A new analysis of Gallup World Poll data, surveying 136,000 people across 132 nations from 2005 to 2006, suggests that income is much more highly correlated to happiness (or at least a form of it) than previously thought.

Even some experts in behavioral finance were surprised:

What was interesting about the study was how universal the desire for financial success was across the world. “People in Togo and Denmark have the same idea of what a good life is, and a lot of that has to do with money and material prosperity,” Daniel Kahneman, professor emeritus of psychology and public affairs at Princeton University, told the Washington Post. “That was unexpected.”

To me, it’s not so surprising.  If you work in the financial services field, you see firsthand how hard people strive to achieve financial success for themselves and their families.  When they fail, they are miserable.

Warren Buffett, on the other hand, has a lot to be happy about.  He has lifelong buddies (Charlie Munger), new friends (Bill Gates),  influence, and financial security.  Although he might be less happy if his friends and influence went away, he probably wouldn’t be miserable because he would still have financial security, Cherry Coke, and the t-bones at Gorat’s.

Source: Yahoo! News

Financial security is a much more important financial good than people give it credit for.  Like most quantities, it seems to be relative.  A retired executive might feel pinched or deprived at a different level of retirement income than a retired janitor, for example.  This psychological insight led some clever financial service professional in the hazy past to popularize the “70% of income in retirement” rule of thumb, which is completely relative.  There’s probably a paper waiting to be written on the S-curve of satisfaction with relative retirement income levels–above (and below) certain thresholds, satisfaction is probably reliably high (or low).  In between, there may be a steep incline, where rising assets equate with rising happiness.  At this point in the curve–where most of us are–the impact of good or bad financial advice can be huge.

Perhaps financial advisors can’t do much about the current worldwide financial malaise, but they certainly have the ability to influence and improve their clients’ finances through the encouragement of savings and the pursuit of sensible investment policies.

Now, when I use the word “smart,” in the context of capital markets, I’m not talking about IQ at all.  You don’t have to be a university professor or have an extensive financial background to be smart.  In fact, it’s even possible those things could work against you.  Rather, being smart about the capital markets requires a very specific skill set consisting of three things.

1) Knowledge.  Smart means understanding which return factors are likely to outperform over time.  If you plow through all of the investment literature as we have, you will see that it largely boils down to two return factors: relative strength and value.  Both are robust and work in numerous formulations.  Although we use a proprietary relative strength factor, there’s no one formulation that is magic.  Success is mainly a matter of consistently exposing the portfolio to the return factor.  Pick one–or both–because they complement one another extremely well.  If you have just this small nugget of knowledge, you are miles ahead of the game.

2) Discipline.  Smart means understanding that execution is more important than knowledge.  It’s not enough to have the knowledge of which return factors will likely work over time.  You need to have a systematic method of exposing the portfolio to your chosen return factor in a disciplined fashion.  You cannot waver or let your emotions get in the way–and believe me, your fear will try to run you into the ditch during every correction.  Maintain your emotional balance.  You must remain resolute up to and including the end-of-the-world scenario.  Maybe the world will end and I will be wrong about all of this.  Probably not.  If you consistently expose your investment capital to a good return factor in a disciplined way, you are light years ahead of your competition.

3) Patience.  Smart means understanding that great patience is required.  Most investors, I suppose, would like to get rich quick.  That’s unlikely to happen.  In a karmic kind of way, the universe actually makes you earn your money by going through trials and tribulations.  The E-ticket ride you get in capital markets is never easy, and often not pleasant.  Both relative strength and value go in and out of favor as return factors, sometimes slipping into eclipse for years at a time.  Great investors are enveloped with a kind of Zen-like calmness.  They are neither their profits nor their losses.  You can’t take giddy mental ownership of your equity high-water mark or despair at your drawdown during a correction.  Stay centered and let compounding work its magic.  The journey of a thousand miles really does begin with a single step, but don’t forget that it also takes a long, long time to walk a thousand miles!

Investors with a small kernel of knowledge and oodles of discipline and patience are likely to see money flow their way over time–that’s how capital markets are designed to work.  As you can see, “smart” relates much more to temperament than IQ.  I would go so far as to say the temperament piece is probably the most important.  While most investors engage in dumb behaviors like  jumping from questionable method to method, adding money when they feel good about their results, pulling money out when they are temporarily panicked, measuring results over a short period of time, hiring and firing managers like a revolving door, and generally running about like a chicken with its head cut off, smart investors pursue reliable return factors with discipline and immense patience.  If you take the perspective that the market is designed to take your money when you do something dumb, investors would be well-advised to think about their behavior carefully before every portfolio change.

The 4% retirement spending rule is clearly a rule of thumb, and I am sure that most practitioners modify it depending on the client’s circumstances.  (We prefer a 3% spending rule, and I’ve seen other rules based on the yields available.  For example, one paper I read advocated a spending rule of 125% of the yield on the S&P 500, arguing that you can spend more when yields are high than when they are low.)  Mr. Sharpe says the 4% spending rule is too simplistic.  He’s right–rules of thumb are supposed to be simplistic.  But no one using it is really going to mistake it for the be-all-and-end-all.

An extraordinarily complex retirement spending rule that takes many complicated factors into account is just as likely–or maybe even more likely–to fail.  The real world is a much messier place than an ivory tower.  Things that seem like good ideas in theory, even to Nobel Prize winners (I’m thinking Long-Term Capital Management here), often fail miserably in practice. 

The reason that complicated things never work in real life is that there are too many unknowns in the equation.  In modern portfolio theory, market returns and correlations between assets are not stable, so the whole thing is essentially unworkable.  A perfect retirement spending rule could be made for each client if the practitioner only knew exactly what their investments would earn each year and how long the client would live.  That’s not going to happen, so we are left with rules of thumb.

The most important thing about any modeling approach is how robust it is.  If you jiggle around the inputs, does it fail miserably or does it continue to work?  Is it based on historical inputs which are guaranteed to change, or does it just adapt without making assumptions?  We have strong feelings about this.  The fewer factors a modeling approach uses, the less likely it is to be knocked down by some unanticipated factor interaction.  We use a single-factor model and test rigorously for robustness (you can read our white paper on Bringing Real-World Testing to Relative Strength here).  Academic finance would be much more useful to real investors if they kept in mind another saying:  it is better to be approximately right than precisely wrong.

Bonds are boring and safe, and are usually the first place investors go for income–except that with current interest rates, there isn’t much income available.  Most retirees can’t live on 2-year Treasury yields of 1.04%, and moving out to the 30-year Treasury at 4.72% brings with it a significant chance of getting hurt by inflation.  Yields on junk bonds (euphemistically known as high-yield bonds) are higher, but that crosses over from investing for income to its less glamorous cousin, “reaching for yield.”  Junk bonds might work for a while, as long as the economy is in recovery mode, but are probably not a long-term solution for a retiree.  As the saying goes, “More money has been lost reaching for yield than at the point of a gun.”

Many investors have looked to the stock market for dividend yield.  Doug Short has a nice piece on the disappearing yields in stocks on his excellent site.  The chart below is taken from his article.  Stock prices have been rising, but dividend yields have been going the other direction.

Click to enlarge. Source: dshort.com

The traditional high-dividend sectors for investors were always banks, oil stocks, utilities, and REITs.  When stock prices plunged in 2008, many banks eliminated or severely slashed their dividends.  Some REITs had the same problem.  Oil stocks and utilities don’t have nearly the dividend yields they used to.  All of the dividend cuts and reductions caused the high-yielding equities to do worse than the general market.  (See the chart below for a comparison of the S&P 500 to the Dow Jones Select Dividend Index ETF.)

Source: Yahoo! Finance

Alternatives range from MLPs (typically finite lives and unstable income streams) to all sorts of structured products.  This morning someone sent me an offering flyer for a 12-year 8% CD, where the quarterly rate is based on the slope of the yield curve.  8% was the cap rate, but it could drop to 0% if the yield curve flattened out.  I’m not sure Mrs. Jones is ready to speculate with derivatives.

All in all, it appears that the income investor has hit a rough patch and there seems to be no easy way out.  I’m going to let you in on a secret that very few investors know: capital gains can be spent just as easily as dividends.  Ok, that’s not really a secret at all, but many investors act like it is.  They chase yield so they can spend the income, but really, total return is all that matters.

Segmentation, like the distinction investors often impose between income and principal, is a natural function of the mind.  Many retirement planners have been using this human tendency to segment things by presenting a retirement income solution that consists of a number of buckets, a solution that is generally well-received by clients.

The first bucket is the liquidity bucket, where spending will be drawn from.  The second bucket is the income bucket, which is typically put into some kind of fixed-income investment.  The third bucket is the growth bucket.  By segmenting the growth portion, the investor might be more willing to leave it alone as it gyrates with the market.

When there is a particularly good quarter or good year, the growth bucket can be trimmed back and the proceeds “deposited” into the liquidity bucket.  Obviously, you could use any number of buckets depending on how finely you choose to segment the investment universe.  The relative size and specific composition of each bucket would be determined by the client’s situation.   Most often, all of this can be done within one account.  The buckets are mental, but they help separate the investments and their specific purpose in the client’s mind.

When viewed in the context of buckets within a single account, it becomes quite apparent that total return is what counts.  Investing for income may be a misnomer; investing for total return is the real deal.

Needless to say, if the government does not act on this problem, the financial markets certainly will at some point.  For example, Reuters recently reported that some of China’s generals have called for using our debt as a weapon against us by having their government sell off U.S. Treasury bonds if we sell arms to Taiwan.

We do not profess to know all that is needed to solve this problem, although obviously we need to throttle back the government gravy train.  As responsible voters, we need to contact our representatives to get them to take the budget problem seriously.  But as investors, we need to have enough flexiblity in our investment policy to position our assets to protect them if our representatives don’t act.

A bill was voted down in the Senate which would have created a bipartisan commission whose job would be to tackle the enormous budget deficit the United States is currently running.  The key words here are bipartisan commission.  This article, taken from the Lawrence Journal, sums up a few of the constraints the commission would have had, which would have kept either party from gaining unchecked authority in balancing the US budget.

The failed bill wasn’t a mandate on how to solve the deficit; it was a bill about setting up a framework of discussion for solving the deficit.  There’s a difference between the two, and the bill would have allowed many paths to a solution.

The deficit clearly needs to be addressed before the U.S. ends up with a forced fiscal austerity program like Greece.  If you want to get a sense for how rapidly our public debt is growing, here’s a website devoted to tallying our nation’s debt: Debt Clock.  (Be sure to hit Refresh a couple times to get a sense of the pace.)  It’s scary and breathtaking.

Anyway, back to the bill voted down in the Senate.  Apparently, six  Senators co-sponsored the writing of the bill, put their name on the bill, and then voted “No” during the roll-call. It might help to repeat the sentence a few times to appreciate the full effect.  The behavior of our elected officials is quite discouraging.  How can anyone justify even one second of the time these six Senators spent working on this bill, only to vote against it during the roll call?  What is the point?  I don’t think there is an easy answer to the deficit problem, but it doesn’t seem like voting against your own bill is part of the solution!

To solve a problem, it seems necessary to first identify the problem’s cause.  If your books are deeply in the red, you must either cut costs, sell assets, or raise revenues.  None of the options is an easy way out; eventually, somebody will have to foot the bill.  It’s not going to be a pleasant process for anybody, but maybe things would be more efficient if our government learned to collaborate a little more effectively.

Both FT Alphaville and The Atlantic had interesting articles about testimony that was heard or should be heard.

The FT Alphaville article is about rethinking the incentives embedded in the system, which seems like a really good idea regardless of one’s political persuasion.  The Atlantic’s article is about the amount of leverage that banks were allowed (and still are) to take on—quite eye-opening.

One finding: Countries with a gross public debt debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections.

Unsurprisingly, economies engaged in paying off the cost of massive government bureaucracies and unrestrained public spending have a hard time being productive.  It’s just difficult enough paying off the debt.  With the U.S. projected to hit the 90% threshold shortly, it’s time to diversify your portfolio.

They recommend waiting until 2012 to implement policy changes to avoid harming their re-election prospects the economic recovery.

The strike-through is mine, obviously.  But the economic recovery is a pretty good cover story. 

In other words, balance the budget–just not now.

And today we have “Praying for Big Bank Bonuses.”

File this under “I” for Irony.  All those big, bad bonuses are actually good for something…tax revenues for state governments running massive deficits. The article approximates that “one in five New York state tax dollars come from Wall Street.”  In New Jersey, the incumbent governor was just booted out, in part because of his inability to wrestle a deficit projected to reach $5 Billion by the next year.  The numbers just aren’t adding up.

There are plenty of ways to spin this story. Here’s mine!

From Wikipedia: “Sometimes unintended consequences can far outweigh the intended effect.”