Thursday, April 20, 2017

Investment Damage Control

The last meeting we had with an attorney and a financial manager 14 years ago, when we set up a non-revocable special needs trust for our daughter, was devoted to playing the devil’s advocate. “Lets review everything that can possibly go wrong with what we have written down in this will.” Now to do the same with the S&P 500 ETF reviewed in the past posts.

On the positive side, we have been advised that we may not run out of money living in residential care. We may not have to qualify for Medicaid. There may be an estate more than having everyone gather at Orange Leaf for a treat of his or her choice.

A prior post establishes that even with a 10% decline in the S&P 500 ETF, it can recover in between 2-3 years on average. The 5-year CD time span can be divided into two periods (of 2 1/2 years each) for comparison with the stock market.

Lets assume that half of the investment is unexpectedly needed at half way to five years. (An expected need would suggest a 2-year CD.)

CD damage control could be to invest in two 5-year CDs; save the $10,000 pot in two fractions. The cost would be one year of interest any time after 10 days from purchase ($5,000 * 2.3% = $115).

Stock market damage control could be to sell $5,000 of shares at a cost of $6.95 per trade. This assumes no change in share price. (This ignores the option of selling less than $5,000 as needed.)

The two above short term methods of damage control do not include the dynamic nature of the stock market. The CD is totally predictable. The ETF is subject to short term and long term trends that occasionally erupt into sudden large rises and falls.

The current 5-year CD earns 2.3% interest. The expected yield on the S&P 500 ETF (dividends and normal increase in value) is about 6.0%. Buying a CD is damage control, for the ETF,  costing about 4% from day one. (The CD is needed when there is insufficient time for the stock market to recover from a decline.)

S&P 500 Dividends
The S&P 500 dividend yield provides a tricky insight into the stock market. The years of high dividends are also the years of low prices ($2/$50 per share = 4%; $2/$200 per share = 1%). The entire historical trend is to a lower dividend rate (%) because of a higher share price ($).

And then something that has always bothered me is the way price is marketed. A 50% correction ($100 * 50% = $50 but is then listed as a 100% increase ($50 * 100% = $50; $50 + $50 = $100). This extreme change only happens if you sell and buy. Investors hold. They see a decline and then a recovery of 50% (-$50 + $50 = zero change in the pot). There is no 100% increase.

I interpret the statement that 2/3 of the time share prices were above 20% or below -10% of the average, also reflects the change in basis when prices fall (from the full pot) or rise (from the residue of panic selling).

A second insight, from the above post, into the nature of the stock market is the variation in prices. Only five times, in the past 42 years (12%), has the market been within 10% of the average. This makes sense. The stock market is a free wheeling system that tends to “hunt”; to overrun before changing course (like someone learning to balance on a bicycle).

This is normal human nature. The search for profit slowly drives prices to their maximum. Fear of short term loses, drives prices to their minimum, as people leave the market. I have found a number of ways built into the process of trading that limit loss and that take a profit before the price falls again. These devices become increasingly important as time to sell is reduced from twenty years (investing) to one minute (gambling).

So, CDs or S&P 500 ETFs (2.3% certain or 6.0% on average)? How long one has been in the market has no bearing on how to exit the market. (You expect to have more money, the longer you have been in the market.)

Waiting Period for Price Recovery
There seems to be no way to pick the best time to enter the market. But there is clearly a best time to exit the market: when you sell at a profit. My estimate is that waiting period, for an optimum time, can be around three years.

So, at 2 ½ years the unexpected happens. The 5-year $5,000 CD at 2.3% compounded interest for 2 1/2 years, minus one year of interest, yields ($5,293 - $115) = $5,178 for a gain of $178.

As an ETF, the $5,000 would earn, on average, $786 (6% total expectation). The increase over the CD is about $600 or $240 per year if all went well, about 12% of the time. The price for damage control by selecting CDs rather than ETFs, on average, would be $20/month.

Assume the market fluctuates +/- 10% ($500), as it, in general, does; the resulting yield would be between $286 ($786 - $500) and $1,286 ($786 + $500). Even at 2 ½ years, the ETF could be expected to match or exceed the CD, on average.

At five years and no damage, the two, $5,000, 2.30% savings CDs yield $11,200 with limited risk; the ETF is estimated to yield $13,380 for a difference of $2,180, on average, for taking unlimited risk. (Or lose $2,180 if all goes very badly on exiting the market.)

If we anticipate the unexpected, we buy two 5-year 2.30% CDs. If we do not anticipate the unexpected, we invest in ETFs with the expectation of more than doubling the return from the CDs down to an equal yield, on average (assuming an exit period of up to three years, a limited sell order, and a good credit card).

I have laid out the playing field; now to watch one of the many games being played.

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