Jonathan Clements's Blog, page 387

All Stocks

AFTER THE MARKET turbulence of recent months, the idea of a 100% stock portfolio would strike many folks as crazy. Yet, when I was in the workforce, that’s pretty much what I owned.

I never felt my all-stock portfolio was particularly risky. My wife and I had solid paychecks to rely on. We always maxed out our retirement plans, while also adding to other accounts, and then lived on whatever remained.

While the stock market���s volatility and the occasional downturns may have been disconcerting, they never changed our all-in stock approach for our long-term savings. In the event of a major downturn, we felt we could always continue working to rebuild our savings and, if necessary, delay our retirement.

In addition to the security offered by our paychecks, the risk of an all-stock portfolio was somewhat mitigated by other areas of our financial life. Like most folks, we were earning Social Security benefits. I was also fortunate to be covered by a traditional pension plan, providing further retirement funds with no stock market risk. On top of that, we had significant and growing home equity.

These various resources provided a solid, multi-legged stool for retirement. In addition, we ended up with another half leg, thanks to an inheritance and some income from a side business, though we never counted on these.

Our confidence in our all-in approach was further bolstered by our conservative stock portfolio. We mainly invested in broad, low-cost U.S. stock market index funds, with almost no foreign market exposure and never any emerging markets investments. I figured I���d let U.S. companies manage our foreign market exposure, along with the related currency and political risk. No doubt we incurred occasional opportunity costs, missing out on hot markets and hot sectors. But our tortoise approach allowed us to stay fully invested in the game.

This approach also delivered lower portfolio volatility, and served us especially well in the 1987, 2000 and 2008 downturns. In fact, I still own my first individual stock, bought in 1977, and my first mutual fund shares, from 1982. Both are up more than tenfold. We also never had to fuss much about rebalancing. We simply let our stock funds compound.

Upon retiring, we cut our stock allocation to 85% initially, followed by a series of smaller reductions that have brought us down to 67%. We made these changes to reflect our lower risk tolerance, because we no longer have those paychecks to back us up. The lower allocations locked-in gains and increased our non-stock assets, so we can better weather any market downturn. With our current allocation, we should be fine, regardless of which direction the market goes.

John Yeigh is an engineer with an MBA in finance. He recently retired after 40 years in the oil industry, where he helped manage and negotiate the financial details for multi-billion-dollar international projects. John now manages his own portfolio and has a robust network of friends, with whom he likes to discuss and debate financial issues. His previous articles were Off the Payroll and��Half Wrong.

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Happily Ever After

I���VE DISCOVERED the solution for young people looking to save for retirement.

The typical engagement ring costs more than $6,300. Why so much? I recently learned there���s a rule that you should spend two months��� salary on an engagement ring. That means a guy earning $48,000 a year is expected to spend $8,000. Where did such a rule come from? Turns out it was started by the De Beers company. Need I say more?

Apparently, there are other rules for engagement rings, such as the tenth-of-the-value-of-your-car rule, which might be more reasonable depending on your vehicle of choice, and the diamond-based-on-your-bride���s-age rule. The latter rule suggests a 32-year-old bride gets 3.2 carats.

No, I���m not the ultimate curmudgeon. But frugal me sees spending lots of money on an engagement ring as a close second to spending tons of cash on the wedding reception. I���ve been to a very lavish wedding costing over $1 million and to one that cost just a few thousand. Neither related to the length or happiness of the marriage. Could this lavish spending reflect the fact that someone other than the bride or groom is often footing the bill?

The average American marriage that ends in divorce lasts about seven years. Maybe we need a rule that says the wedding should cost no more than $2,000 for each expected year of marriage. I���d be a loser on this one: My wife and I just celebrated our 50th anniversary.

In 1968, I purchased an engagement ring for $1,500, while I was in the army making less than $100 a month. To buy it, I sold some stock at a loss. The next time I came home on leave, I could have paid for the ring with profits from the stock I sold too soon. Market timing is not my strong point.

If you invest $6,300 not in a ring, but in the market for 30 years at an annual return of 7%, you would have the tidy sum of $47,957.21. What if you cut your spending on the reception by two-thirds and also invested that money? You���d be well on your way to a comfortable retirement.

There���s a TV show called ���Say Yes to the Dress,��� where brides and their entourage shop for the wedding dress. The first question asked is, ���What is your budget?��� The typical low-end answer is $3,000. Many are in the $8,000-and-up range. Frequently, the budget is exceeded by a few thousand for the ���yes��� dress. Parents are shamed into spending way above budget because ���I want my little girl to be happy.��� I, too, wanted my little girl to be happy���but not by spending four times the average monthly Social Security benefit on a dress to be worn for 10 hours and forgotten like last year���s Christmas present.

Hey, you can have a good, memorable time without spending lavishly or going into debt. Impressing relatives and friends is an expensive investment, with little or no return. And it strikes me that that goes not only for the marriage process, but also for a great deal of other spending. Our biggest financial problem may not be our income, but rather our spending priorities and our foolish attempts to impress others.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include The Office,��Still Learning��and��Healthy Change.��Follow Dick on Twitter��@QuinnsComments.

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Too Familiar?

INVESTORS OFTEN think of their portfolio as conservative or aggressive. More conservative investors put a larger percentage of their portfolio in bonds, while aggressive investors favor stocks. But there���s a different meaning of the word conservative���what I think of as behavioral conservatism.

Conservatism means you lean toward the safe side. You favor things that are familiar, preferring them to the new and uncommon. The dictionary definition of conservatism is this: commitment to traditional values and ideas, with opposition to change or innovation.

This might be reflected in your investment portfolio. You have a bigger position in your home country, the industry where you work or your employer���s stock. The familiarity makes you more comfortable���it���s what you know. Problem is, those good feelings have consequences. With too much allocated to one country or company, you may not be as diversified as you thought.

Another sign of conservatism: You opt for the default 401(k) choices. The plan���s auto-enrollment feature may have you contributing just 3% of your paycheck. That���s a decent start. But you won���t be happy with your retirement if you stick with that 3%.

Want to avoid the trap of behavioral conservatism? Here are five strategies that���ll help you step outside your comfort zone:

1. Take your time.��Try reducing the number of impulse decisions you make. That���s right, I���m giving you permission to procrastinate. You���re more likely to favor the financially familiar when you make impulse decisions, such as when offered an ���exclusive��� investment opportunity or when choosing a health insurance plan during open enrollment. My advice: Slow it down, evaluate your options���and make a less pressured decision.

2. Buy the unfamiliar.��One of the most common investing tips I hear is ���buy what you know.��� It was made famous by the legendary investor Peter Lynch.

But in truth, investing is much more complex than simply purchasing shares of Apple because all your friends own an iPhone. Humans tend to feel they���re taking less risk when they invest in a company that���s familiar. The danger: This approach can leave your portfolio with a few overly large positions. Instead, look to invest in companies, industries and countries that are foreign to you.

3. Invest across the globe.��It���s easier than ever to invest your portfolio across the world utilizing low-cost index funds���and you���ll be better diversified than if you give into ���home bias.��� Mutual fund companies also have all-in-one funds that can provide you with a fully diversified portfolio that���s automatically rebalanced. Alternatively, you can simply add international funds to offset the excessive exposure your portfolio might already have to your home country.

4. Use your 401(k) plan���s auto-increase feature.��Are you saving just a small amount of each paycheck and you can���t get yourself to contribute more? Your 401(k) plan may have an auto-increase feature that boosts your contribution at a set time in the future. A 1% auto-increase once or twice per year will get you headed in the right direction.

5. Prepare for the worst.��Before taking investment risks, make sure your life���s financial foundation is in good order. My philosophy: Once money goes into an investment account, it should stay there for the long haul. For that to happen, you first need to build up your emergency fund and pay off any consumer debt, especially credit card debt. That way, you won���t have to dip into your investment portfolio to pay for short-term needs���and that should give you the confidence to buy less familiar investments.

Ross Menke is a certified financial planner and the founder of�� Lyndale Financial , a fee-only financial planning firm in Nashville, Tennessee. He���s passionate about helping folks make financial decisions that reflect their true purpose. Ross���s previous blogs include Hole-in-One, Seeking Certainty��and��Spending Happily. Follow Ross on Twitter�� @RossVMenke .

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Cancel the Movers

I’VE BEEN RETIRED for a decade. During that time, I have often wondered what it would be like to live somewhere else.��Europe, with its rich history, seems like an exciting option. If not Europe, why not move to another part of the country, like Old Town Alexandria in Virginia? Rachel has a son and sister living in the area. We���d be close to Washington, D.C., and other interesting new places.

As I ponder that question, I realize my life���s foundation is in California. Just like your house needs a strong foundation to survive earthquakes and floods, so does your life. When it comes down to it, your life is only as good as the foundation it rests upon: your relationships with friends and family, health care providers, local financial institutions and others.��The trust you develop with these people is crucially important. The memories you have living in your house and community are also part of that foundation.

As you get older, it���s harder to build a new foundation in another part of the country, because you aren���t as active and mobile as you once were. It also takes time. Trust and close friendships are not established in one day.

It isn���t just you who can be affected by a move to a faraway location.��It’s everything in your life. Even pets can feel the effects of losing a strong foundation. My parents had a dog named Brandy. When she was eight years old, they moved to another town.

My parents said Brandy would cry when she saw an old toy that she used to play with at their old house. They thought the toy reminded Brandy of her previous life: the times when the neighbor’s cat would eat her food, the dogs that would walk by, the backyard she used to play ball in, the walks through the neighborhood. My parents thought Brandy was happier in the old house and wanted to move back.

I’m just like Brandy. I would miss my eclectic group of friends, including Ron, who doesn’t eat anything red, green and yellow. Bob, who broke up with his girlfriend because she kept leaving the lid of the toilet seat up. Eric, Rob, Craig, Jeff, Colette and Tom at the gym. Lunches with Al and his wife Mable.

There are also my doctor, pharmacist, dermatologist, optometrist and dentist, who I have so must trust in. Greg, my automobile mechanic, who has been servicing my cars for 30 years. My old college buddy Chuck and his wife Marie. All my ex-coworkers: Steve, Cindy, Diane, Gayle and Stan, who I still stay in touch with. The next door neighbors who are willing to help in an emergency. My family connections, including my sister Diane, brother in-law Wayne, and relatives Barbara, Kent and Linda.

I’m not willing to give up this strong and well-built foundation on the chance that I might be happier in a new place. If we move to Virginia, there���s no guarantee that Rachel’s son and sister will always stay there. What happens if one of us passes away? The other one would be alone in a place with a weaker foundation, including fewer friends and a less trusted medical support team.

Rachel and I decided we���re staying in California.��We still want to experience what it’s like to live in other parts of the world. We decided to try different��places for a month at a time. We���re interested in Boston, Quebec and perhaps even Prague, in the Czech Republic. But Los Angeles county will always be our home. We���ll always spend enough time here to make sure��our foundation stays strong.

Dennis Friedman retired at age 58 from Boeing Aerospace Company. He enjoys reading and writing about personal finance. His previous articles include Let’s Take a Ride, I Can’t Do That and��Subtraction Mode . Follow Dennis on Twitter��@dmfrie.

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Hole-in-One

HAVE YOU EVER played a round of golf? If so, how many holes-in-one do you have? I���ve been playing since age four and have yet to make one. Even the best players in the world know how difficult it is to make a tiny ball go into a 4��-inch hole that���s 200 yards away.

I got close once. It was a windier than normal day in Iowa, when I hit my first shot on a par three. It went left into the tall weeds. I let my college teammates know I was taking a penalty, and I replayed the shot. This time, the ball was struck perfectly, landed in front of the hole and hopped in. Because of the penalty, I couldn���t count it as a hole-in-one.

What if you could change the game a little? Suppose that, instead of hitting one shot at a time, you could hit thousands simultaneously. Now, your odds of hitting a hole-in-one start to look far better.

Picking individual stocks is a lot like golf. No matter how long you play, all the stars may never align. But what if you could also change the investing game?

This is where index funds enter the picture. Index funds are like hitting a thousand shots at the hole at the same time. You still need to step up and make the initial investment. But after that, the heavy lifting is done for you.

Index funds own a basket of stocks that track a predetermined market index. For instance, the Vanguard Total Stock Market Index Fund has exposure to the entire U.S. market���some 3,500 individual stocks. Instead of researching every company in hopes of finding a few individual winners, you can receive the returns of the entire market with very little effort.

Sure, you���ll end up owning the market���s clunkers. But you���re also guaranteed to own the market���s big winners���those rare stocks that are like a hole-in-one���and these days you can do so at an extraordinarily low investment cost. Indeed, beyond being far easier than trying to pick winning stocks, index funds help in a host of other ways:

Diversify broadly.��As you can see from the Vanguard example above, index funds can provide exposure to an entire market with a single investment. This sort of broad diversification has been called investing���s only free lunch, because it gives you the same expected return as a handful of individual stocks, but with far less stomach-churning volatility.

Reduce risk.��In economics class, you learn about two types of risk: systematic and unsystematic. Systematic risk is the uncertainty of the overall market. If you invest in stocks, you can���t get away from that. Unsystematic risk is the uncertainty that comes with owning any one individual company. Index funds allow you to diversify away this unsystematic risk. That means that not only will you have a less volatile portfolio, but also you won���t get badly hurt if one or two individual companies get into financial trouble.

Avoid behavioral mistakes.��Yes, mistakes happen when owning index funds. But individual stocks tend to exacerbate behavioral problems. You may become too attached to an individual stock, leading you to invest too much and to ignore signs of trouble.

Save time.��When you try to beat the market by picking individual stocks, you���re competing against the world���s best investors and fastest computers. To find a winner, you���ll have to devote considerable time to research���and, even then, you need to hope you get lucky. Want to save time and avoid headaches? Consider using a few index funds to invest your money across the globe.

Ross Menke is a certified financial planner and the founder of Lyndale Financial , a fee-only financial planning firm in Nashville, Tennessee. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross���s previous articles include Seeking Certainty,��Spending Happily��and�� Picture This . Follow Ross on Twitter @RossVMenke .

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Don’t Overthink

IMAGINE YOU���RE trying to guess the winner of a basketball or ice hockey game. Which of these methods do you think would work best?

Flip a coin.
Make an educated guess.
Gather data and conduct an informed analysis.

In a classic study, researchers Paul Slovic and Bernard Corrigan attempted to answer this question. Instead of basketball or ice hockey, they looked at horse racing, but the results are equally applicable.

In their study, Slovic and Corrigan asked expert handicappers to make predictions using varying amounts of data about the horses in a race. Some of the handicappers received just five statistics on each horse, while others received 10, 20 or 40. The study produced two interesting findings.

First, as handicappers received more data, they became more confident.��Those who received 40 statistics about a horse were far more confident in their predictions than those who received 20. The latter, in turn, were more confident than those who received 10, and so forth.

Second, despite increasing confidence, more information didn’t necessarily lead to better results.��While those with the least information ended up making the worst predictions, there appeared to be a point of diminishing returns as each handicapper received more information. In fact, beyond a certain point, more data actually resulted in��less��predictive accuracy.

Taken together, these findings provide an important lesson for individual investors: When it comes to making predictions, you definitely want to gather��some��information, but not too much. No question, you can’t simply flip a coin. At the same time, it’s counter-productive to dig too deeply into the data. An educated guess, it turns out, has the best chance of being right.

I mention this because it’s so counter-intuitive. Especially when it comes to financial decisions, everyone wants to feel that they’ve ���done their homework��� and conducted a thorough analysis. But as the authors of this study explain, the problem with having��too��much data is that we end up drowning in it. We overthink things, we become distracted by outlier cases, we generally miss the forest for the trees���and yet we don’t even realize it. We think we’re becoming more expert when, in fact, we’re just getting ourselves tangled up.

I want to draw an important distinction. The findings in the horse racing study apply only to questions that involve predictions. Examples include:

How much of my portfolio should I invest in international stocks? This requires predicting future market returns and exchange rates.
Should I take advantage of the Roth option in my 401(k)? This requires predicting future income and tax law changes.
If I have a lump sum to invest, how should I time my investments? This requires predicting future market returns.
When my long-term care contract renews, should I pay the premium increase or accept reduced coverage? This requires predicting health and longevity.
Is it safe to invest in long-term bonds? This requires predicting interest rates.

In all of these cases, because they require some element of prediction, I believe the horse racing study applies. This is when you want to make an educated guess.��That educated guess may involve saying, ���I just don���t know,��� at which point you should focus on other issues, such as the risk reduction benefits of adding foreign stocks to a U.S. portfolio or whether you have the financial wherewithal to handle nursing home costs.

But there are lots of other cases that do not involve any element of prediction. In those cases, you definitely do not want to guess. Life insurance is a good example: Yes, your needs might evolve over time, as the children leave home and as your nest egg grows. But to calculate how much insurance you should carry today, you don’t need to make any predictions about how long you���ll live. To answer a question like that, don’t guess. Instead, just sharpen your pencil.

Adam M. Grossman���s previous articles��include B Is for Bias,��Humble Arithmetic��and��Repeat for Emphasis . Adam is the founder of�� Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He���s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter�� @AdamMGrossman .

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Working Late

WE NEED FOLKS to stay in the workforce longer���for their sake and the sake of the economy. And I don���t think it���s a bad thing.

I���ve written in the past about the demographic��challenges facing the U.S. and other developed nations. The 10-second recap: Many of the economic issues we fret about���soaring federal government debt, lower long-run GDP growth, a shrinking Social Security Trust Fund���can all be traced to the same root cause. We���re rapidly approaching the point where we don���t have enough workers producing the goods and services that society needs.

But forget what society needs. I���d argue that, for each of us individually, working longer can also be beneficial���for three reasons.

No. 1:��A fatter nest egg. Postponing retirement by a year or two��gives us more time to pay off debt, sock away dollars and earn investment returns. We also shorten our expected retirement. That should allow us to squeeze more income out of our retirement savings, especially if we use part of our nest egg to buy a lifetime income annuity.

Indeed,��one study found that if folks delayed retirement by a tad more than one month, that would have the same financial benefit as saving an additional 1% of their income over their final decade in the workforce. What if you���re three decades from retirement? Depending on the rate of return assumed, you could match the gain from saving an additional 1% for 30 years by simply postponing retirement by three to five months.

No. 2:��A bigger Social Security check. Working longer makes it financially easier to delay Social Security and thereby get a larger monthly benefit���a strategy favored by many financial commentators, including me. What if you���d like to start Social Security early, while also continuing to collect a paycheck? If you���re younger than your full Social Security retirement age���either 66 or 67, depending on the year you were born���you���ll likely run afoul of the Social Security earnings test.

What���s that? Until the year when you reach your full Social Security retirement age, you lose $1 of benefits for every $2 you earn above a threshold amount, set at $17,640 for 2019. The good news: Once you reach your full retirement age, your monthly check will be adjusted upward to reflect the benefits you earlier lost. Despite that, many view the earnings test as a punitive tax���and one study suggests it can discourage folks in their early 60s from working. Hey Congress, want to keep people in the workforce longer, so they stay economically productive and help fill the government’s coffers with taxes? How about nixing the earnings test?

No. 3: A happier, longer life.��One study found that working longer seems to increase longevity, at least in men. Meanwhile, there���s ample evidence that a strong social network can bolster happiness and help life expectancy. For many in their 60s, continuing to work will provide that strong social network, while also giving them the sense of purpose that comes with doing work they consider worthwhile.

Of course, this assumes those in their 60s can either find work they enjoy or keep the jobs they have. Historically, that���s been an issue, thanks to mandatory retirement policies and age discrimination. But there are indications that employers are becoming more open to hiring older workers.

You have to imagine this will continue���and not because employers are becoming kinder and gentler. Rather, it���s because they���re struggling to find and retain workers, as huge chunks of the labor force head into retirement each year.

Even if jobs for older workers become increasingly available, are they jobs that these workers can do? The irony: Older blue-collar workers, who are more likely to need continued employment for financial reasons, are in the toughest spot. I could spend decades more sitting here at my laptop, tapping away at the keys. But if I had to spend all day on my feet, let alone carrying heavy items, I doubt I could work much beyond my early 60s.

Follow Jonathan on Twitter��@ClementsMoney��and on Facebook.��His recent articles include House Rules,��Price Still Slight and��Choosing Our Future. Jonathan’s��latest book:��From Here to��Financial��Happiness.

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A Better Trade?

FOR MORE THAN 20 years, I���ve been the biology department manager at a small, liberal arts college located in the Pacific Northwest. My job is unique because I interact, on a daily basis, not only with students, staff and faculty at the college, but also with various building maintenance personnel, sales reps and instrument-repair folks who are critical to the successful operation of the department.

For me, it���s an interesting study in contrast.

I see students in their 20s taking on debt to fund their education. Once they graduate, some have difficulty landing jobs in their field of study. Those who find meaningful employment may struggle for several years as they manage their debt payments, alongside various other financial obligations.

I also meet blue-collar workers, many in their 50s and 60s. Most don���t have any formal education beyond high school and they face a completely different struggle. They���re discovering it���s nearly impossible to find members of the younger generation who possess the skills necessary to replace them once they retire.

For years, economists have been talking about a skills gap that exists in the current job market. Many of the articles blame a lack of relevant training on college campuses. Economists have found technology is changing at such a rapid pace that it���s nearly impossible to keep students up-to-date as they make their way through school. Indeed, major tech companies, such as Google and Apple, no longer require new hires to have a bachelor���s degree. Instead, many of these companies are increasingly relying on new hires who received their education at coding boot camps or through vocational classes.

General laborers are also facing their own skills gap. The lack of skilled blue-collar workers is often attributed to the fact that, for the past few decades, a college education has been touted as the only real path to a successful career. Meanwhile, millions of trade jobs, many of which pay well above minimum wage, are left unfilled. Younger workers aren���t flocking to high-paying construction and equipment-repair jobs. Result: The cost of getting this type of work done is on the rise.

From my own vantage point, I see the results of both skills gaps. Tuition rates at colleges continue to increase each year, with the average tuition and fees at a four-year private college currently averaging about $32,000 per year. The amount of debt students accrue during their college careers directly impacts their life for years to come.

Meanwhile, the cost of having equipment repaired, and having building maintenance performed, also continues to spiral upward. I recently needed to hire an instrument repairman to come to the college to fix a broken piece of equipment. Because there wasn���t anyone in my immediate area who possessed the necessary skills, I had to pay for someone to travel three hours to our location. The travel time was billed at $249 per hour, while the actual labor for the repair cost $349 an hour.

An obvious question: Will today���s young adults start weighing the cost of a college education against the handsome incomes available from some trade jobs���and decide four costly years at college aren���t a good investment?

Kristine Hayes’s previous articles for HumbleDollar include a series of blogs about her ��2018 home purchase:��Heading Home (I), (II), (III), (IV)��and��(V). Kristine��enjoys competitive pistol shooting and hanging out with her husband and her two corgis.

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Let’s Take a Ride

MY MOTHER is 95 years old and still has her driver���s license. She drives her car on rare occasions. You might ask, ���Why are you letting your mother drive at this age?��� Answer: She passed her written driving test at age 93 and is actually a safe driver. She also doesn’t text or talk on her cell phone while driving, unlike so many other people.

My mother is an independent woman���and enigmatic, too. She���s self-assured about driving and yet fearful of seasoning the family dinner, worrying that she���ll add too much salt or pepper.

When it comes to spending money, my mother exhibits this same enigmatic behavior. She owns a 2000 Chevrolet Impala. It needed a lot of work and the estimated cost to fix it was $1,500. Without hesitation, my mother authorized the repairs. She isn���t, however, always so agreeable when it comes to spending money. When ordering dinner, she refuses to pay an extra dollar to substitute a vegetable for the French fries. She���d rather suffer with her old pair of sunglasses than pay for a new pair.

It’s not like she needs this car in her life. She rarely drives anymore. When she needs to go somewhere, I usually drive her. If I’m not available, my sister or a neighbor can take her. The car is driven about 1,000 miles a year and mostly by me.

I tried to talk my mother into selling the car. I explained that eliminating the cost of the insurance and maintenance alone would save her a substantial sum. My mother isn���t wealthy and she could use the money.

But there���s something about the car that keeps her plowing money into it. After listening to my mother, I realize it isn���t just about the car. It’s what the car symbolizes. It represents the past and the future for my mother. She���s emotionally tied to this car.

The car reminds her of her history. She and my father traveled across the country in it, visiting family and friends. It’s like her house: There���s a lot of memories stored in the car. It also reminds her of the future and what it might look like. Losing this car would be like losing another part of her life���another chink in the armor, another sign that time is running out.

This car is important to her. I get it. The car will stay as long as my mother wants it. It is a comforting reminder of not only who she is, but also who she was. It���s part of her life’s foundation. It’s money well spent.

Dennis Friedman retired at age 58 from Boeing Aerospace Company. He enjoys reading and writing about personal finance. His previous articles include I Can’t Do That,��Subtraction Mode��and��Be Like Neil��Young . Follow Dennis on Twitter��@dmfrie.

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Yielding Clarity

THE YIELD CURVE has lately received a lot of press. Specifically, the inversion��of the yield curve has many people worried that a recession is around the corner. I���ve been spending a lot of time recently thinking about the yield curve. I need to get a life, right?

You may be asking yourself, ���Why should I even care about the yield curve, whatever that is?��� Here���s why: The yield curve has inverted prior to every U.S. recession since 1970. Check out the chart below��from the Federal Reserve Bank of St. Louis.

The shaded bars indicate recessions. The blue line is the difference in yield between 10-year and two-year Treasury notes. When the line goes negative���meaning the 10-year yield is lower than the two-year yield���we have an inverted yield curve. You can see how remarkably accurate the yield curve has been in predicting recessions. It may not be a perfect indicator, but it���s a darn good one���probably the best we have.

There���s always a time lag between when the yield curve inverts and the recessions that follow���sometimes a sizable one. For example, while the yield curve briefly inverted in December 2005, the Great Recession was still two years away. If you had taken a more conservative investment stance at that time, by lightening up on stocks, your patience would have been sorely tested. The S&P 500 would go on to rally another 25%, before it peaked in October 2007���just months before the recession began.

Ultimately, however, your caution would have been rewarded, because you would have sidestepped at least some of the carnage of the horrendous 2007-09 bear market. If you use the yield curve to try to precisely time the stock market, you���re likely to be disappointed. But as the renowned investor Howard Marks likes to say, ���While you can���t predict, you can prepare.��� I like to think of the inverted yield curve as the prudent investor���s proverbial canary in the coal mine.

What exactly is the yield curve?��It simply shows the current interest rate on U.S. government bonds of different maturity. For instance, a typical yield curve might plot five different Treasurys, those maturing in three months, two years, five years, 10 years and 30 years. As a bond���s maturity increases, so too does the yield���usually.

Why is this? Imagine your best friend wants to borrow $1,000 for two weeks, until his next paycheck arrives. Would you charge him interest? Probably not (unless you���re looking for a new best friend). But what if he wanted to borrow $1,000 for 10 years? Hmmm. Why is this different? We all know instinctively that, in 10 years, money won���t buy what it can buy today.

It stands to reason that the longer a bond���s maturity, the more a bondholder needs to be compensated for the risk of inflation, which is public enemy No. 1 for bonds. This compensation takes the form of higher interest rates. In other words, because of inflation, owning a 30-year Treasury is far riskier than owning a two-year Treasury, so the 30-year bond should normally have a higher yield.

What if investors expect inflation to rise? They know that, because most bonds have a fixed payout, those future payouts will have even less spending power. That means investors will be less willing to own bonds, and the resulting lower price equates to a higher yield. In short, higher inflation leads to higher bond yields���and lower inflation to lower bond yields.

But the yield curve isn���t just a reflection of inflation. Short-term Treasury yields are largely controlled���some would say manipulated���by the Federal Reserve. It achieves this by changing the federal funds rate���the interest rate one bank charges another for borrowing funds overnight. It���s no coincidence that the federal funds rate currently stands at��2��% to 2��%, which is where short-term Treasury yields currently hover.

Meanwhile, intermediate and long-term Treasury yields are normally driven by market forces. How so? Bonds, like stocks, are constantly traded. That means their prices fluctuate. And as bond prices fluctuate, so do their yields���but in the opposite direction.

You can think of the yield curve as a rope. The left side of the rope, where we have three-month yields, is tethered by the Fed. But the middle and right side of the rope is free to roam. It���s the collective wisdom of bond market participants that determines the position of the middle and right end of the rope.

Why does an inverted yield curve predict recession?��Since bond yields are essentially a reflection of inflation, both now and in the future, what the yield curve tells us is what investors think about future inflation. If the market believes inflation will be stable or higher in the future, this will translate into higher yields for longer-term bonds. The yield curve will slope upwards, with yields increasing for those bonds with a longer time until they mature. This is the normal situation.

If the market instead believes inflation will be lower in the future than it is today, this will be reflected in lower yields for longer-term bonds. The yield curve will slope upward less steeply���and it might slope downward. Voila, an inverted yield curve. What would cause the bond market to believe the inflation rate will fall? The answer: a slowing economy, including the possibility of recession. That slowing economy would reduce demand for goods and services, causing inflation to subside.

Five years ago, the difference between two-year and 10-year Treasury yields was 2.4 percentage points. Today, it���s just 0.2. We don���t yet have an inverted yield curve, but we���re awfully close. Does that mean a recession is in the offing? Only time will tell. But if you feel you���re taking too much risk with your portfolio���or there���s a danger you���ll lose your job if economic growth slows���think of it this way: You���ve been warned.

John Lim is a physician who is working on a finance book geared toward children. His previous articles��were Grab the Roadmap,��Bearing Gifts and�� Lay Down the Law . Follow John on Twitter @JohnTLim .

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