we’re all becoming investors is answered on the first page of The Intelligent Portfolio , written by Christopher L. Jones. I found that this book is well written and contains many interesting subjects. However, I don’t always agree with the author. I will be discussing several topics from this book individually over the next while. It turns out that people are living longer, making retirements much longer. The cost to defined benefit pension plans is skyrocketing. Companies don’t want to pay for these dramatically increasing pension costs. So, pension plans are being replaced with individual retirement accounts. In Canada these accounts are primarily RRSPs, and in the U.S. they are mostly 401(k) plans. Instead of funding pension plans, many companies now match contributions to individual retirement accounts...

I confess that I’ve never actually created a budget for my family. I’ve started budgets a few times, but never made it even half way through. Patrick over at A Loonie Saved describes an approach to family budgeting that seems less painful than what I tried to do. He begins with what he calls descriptive budgeting and evolves into prescriptive budgeting. What I have done for my family a few times over the years is some financial forecasting. I looked at our spending patterns, income, and one-time expenditures at a very coarse level to predict how much savings we would have a year or two later. This is similar to Patrick’s descriptive budgeting, but I suspect that my analysis was much less detailed. If you’re looking at your budget for the purpose of estimating future savings without trying to change your spending habits, you don’t need much detail. If I always take $400 out of a bank machine each month, it doesn’t matter what I spend it on unless I’m trying to reduce this sp...

Whenever economic conditions change, there are obvious primary effects and less obvious secondary effects. Rising oil prices have the primary effect of causing people to spend more on gas. Secondary effects include reduced oil use, reduced demand for gas-guzzlers, higher food prices, and increased research into alternative energies. Asako Ohinata at the University of Warwick did a study of the effect of a working families tax credit on fertility in the UK . The question was whether people would actually have more children if given a modest economic incentive. The results were mixed. The tax credit did not affect when couples had their first child. But, among couples who had one child, they had a second child sooner as a result of the tax credit. This speaks to the amazing power of economic incentives. If you want to reduce dependence on foreign oil, then increase gasoline taxes. If you want to reduce garbage output, then tax items at the time of purchase based on the amount of g...