Personal Finance for Geniuses*

Five signs the investment article you are reading is B.S.

noreply@blogger.com (John Scherer) — Fri, 09 Dec 2011 22:52:00 +0000

I keep getting emails from a particular contributor to Kiplinger's with headlines like '5 Reasons to Buy Gold Stocks', '5 Best Low-Risk Stock Funds' and '5 Great dividend-Paying Stocks to Buy -- Even Now'. He used to be a Kiplinger columnist, but now is an independent investment advisor and uses the columns to generate business. I don't know why I even bother looking at such drivel, but apparently it's like a car-wreck that you can't help but look at.

The most recent one was so laughable I had to share. It was titled "5 Formerly Top-Performing Mutual Funds to Sell in This Market'. Here is some of the insightful writing:

Legg Mason Value - "Over the past five years, Value lost an annualized 9.4%, while Standard & Poor’s 500-stock index was roughly flat (all returns in this article are through December 6). Recent results have been so pathetic that they make Miller’s long-term record look like the work of an amateur."

Longleaf Partners - " Longleaf lost 64.8% in the 2007-09 bear market, compared with a 55.3% drop for the S&P index. Despite good performance since, the fund has lost an annualized 3% over the past five years and ranks in the bottom 10% among its peers for that period."

Bridgeway Aggressive Investors 1 - "The 2007-09 bear market was Bridgeway Aggressive’s Waterloo. It plunged 64.4%, 9.2 percentage points more than the S&P. Over the past five years, the fund lost an annualized 6.4%, an average of six percentage points per year worse than the S&P."

So these funds ruled the investment world, but in the last five years have tanked and now we should get out. Thanks for that look in the rear-view mirror. Might've been nice to have told us that BEFORE they crashed.

CGM Focus - "Over the past ten years, Focus returned an annualized 7.8%. That’s an average of 5.1 percentage points per year better than the S&P and good enough to place the fund in the top 1% among large-company-growth funds. He has beaten the market only twice in the past five years. Over that stretch, the fund lost an annualized 1.7%, including a 22.7% loss so far this year."

Fairholme Fund - "Over the past ten years, the fund returned an annualized 7.5%, an average of 4.8 points per year better than the S&P. But so far in 2011, it has tumbled 27.9%."

So if a manager underperforms significantly in one year dump him. Apparently the recommendation here is to not think long term for your investments, but instead act on short term results.

In fairness, the author did say in 2010 he didn't like the direction manager Bruce Berkowitz was taking the Fairholme Fund. But articles like this serve as reminders of the folly of active management and trying to beat the market.

The smart money still indexes.

Greece is the Problem? How Dumb Do They Think We Are?

noreply@blogger.com (John Scherer) — Tue, 18 Oct 2011 11:07:00 +0000

There has been a tremendous amount of nervousness in public sentiment about the state of the economy. Some of it is certainly legitimate, with the S&P 500 down double digits in the 3rd quarter alone. As I started to write writing this in early October, much talk over the summer about the market tumble centered around the European debt crisis as being a primary factor. Then last Thursday's local paper proclaimed "U.S. stocks surge after course of action is presented to strengthen Europe's banks and lower Greece's debt" following the S&P's 8% gain over the trailing week and I couldn't put off injecting some intelligent thought into this discussion.

While it is factually true that Europe has a debt problem, how can anyone give legitimate credence to that problem 'causing' the stock market decline? Let's look at the facts - last year between April and July the market plummeted over 15% because of the threat of Greece defaulting on their debt. So far, so good, right?

Then, for the nine months between July 2010 and April 2011, the market went up 33%.

What happened to Greece and the Euro debt concerns during those nine months? Were they fixed?

Do the talking head really expect us to believe that the Greek / European banking problems signaled impending doom for three months in 2010 (causing the markets to drop sharply), then became magically cured for nine months (causing the stock market to soar majestically), and then become a sign of the apocalypse once again earlier this year - and now that there's a plan in proposed to fix them, markets should rise again?

If it sounds silly when reading the above paragraph out loud, forgive me for for interrupting the hysteria with facts.

I cannot predict what the short-term future holds with regard to European banks, Grecian debt or stock market returns (and neither can anyone else - at least I don't pretend to!) But it seems far more likely to me that the current death-of-equities is, as usual, caused by media-driven fear as opposed to real economic disaster.

An Analogy to Help Deal with Market Volatility

noreply@blogger.com (John Scherer) — Fri, 09 Sep 2011 18:59:00 +0000

A financial planner whom I respect, Michael Zhuang of Washington DC, had a great analogy regarding market volatility in a recent post to his blog:

Imagine your house has a ticker symbol, and it scrolls along the bottom of CNBC together with other ticker symbols. The price of your house, like a stock price, is set by a bunch of people you’ve never met making apparently random bets based on a combination of intuition, general economic statistics, output of an automatic-trading program, and, a couple of times a year, the real price achieved by one of your neighbors actually selling a house.

Minute by minute, the price of your home would gyrate wildly. If you are a nervous type, you might lie awake at night wondering if its value would cover your mortgage in the morning.

Of course, no one frantically checks their home value every day, wondering if he should sell. But if we had minute-by-minute reporting of real estate values, your house would be every bit as volatile as your stocks.

Granted, your house is not just an investment, it is your home which has more than financial value. But the same principle applies if the real estate in question was a rental duplex or an office building. Thinking of your investment balances as something to update on a year by year - or even over multiple year - basis, like your real estate, will help keep your emotions on par with your plan.

A Holistic View on Stock Market Volatility

noreply@blogger.com (John Scherer) — Tue, 16 Aug 2011 16:05:00 +0000

The last few weeks have certainly been an interesting time in the markets. But despite what the general media would have you believe, investors who didn't panic and bail out on their investment plan are doing ok. For evidence of that, consider in generic terms a hypothetical $500,000 portfolio invested half in Vanguard 500 Index Fund (VFINX) and half in Vanguard Total Bond Market Index Fund (VBMFX) as of the recent stock market peak of of July 22. VFINX was at 124.01 on 7/22 and closed at 108.72 last Friday - a drop of about 12%. (ugh!)

Seeing $250k drop almost $31,000 down to $219,175 is gut-wrenching for sure.

But remember that is only part of the overall holdings. The other half of the money was in the Total Bond Market Index Fund, which moved from 10.77 and to 10.99 over that same period - an increase of about 2%. Which left the entire portfolio sitting at just over $474,000 on a combined basis - down about 5%.

Not great, but hardly tragic.

Obviously this is not a statistically accurate analysis of any specific portfolio and is certainly no prediction of any future performance. And a properly diversified portfolio doesn't just hold U.S. large cap and U.S. bonds; real diversification means owning both large and small companies, domestic and international stocks, U.S. and foreign bonds. But the concept is spot-on and critical: the only sane way to look at your investments is to look at your investments as a whole.

And that reality is rarely as bad as we feel after watching the news.

Considerations in Deciding When to Take Social Security

noreply@blogger.com (John Scherer) — Thu, 16 Jun 2011 20:42:00 +0000

Recently I responded to a post from a blogger I respect, The Oblivious Investor, about decision making regarding whether to take early Social Security benefits for retirement or not. It contains enough food for thought regarding this decision that my comment is presented below in its entirety.

There are obviously too many variables to consider regarding taking social security to be able to give one-size-fits-all guidelines, but I want to point out one non-financial consideration: with the break-even point of taking benefits at 62 vs 70 generally falling somewhere around age 80, for people who have ample resources they need to consider the USEFULNESS of the income between ages 62 and 80 versus ages 80 and say 98.

Each person has to make their own decision, but my experience is that generally people are as healthy and active as they can in those earlier years of retirement, and then at some point they’ve “been there, done that, got the t-shirt” and the extra income is less useful.

I googled ‘social security break even’ to find a quick verification of the break even point being somewhere around age 80, and found a good article from BusinessWeek . Coincidentally a colleague of mine in the fee-only Alliance of Cambridge Advisors, Bert Whitehead, was quoted in the article and he made a good point that if one invests the social security income they receive between ages 62 and 70 then the breakeven point gets pushed out to somewhere into age 92+.

I didn’t realize he was in that article, but at the risk of being biased in that I know he’s a great financial planner I think it’s a worthwhile read.

Actual Rules from Wall Street

noreply@blogger.com (John Scherer) — Tue, 17 May 2011 17:15:00 +0000

Goldman Sach's in 2001 published guidelines that employees must follow for written communications (eloquently titled United States Policies for the Preparation, Supervision, Distribution and Retention of Written And Electronic Communications, although I'm sure that people in-the-know refer to it as 'USPPSDRWAEC'). Here is a direct quote from USPPSDRWAEC:

"Prior to recommending that a customer purchase, sell or exchange any security, salespeople must have reasonable grounds for believing that the recommendation is suitable."

So not only do investment recommendations need not be in clients best interest - merely needing to be suitable - apparently it is not even required that the salespeople (How come these people are never referred to as 'salespeople' on their business cards or in those TV commercials? When their company itself calls them salespeople, why are they allowed to masquerade as 'financial advisors', 'financial consultants' and 'wealth managers'? But I digress...) know for certain that their recommendation is suitable. They just need to have 'reasonable grounds' - any defensible theory that in some circumstance the investment would be reasonable - to believe so.

This must be very reassuring to their clients

Abelson, Max and Winter, Caroline. “The Goldman Rules: Excerpts of the bank's real, actual communication policies.” BusinessWeek, April 25 - May 1, 2011

Resilience in Military and Markets

noreply@blogger.com (John Scherer) — Sat, 19 Mar 2011 14:16:00 +0000

It was eight years ago today (March 19 in the US, March 20 in Baghdad) that the bombing which initiated Operation Iraqi Freedom started. When I recently read that I thought of the sacrifices and heroism of our men and women overseas and I'm grateful to live in the greatest country in the world. Let's not think of our servicemen only on Veterans Day and Memorial Day - thank a soldier today.

In thinking of the significance of the war and how much time has passed since it started, I also thought of how significant the changes in our financial world have been over that same time. When the war started we were coming out of the worst bear market since the early 70s and one that rivaled the Great Depression for the depth of market losses. Since that time think about all the terrible things that have happened in the financial world:

the war in Iraq has continued to drag on
oil spiked up to $140 per barrel
housing prices have tanked, dropping as much as 50% in some markets
Bear Stearns was bailed out by the government
Lehman Brothers wasn't bailed out and went bankrupt
AIG, the largest insurance company in the world, had to be bailed out
Fannie Mae and Freddie Mac had to be taken over by the government to avoid bankruptcy
unemployment reached double digits for the first time in 30 years

It has truly been a difficult time to be an investor during the past decade. But a closer look at market performance shows the resiliency of capitalism. The S&P 500 back in March 2003 was just below 900, closing on 3/20/2003 at 876. After all of those terrible events in the interim, today the SP is just under 1300 - an increase of around 5% annualized. And that's on price-only basis, dividends which historically account for about 1/3 of market returns are not included in the index levels.

And that's also on an undiversified US large cap only basis; over the past eight years globally diversified index fund portfolios have returned in the 7-12% range (annualized including dividends) depending on the mix of stocks and bonds being considered.

Capitalism does work, and to participate in the gains inherent in capitalism one need not pick the best stocks, or hottest funds, or anticipate interest rate changes, or time the market to get out when it goes down and in before it goes back up, or pay attention to any of the myriad 'new normal' or 'this time it's different' media fallacies.

All we need to to is be invested and be patient.

Ten Investment Resolutions for 2011

noreply@blogger.com (John Scherer) — Fri, 21 Jan 2011 17:33:00 +0000

It's that time of year when many of us establish one or more New Year's resolutions. This often means committing to improving one's lifestyle by losing weight, exercising more, or drinking less. Many investors could benefit from resolutions targeting their financial health as well. Just as many individuals endanger their well-being with bad habits, numerous investors suffer from ill-advised practices that are detrimental to their wealth. Perhaps a set of New Year's investment resolutions, along with an advisor capable of helping investors adhere to them, will lead to a more prosperous future.

Most of us are creatures of habit and discover that making permanent changes in our behavior is surprisingly difficult. To make matters worse, our commitment to change is sometimes tested by examples of those who ignore prudent behavior to their apparent advantage and those who follow it to their apparent detriment. Winston Churchill lived to age 90, fortified by an ample supply of champagne and cigars, while author and jogging enthusiast Jim Fixx died of a heart attack at age 52. These isolated examples may test our faith but should not encourage us to abandon a proven set of prescriptions; continuing to apply them will still improve our odds.

So, for those who find making such promises useful, here are ten investment-related resolutions that will stack the deck on your favor for better long-term wealth:

I will not confuse entertainment with advice. I will acknowledge that the financial media is in the entertainment business and their message can compromise my long-term focus and discipline, leading me to make poor investment decisions. If necessary I will turn off CNBC and turn on ESPN.
I will stop searching for tomorrow's star money manager, as there are no gurus. Capitalism will be my guru because with capitalism there is a positive expected return on capital, and it is there for the taking. And for me to succeed, someone else doesn't have to fail.
I will not invest based on a forecast—whether it is mine or anyone else's. I will recognize that the urge to form an opinion will never go away, but I won't act on it because no one can repeatedly predict the future. It is, by definition, uncertain.
I will keep a long-term perspective and appropriately consider my investment horizon (i.e., how long my portfolio is to be invested) when determining my performance horizon (i.e., the time frame I use to evaluate results).
I will continue to invest new capital and work my plan because it is time in the market—and not timing the market—that matters.
I will adhere to my plan and continue to rebalance (i.e., systematically buying more of what hasn't done well recently) rather than "unbalance" (i.e., buying more of what's hot).
I will not focus my portfolio in a few securities, or even a few asset classes, as diversification remains the closest thing to a free lunch.
I will ensure my portfolio is appropriate for my goals and objectives while only taking risks worth taking.
I will manage my emotions by learning about and acknowledging the biases and cognitive errors that influence my behavior.
I will keep my cost of investing reasonable.

Most of us find it hard to follow a sensible diet or a sensible investment strategy 100% of the time. If you must stray when managing your wealth or well-being, moderation is the key. Chocolate cake is OK, as long as it's not for dinner every night. Speculating on a stock or two is all right as well, as long as you don't do it with your investment capital.

Finally, just as successful athletes rely on coaches and trainers to help them achieve their goals, most investors can benefit from having a "financial coach" to remind them about their New Year's resolutions and keep them on track toward a more prosperous future.

Here's to good health and good wealth in 2011.

Thanks to Brad Steiman and Weston Wellington, both Vice Presidents at Dimensional Funds Advisors, for providing the main content of this post.

Long Term Care Insurance - expect premium increases

noreply@blogger.com (John Scherer) — Mon, 06 Dec 2010 19:34:00 +0000

I've long been skeptical of long term care insurance (LTCI) being priced properly. A recent article in the New York Times noting MetLife's decision to stop issuing LTCI policies business gives a good example of my cause for concern.

The article states that, in addition to MetLife's LTCI problems

"The two leading players in the industry are trying to raise prices, too. Genworth Financial is seeking an 18 percent increase on older policies held by about 25 percent of its customers. And John Hancock has filed for permission to raise premiums for about 80 percent of its customers by an average of 40 percent. It has also temporarily stopped offering new long-term care insurance plans through employers while it tries to figure out what to charge."

The article goes on to say that 11 companies that were in the top 10 in market share at some point over the past decade have bailed out of the LTCI marketplace.

It hardly instills confidence that the two leading LTCI companies can't figure out what to charge for their insurance, and is no doubt unsettling for people who bought insurance from a company because of its high standing in the LTCI world to think that their premiums which are already not cheap might increase 20-40%.

AARP & Jane Bryant Quinn recommend ACA

noreply@blogger.com (John Scherer) — Mon, 17 May 2010 22:30:00 +0000

In the April print edition of the AARP Bulletin, financial advice columnist Jane Bryant Quinn cites the Alliance of Cambridge Advisors as one of the go-to sources for unbiased financial advice. I don't always agree with much of what Quinn writes, but this article is spot-on on most fronts, especially regarding saving more and avoiding annuities and reverse mortgages.

A couple of her points are less wise, such as pre-paying your mortgage (why would you give up the best leverage you have against inflation, especially in these times?) and taking Social Security as late as possible (you don't get healthier and better able to enjoy your money as you get older, and you can always re-set your benefits once you reach full retirement age if you have enough savings to do so).

But those misses are minor compared to the on-target points - especially, of course, using a fee-only financial planner such as one from ACA.

Over One-Third of Filers Paid Zero Taxes in 2008

noreply@blogger.com (John Scherer) — Fri, 30 Apr 2010 14:42:00 +0000

A study of IRS data published by the Tax Foundation found that out of 142 million tax returns filed in 2008, 51 million paid no federal income taxes - meaning the filers got a refund of every dollar withheld from their paychecks, and often more than that due to 'refundable' credits such as the Earned Income Credit.

The number of returns with zero income taxes has grown from 32.6 million in 2000 to 51.6 million in 2008. That's a 59% increase in tax returns paying zero income taxes during a period where total returns filed increased only 10%.

A record for nonpayers has been set every year since 2002 (30.1 percent), primarily because tax cuts implemented by the Bush administration such as the refundable child tax credit pushed low- to middle-income people off the federal income tax rolls. So much for the Bush tax cuts benefiting the rich and punishing the poor, eh?

The study, Tax Foundation Fiscal Fact, No. 214, “Record Numbers of People Paying No Income Tax; Over 50 Million ‘Nonpayers’ Include Families Making over $50,000,” was authored by Tax Foundation president Scott Hodge. A couple of key quotes from Hodge (emphasis mine):

“Nonpaying status used to be a sure sign of poverty, but thanks to increased use of the Tax Code to deliver social benefits, incentivize behaviors and funnel money to targeted groups, middle-class families have now been pulled into the growing pool of nonpayers. We’re now in a situation where a record number of tax filers are completely disconnected from the cost of government.”
“Tax years 2009 and 2010 are likely to produce a number of nonpayers equal to or greater than in 2008 because of Obama's new tax credits targeted at lower- and middle-income taxpayers. As the number of refundable tax credits continues to grow, more and more tax filers are seeing the IRS as a source of income, not something to which taxes are paid."

"With no skin in the game, these nonpayers have little reason to care how much government grows.”

All the Serious Money is Indexed

noreply@blogger.com (John Scherer) — Wed, 24 Mar 2010 14:14:00 +0000

A recent New York Times article discussed how index funds are not only the most efficient way for people of modest means to accumulate wealth but are also the best way for wealthy investors to keep and grow their wealth.

The reporter interviewed Princeton professor of economics Burton Malkiel, author of the 1973 investment classic "A Random Walk Down Wall Street" and pioneer in research which shed light on the folly of trying to beat the market. In the article he postulated that of all of the mutual funds in existence or created since the 1970s, the number that actually beat the broad indexes through 2009 would be in the single digits.

The counterpoints in the article from some active managers border on laughable. One compared stocks to baseball batters, saying "If you find the ones with the higher average, you're adding real value." Well no kidding...except that study after study shows that the odds of doing that are about the same as the odds of any single person reading this becoming an American Idol winner.

The same manager also said "We're selecting high-quality companies with earnings streams and eliminating all the bad stocks in the S&P that you have to own because it's an index." Apparently they're buying those great stocks from other active managers who prefer low-quality companies without earnings streams. (Remember they're not buying them from those silly indexers, because the indexers own a proportionate share of everything in the market.)

Malkiel also dispels the notion that commodities belong in a portfolio as a distinct asset class, because by properly diversifying one already has such exposure: "...if you're really well diversified and into emerging markets you're going to have some investments in Brazil, which is natural resource rich. It's simple."

Malkiel also divulges his personal holdings, which include buying some individual stocks "because it's fun. All the serious money is indexed."

Who wins when your financial advisor sells you a product?

noreply@blogger.com (John Scherer) — Wed, 24 Feb 2010 14:40:00 +0000

A column by syndicated financial journalist Humberto Cruz appeared in my local Sunday paper this week titled - at least in our paper - "Who wins when your financial advisor sells you a product?" (You can read the full text of the article on the Salt Lake Tribune website.) The dozen paragraphs are a must-read for anyone seeking advice from a financial professional.

The article uses a specific example from Edward Jones, but every other brokerage firm, bank investment arm and insurance company is the same in that its registered representatives are held to a suitability standard rather than a fiduciary one. This means that reps must be able to prove that their recommendations are suitable for a customer's situation. In contrast, registered investment advisors (RIAs) who are held to a fiduciary standard must make recommendations that are in their clients best interests.

As an example consider a person whose portfolio would benefit from having exposure to the large cap asset class. As long as a registered rep recommended a large cap fund he or she would be meeting the suitability standard, regardless of whether that fund cost the investor 0.25% or 2.25%. The registered investment advisor must recommend the large cap fund that was in the investor's best interests. This does not necessarily mean the lowest cost fund, but in most cases lower costs directly result in better investment options. But in the event that a more expensive fund makes the most sense, the RIA must be able to prove why that fund is in the investor's best interests.

To quote Cruz "In plain English: When brokers recommend a product, you can't be sure it's because it's best for you or best for them."

Store Money in Your Pantry, Grow It in Your Fields

noreply@blogger.com (John Scherer) — Fri, 19 Feb 2010 14:35:00 +0000

Our last post referenced an industry article which talked about a new way to build bond ladders outside of the Functional Asset Allocation™ method of using Treasury STRIPs, and this follow up addresses the danger of chasing return in fixed income vehicles.

(For a quick refresher on the simple genius of FAA and how the interest earning 'Pantry' combines with the 'Farm' real estate and 'Crops in the Field' equities to produce the best real life asset allocation model, read our newsletter Cents & Sensibility #19.)

We must be very careful in introducing credit risk to a bond ladder. The 'bond bridge' strategy described in the article takes a reasonable approach as using Treasuries, TIPS and FDIC insured CD's to build a ladder guarantees that those vehicles mature to their stated amounts on their stated maturity dates, backed by the ability of the U.S. government to print money. However, using other vehicles like municipal or corporate bonds, even if high grade, means that the return of that capital cannot be guaranteed. The only true guarantee we have of return of principal is from an entity that can print money.

This may not seem like a big deal when so many large companies seem like they have a license to print money and the excess return their bonds might provide is attractive. But remember that one unchanging fundamental of investing is that there is no extra return without taking on some kind of extra risk - none. And when we plan to have a specific amount of retirement income available at a specific time, that extra risk, however small, is unacceptable.

Imagine being retired in the fall of 2008 and counting on your income for 2009 to come from a bond ladder containing Fannie Mae, Freddie Mac and Lehman/Goldman/AIG bonds. Five years earlier when building that ladder, those bonds looked as blue-chip as they come, and paid an interest rate that was more attractive than Treasuries.

As it turned out, holders of those bonds came out OK because of the bailout. But how much peace of mind would you have had knowing that failure of one or more of those institutions meant that you either had to: 1) sell stocks in the middle of one of the worst market crashes in history which could cripple your financial future or 2) go back to work to make ends meet. How well would you have slept at night?

Our last newsletter #27 highlighted the huge deficits some states are facing, and you can bet that many municipalities are in the same boat. If you were building a bond ladder 10 years ago (when the economy had been surging along for 7 years running) to provide reliable income for retirement, who would have guessed that Fannie, Freddie and Lehman would go bankrupt and that more than half of states would be swimming in red ink within the decade?

Remember that the purpose of the fixed income Pantry is storage, return OF capital not return ON capital. Focus your efforts for growth in the equities in your Fields. And as Bert Whitehead says in the Investment News article, remember that in fixed income safety trumps yield.

Others Are Discovering What We've Known for Years

noreply@blogger.com (John Scherer) — Fri, 12 Feb 2010 14:37:00 +0000

February is when most Treasury STRIPs mature in bond ladders for our retirees, so in addition to preparing tax returns we've been busy talking with clients about cash flow. It's been very gratifying to visit with people who are depending on their portfolios to provide their income, yet despite the market turbulence of the past two years have had no worries about needing to reducing their current standard of living and have been able to comfortably maintain a long-term view of their investments.

Having these discussions reminded me of an article I read in the fall. Jeff Benjamin wrote in the financial trade journal Investment News about how others in the industry are 'discovering' new ways of building a bond ladder and supposedly changing the 'way financial plans are constructed' by focusing in cash flow rather than risk tolerance.

As you may know, I am a founding member and past-president of ACA - the Alliance of Cambridge Advisors. ACA is an elite group of holistic, fee-only advisors who practice true financial planning - not just investment management, not investments and retirement planning, but inclusive planning including proactive tax, insurance, estate and lifestyle planning as well as investment strategies based on Functional Asset Allocation™.

ACA has embraced objective endogenous factors such as cash flow needs over subjective factors such as risk tolerance surveys since its inception. It's sort of interesting (and more than a little satisfying) to see principles that have been standard ACA strategy for years being touted as a 'new' way of looking at fundamental financial planning.

More Proof Indexing Works

noreply@blogger.com (John Scherer) — Fri, 15 Jan 2010 14:10:00 +0000

In this month's Forbes magazine, Rick Ferri talks about the performance of a basic index fund strategy over the past decade in his column 'A Decent Decade for Investors'. He calls it the 'Core-4' because he uses four Vanguard index funds - Total Bond Market, Total International Stock, Total US Stock Market, and REIT Index. His breakdown of the equity component of the portfolio always has the same ratio - 60% Total US, 30% Total International and 10% REIT, very similar to the allocation ratios that we employ at TFP (although we take an approach that expands on that basic theory with tilts toward small and value stocks per the Three-Factor Model, our overall domestic, foreign and real estate ratios are the same).

Ferri calculates that the returns on blended portfolios of those four funds for the decade ending 12-31-09 range from 3.1% to 5.4%, while the Consumer Price Index was 2.6% over that same time. Hardly a 'lost decade', as so many would have us believe. As Ferri says in the article "All portfolios outperformed the CPI, and that means all portfolios made money in real terms. Since this is true, was the first decade of this millennium really an investor's Hell? Not as I see it."

Active-management proponents often claim that when the markets go up index investing looks good, but when markets drop indexing doesn't produce results.

That sounds good, but the facts tell a far different story.

Once Burned, Twice Shy

noreply@blogger.com (John Scherer) — Fri, 08 Jan 2010 14:07:00 +0000

As we start the new year a hot topic of conversation in the financial world revolves around 'what the market is going to do.' Despite it's popularity, this is a futile question to spend time thinking about because:

1) no one - and I mean no one - really knows the answer (despite how good the talking heads might sound, the crystal ball has yet to be invented that can predict the market);

2) investment returns are just one - and far from the most important - of many factors affecting financial success (things like how much you save, how much you pay in taxes, and how stable your relationships are have a much greater impact on net worth than investment return); and

3) even just on a portfolio-specific level, the short-term direction of the market has little bearing on the long-term performance of a properly diversified portfolio.

My Alliance of Cambridge Advisors colleague Bert Whitehead wrote a great piece on the perils of forecasting and market timing on his blog. Here is an excerpt:

It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.

Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?

This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.

If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.

Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.

You can read his whole posting at bertwhitehead.blogspot.com.

The more things change...

noreply@blogger.com (John Scherer) — Sat, 17 Oct 2009 13:00:00 +0000

If you read the Time magazine article reference in my last post you can skip this paragraph right now and move on to the next. For those that didn't get around to reading the full article, the punch line is that despite sounding very much like something written in September 2009 with its references to high unemployment, credit problems, and the economy in a profound, once-in-a-lifetime state of turmoil, the article was in fact written in September 1992.

I would venture to guess that not many readers really remember the disastrous recession of '91, just like the crash of '01-02 is becoming an ever distant memory. Rest assured that the great debacle of '08-09 will take on a similar hazy recollection down the road.

But as the Time article reminds, it is in fact scary when we are in the midst of the downward part of the cycle that regenerates growth. Much like a destructive fire ultimately regenerates the forest, we need to remember that market declines are a natural and necessary part of capitalism.

Currently many major publications are talking about the 'new normal' economy. Rest again assured that today is not any more a new paradigm than when Japan was going to take over the world in the 80's, or when technology signaled the new economy in the 90's, or when stocks were dead in the late 70's.

The more things change, the more they indeed do remain the same.

The State of the Economy

noreply@blogger.com (John Scherer) — Mon, 12 Oct 2009 21:01:00 +0000

As you may have surmised from my slightly sarcastic posts last week, I find little of real educational value regarding financial topics in most consumer publications. But Time had an article 'The Long Haul: the U.S. Economy" which provides spectacular perspective on how to view our current economic situation. Here are some compelling excerpts:

If America's economic landscape seems suddenly alien and hostile to many citizens, there is good reason: they have never seen anything like it. Nothing in memory has prepared consumers for such turbulent, epochal change, the sort of upheaval that happens once in 50 years.

The outward sign of the change is an economy that stubbornly refuses to recover from the ... recession. Unemployment is still high; real wages are declining. The current slump already ranks as the longest period of sustained weakness since the Great Depression.

That was the last time the economy staggered under as many "structural" burdens, as opposed to the familiar "cyclical" problems that create temporary recessions once or twice a decade. The structural faults ... represent once-in-a-lifetime dislocations that will take years to work out. Among them: the job drought, the debt hangover, ... the real estate depression, the health-care cost explosion and the runaway federal deficit. "This is a sick economy that won't respond to traditional remedies," said the chief economist at Pittsburgh's Mellon Bank. "There's going to be a lot of trauma before it's over."

The U.S. workplace is "in a profound, historic state of turmoil that for millions of individuals is approaching panic," according to labor consultant Dan Lacey, publisher of the newsletter Workplace Trends.

Bank regulators clamped down on lenders, while borrowers either swore off the credit habit or were deemed bad risks. The result was a credit crunch that has severely hurt businesses, especially small ones.

I hope that you will read this entire article and consider what it means for us going forward.

No, Wait - We 're Headed Down Again

noreply@blogger.com (John Scherer) — Wed, 07 Oct 2009 12:20:00 +0000

After being confused about whether the market was going to to up or down, I read The Dow Will Hit 10,000 Soon. So What? in the Wall Street Journal which clarified that the market was likely to surge up in the fourth quarter, but then drop again heading into 2010. Here is some excerpts:

A fund manager I know suggested this week we might see a big run-up in the fourth quarter. The market, he said, might be forced higher as more people come off the sidelines—most likely at the worst possible moment. Institutional investors have been too cautious through the rally of the last six months. That's true for the public, too; they sold through the crash, and the latest data shows they were still selling shares in August.
Yet even if the market's rise attracts more investors, stocks are becoming less attractive long-term investments. Shares don't get better as they go higher. They get worse. A share is just a claim on future dividends. The more you pay, the worse the deal.

And a rising stock market does not necessarily mean the economy will keep getting better. The current rally ignores some ominous economic trends. Bank lending has slumped, and so, too, have long-term Treasury yields. Neither is a happy omen. And of course, in the real economy, the pain continues. Unemployment has risen to 9.7%, even as Wall Street has rallied.

So instead of the 4th quarter drop followed by better times as per BusinessWeek we should expect a 4th quarter runup followed by worse times.

Or something like that.

The Case for Optimism by Gloomy Fund Managers

noreply@blogger.com (John Scherer) — Mon, 05 Oct 2009 22:20:00 +0000

Wait a minute, I think I'm getting my stories confused...

A special report from BusinessWeek in August touted The Case for Optimism with headlines such as 'Why It's Smart To Be Optimistic', 'Signposts That Point to the Positive', 'The Vibrant Promise of Cities', 'Why the Statistics Point Toward Progress', and 'Keeping the Faith in Silicon Valley'.

There's even a video of CEO's from Dow Corning, Eastman Kodak, Intuit and others opining that beyond the issues facing the global economy currently, there are many underlying positives such as the power of technology and the recovery of the housing markets that give cause for optimism over the next few years.

There was also an article in the October 1 BusinessWeek that highlighted 'prominent fund managers' who are preparing their portfolios for a fourth quarter stock sell-off. Included are quotes such as:

I'm concerned we've put a Band-Aid over an infection.

The market's rally was driven by sentiment, and the fundamentals hadn't improved enough to justify those gains. There is still too much debt on corporate balance sheets, with around $2 trillion - or 65% - coming due in the next four years.

(in reference to the beginning of 2009) The world looked like it was going to end. And there's no point investing in an end-of-world scenario.

I guess in the magazine business it makes sense to take a stand as both a bear and a bull. No one will connect the dots when the articles are published two months apart, and then whatever happens in the future you can say that you were writing about that outcome months before it happened.

Have you read your brokerage agreement?

noreply@blogger.com (John Scherer) — Thu, 01 Oct 2009 12:38:00 +0000

Dan Solin of the Huffington Post had a great blog post titled 'Why Don't You Just Give Your Broker a Gun and Tell Him to Shoot You?' It's 12 short paragraphs, and truly shines a light on the creepy, crawly corners of working with a broker as opposed to a fiduciary.

My favorite line is this (after explaining some of the provisions in the brokerage firm contract he reviewed):

"Why would you entrust your assets to a firm that tells you it does not have to act in your best interests and further that it may have conflicts of interest with you which it will resolve in its favor?"

There's not much for me to add to his posting - you should read it.

Reduction in 401(k) limits possible

noreply@blogger.com (John Scherer) — Mon, 28 Sep 2009 12:02:00 +0000

One of the good things to come from the current recession is that inflation has been virtually non-existent and we've even seen a reduction in the cost of living depending on the time frame measured. Through September 2008 inflation was just under 5% due to energy costs, but we've had deflation since March 2009. While this is good on the pocketbook, the IRS may be forced to reduce the maximum contribution from its current $16,500 (plus $5,500 for those over age 50) because the 401(k) law bases contribution limit increases on the Consumer Price Index's measure of inflation.

The law is a bit gray in this area, as this has never happened before. But with the average 401(k) plan balance down over 25% in 2008, a reduction in the contribution limit could hinder the ability to buy more shares at lower prices - cutting at the heart of dollar cost averaging.

A five-minute email to your representatives in Washington can help the opposition to this possibility.

Pitt, David. “401k contribution limits face potential fall.” Atlanta Journal Constitution, September 4, 2009.

Block, Sandra. “In 2010 IRS could cut 401(k) contribution limit to $16,000.” USA Today, August 28, 2009.

True Investor Returns, Pt II

noreply@blogger.com (John Scherer) — Thu, 24 Sep 2009 12:21:00 +0000

After writing the last post, I was curious about the actual results of previous studies and decided to do a little digging about the history of the DALBAR anlaysis of investor vs. fund returns. My gut agreed with Nick Murray's contention that the underperformance of investors vs. funds remained fairly constant (in all the time I can remember seeing the survey results since I started in the financial business in 1994 that seemed to be the case), but I wanted to verify that. I did some googling and found these excerpts taken from the public pages of DALBAR's website, proving that this is not a new phenomenon.

From the 2001 update page

QAIB (Quantitative Analysis of Investor Behavior) examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2000. The study was originally conducted by DALBAR, Inc. in 1994 and was the first to investigate how mutual fund investors' behavior affects the returns they actually earn.

The following annualized returns for investors, whose average fund retention was 2.6 years in 2000 (down from 2.8 in 1999, but up from 1.7 after the stock-market crash in 1987), compared to corresponding indexes, clearly illustrate the benefit of buy-and-hold strategies:
The average fixed-income investor realized an annualized return of 6.08%, compared to 11.83% for the long-term Government Bond Index;
The average equity-fund investor realized an annualized return of 5.32%, compared to 16.29% for the S&P 500 Index; and,
The average money-market fund investor realized an annualized return of 2.29%, compared to 5.82% for Treasury Bills and 3.23% for inflation. Money-market fund investors lose money after inflation.

From 2003

Motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns. Most investors are unable to profitably time the market and are left with equity fund returns lower than inflation.

The average equity investor earned a paltry 2.57% annually; compared to inflation of 3.14% and the 12.22% the S & P 500 index earned annually for the last 19 years.
The average fixed income investor earned 4.24% annually; compared to the long-term government bond index of 11.70%.

From 2004

It is widely believed that rapid fire trading produces huge profits for traders at the expense of the average investor. But the latest DALBAR study shows that market timers actually lose money instead of making healthy profits.

Examining the flows into and out of mutual funds for the last 20 years, the DALBAR study of investor behavior found that market timers in stock mutual funds lost 3.29% per year on average. Over a period when the S&P grew by 12.98%, the average investor earned only 3.51%.

“This finding is consistent with the well known behavior of investors to brag about their gains, but remain silent about losses” said Lou Harvey, DALBAR President. “The occasional money makers create the illusion that all timers are winners all the time. The fact is that most timers lose money most often and this data now confirms it.”

The study for the 20 years ending 12-31-2008 didn't have a public page, but the updated results showed equity investor annual returns of 1.87% versus S&P 500 index returns of 8.35% and fixed income annual investor returns of 0.77% versus the Barclays Aggregate Bond index returns of 7.43%.

True Investor Returns

noreply@blogger.com (John Scherer) — Mon, 21 Sep 2009 12:56:00 +0000

In a statistic that never ceases to amaze me, research firm DALBAR calculates that the average investor return is consistently less than half of the return of the average mutual fund. I was reminded of this twice recently: first in reading Nick Murray's book "Behavioral Investment Consulting," in which he cites the 2007 version of the DALBAR survey as calculating the average equity fund investor having a 4.48% return versus the average equity fund realizing a 10.81% return over the previous 20 years. Every year that I've seen this study the results have been pretty consistent, and Murray says in his book that "...although these two numbers will bounce around a lot from year to year, the relationship between them remains eerily constant: over 20 year periods, the average fund investor consistently manages to capture much less than half of the return of the average fund." (emphasis his)

The second reminder of this phenomenon came in an article on Morninstar.com titled "Did You Do As Well As Your Fund?" I have not reviewed Morninstar data on this topic previously, but since 2006 the firm has been calculating Investor Returns in comparison to Fund Returns. This article has a very enlightening analysis of popular funds such as CGM Focus and Fairholme in relation to the exceedingly poor investor returns relative to total fund performance.

Morninstar calculates that investors in Fairholme have received a -1.68% return over the past five years compared to Fairholme's 8.56% fund performance over the same time period. CGM Focus investor's return underperformed the fund by a whopping 20% over the past five years! (And that's not 20% total, that's 20% annually!)

More evidence that we don't need to have an accurate prediction of the future to have a good investment experience, we just need to have a good plan and stick to it.