From the December 2011 newsletter:

As mentioned last year, valuation ratios such as P/E are not very useful in making one year market predictions. This is disappointing, since they do a fair job of predicting longer-term returns of at least 5-10 years. As a result, you will not see a market forecast from us for 2012 or any other single year, unless we can support it with a high standard of evidence.

The next best thing is to evaluate the markets today using those valuation ratios and consider how that affects future returns in the 5-10 year time frame. It’s not as exciting, but it’s far more responsible and reliable based on historical market data.

The following table shows valuation ratios for US stocks and US real estate as of 12/23/2011, with P/E ratios using 10 years of earnings. Estimates for future returns assume that valuations revert to fair levels 10 years from now, and that asset classes otherwise perform in line with their historical averages.

The two valuation ratios for stocks (Q and P/E) are calculated using separate sets of data, yet produce essentially the same results, indicating that our methods are at least consistent.

Both stocks and real estate are currently overvalued by a significant amount, so we can expect lower than average returns for both assets classes over the next 10 years. However, tactical bets should be measured, since 10 year returns are still expected to be positive and the margin of error in these predicitons is meaningful.

Related Blog Posts

• Valuing Real Estate (REITs)
• Predicting the Stock Market Using P/E
• Stock Market Predictions Using Q

The December 2011 newsletter is out. Happy holidays!

Related Blog Posts

• Newsletter: March 2011
• Newsletter: September 2011
• Newsletter: June 2011

From the September 2011 newsletter:

In prior newsletters, I made the case for using the P/E ratio to value the stock market and to predict future returns. Now let’s apply the same analysis to real estate, or more specifically REITs.

One crucial feature of REITs is that they are required to distribute almost all their income to maintain their tax status. This means earnings (the E in P/E) can be closely approximated by dividends. And dividend data is far easier to find for individual investors. Even better, the REIT industry provides historical data on their website for budding data scientists.

With a little data manipulation, you can create the chart below. “P/E” in this case uses 10 years of dividends, not earnings. The relationship we saw for stocks seems to hold again for real estate: P/E ratios using a longer horizon have a close, but not perfect, relationship with subsequent returns–in this case 2 year returns. High P/E ratios (blue line) tend to line up with below average returns (red line).

Source: REIT.com data and Mariposa calculations as of 9/28/2011.

Like stocks, this relationship does not work as well at shorter time periods (1 year or less). And below average returns for real estate can still be positive, weakening the case for using this analysis for short-term trading. As a result, my primary use is to make measured tactical adjustments vs strategic asset allocation targets, knowing that it may take years for the market to correct.

And how does the US REIT market look today? At Monday’s close (VNQ at $56.06), REITs look to be around 40% overvalued. It’s not alarming, but you should expect returns that are lower than the historical average.

Related Blog Posts

• 2011 Year-End Valuations
• Investment Options: US Real Estate
• Is Real Estate a Good Investment? (Part 1)

The September 2011 newsletter is out!

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• Newsletter: December 2011
• Newsletter: March 2011
• Newsletter: June 2011

From the June 2011 newsletter:

If you have ever switched jobs, you probably have more than one old 401k (or 403b) account with past employers, with the occasional unexpected statement as your only reminder that they even exist. You suspect just leaving it there is not what you should be doing, but what is the best strategy with old 401k accounts?

When leaving a job and starting a new one, you generally have four options with your old 401k (exceptions always apply):

1. Leave it there.
2. Transfer it to your new 401k.
3. Roll it over to a Rollover IRA.
4. Roll/convert it to a Roth IRA.

What do I do? I’ve generally rolled my old 401k accounts to a Rollover IRA as soon as I leave. I do this mainly for the freedom to buy the investments that I want, which are usually lower-cost and a better fit for my retirement portfolio. Also, I keep the option to convert to a Roth in the future. However, there are good reasons to choose some of the other options.

Especially if your 401k is your sole investment account, transferring your old one to your new job keeps things very simple. You only have to worry about managing one account. Since you are limited to the investment choices in your new 401k, this is a good option for simplicity as long as those new investment choices are decent.

An advanced option is to roll your old 401k to a Roth IRA (doing a Roth conversion in the process). Since this is just a combination of rolling it over to a Rollover IRA and then converting it to a Roth, you should only consider this if you’ve decided to do both steps anyway. Remember that doing this triggers income taxes, just like a regular Roth conversion would.

And if you are still undecided, leaving it there is a perfectly fine strategy as you figure out what to do next. And it’s also a good temporary option if you’re just waiting for your new job to start, or waiting for the next calendar year to do a Roth conversion.

Another factor you may consider is that 401k’s and IRAs can have differing asset protection features. If this is a critical feature for you, make sure to consult an attorney.

One option I intentionally left out is to withdraw the funds, incurring income taxes, and penalties for those less than retirement age. Although this could be an emergency source of cash, it is not a recommended option. Really, do one of the other options.

Related Blog Posts

• Roth IRA Basics
• The Roth 401k Decision
• Smart Year-End Investing Moves

The June 2011 newsletter is out!

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• Newsletter: December 2011
• Newsletter: March 2011
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From the March 2011 newsletter:

When I list “full diversification” as one of core components of Mariposa’s investment strategy, what does that really mean? What’s the point of diversification?

Before answering those questions, let’s first discuss one interesting, but often overlooked, property of investments: the difference between the realized, annualized return and the average return. For example, if you experience returns of +10% in one year and then -10% in the next, your realized return is not 0%, but slightly negative (-1% if you’re calculating at home). I like to think about this relationship as a simple formula:

Annualized Return = Average Return - Risk Penalty

In the example above, the average return is zero, but the annualized return (the one that matters) is slightly negative because there is some risk. If the risk were higher (let’s say returns of +50%, then -50%), then the risk penalty would be higher, reducing the annualized return further.

Knowing this, one way to increase the type of returns that you care about (annualized) is to reduce risk without reducing average returns. The advantage of diversification is that it does just that.

Let’s look at a very simply diversified portfolio composed of 60% US stocks and 40% US bonds. This example works because bonds and stocks generally don’t move up or down together. In many cases, they move in opposite directions, absorbing some of the shock of market movements.

The total portfolio earns an annualized return that is 0.54% higher than what you would expect if you simply averaged the components. This “bonus” in annualized return is purely due to the reduction in risk, not any increases in average returns. Diversification in this case lets you capture more of the average return that is rightfully yours.

If diversification works with a very simple 60-40 portfolio, wouldn’t you want to try portfolios that are more fully diversified? You can easily add investments such as real estate, foreign stocks, and commodities to diversify and reduce risk even further. And these are the results if you do that, while still keeping the overall percentages as 60% risky assets (stocks, real estate, and commodities) and 40% bonds:

In this case, the diversification benefit is 1.40% per year. The addition of investments that move differently from US stocks and bonds provides a significant return boost, even if the average return doesn’t change.

So ignore active mutual funds, Morningstar ratings, or even earnings forecasts, just select an asset allocation that has the appropriate level of risk and diversification for you and rebalance periodically. Then spend the extra time and returns on activities you actually enjoy.

Related Blog Posts

• Predicting the Stock Market Using P/E
• Valuing Real Estate (REITs)
• Stock Market Predictions Using Q

The March 2011 newsletter is out!

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• Newsletter: December 2011
• Newsletter: September 2011
• Newsletter: March 2010

Here are the five most popular articles with our readers in 2010, our first full year of blogging:

1. Are Morningstar Ratings Useful?
   A brief evaluation of Morningstar ratings as a predictor of future mutual fund performance. This article was also published on Get Rich Slowly.
2. Is Real Estate a Good Investment? (Part 1)
   The first of a two-part series covering real estate as an investment. This one evaluates buying rental property as an investment. Part 2 covers buying a home vs renting.
3. Glide Path: A Target-Date Fund’s Secret Sauce
   Although marketed as a all-in-one solution, not all target-date funds are alike. One difference is how each fund changes its asset allocation over time (its glide path).
4. Online Investment Advisors: Marketriders, Betterment, and Plantly
   New online investment companies are bringing customization and automation to personal investing. See how they match up.
5. Top 3 Problems with 529 Age-Based Options
   Although a decent all-in-one option for 529 plans, there are a few design flaws to be aware of with age-based options.

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• Online Investment Advisors: Asset Allocations
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• Investment Options: US Real Estate

Last month, we used the P/E ratio to predict stock market performance over next 1 to 20 years. This time, let’s try using another valuation metric: the Q ratio. An easy way to calculate Q is by using the Federal Reserve’s Z.1 data, which was just refreshed last Thursday. And as mentioned previously, we know that predicting stock market movements profitably is extremely difficult, so we need to proceed with care.

Using data since 1945, the chart below shows the historical relationship between Q and S&P 500 returns over the following 1 and 20 years (annualized and adjusted for inflation).

Source: Robert Shiller data, Federal Reserve data, and Mariposa calculations as of 12/13/2010

The two sets of data look completely different. 1-year returns (in blue) are not only highly volatile, their relationship with Q ratios is also not very consistent. The 20-year annualized returns (in orange) are more stable as expected, and they also show a stronger, more consistent relationship with Q ratios. It looks like Q ratios are helpful in predicting stock market returns, but the predictions are only reliable over the long-term.

To see the benefit of using Q ratios, let’s predict returns for the next 1 to 20 years starting at an S&P index level of 1240 (12/13/2010 close), which Q estimates to be 67% overvalued. The lines below show the range of predicted returns (plus/minus two standard deviations) with and without the use of the Q ratio.

Source: Robert Shiller data, Federal Reserve data, and Mariposa calculations as of 12/13/2010

The two blue lines show the typical range of returns calculated simply from historical returns. The two orange lines show the range of returns predicted by the Q ratio based on current market levels. Even with the market estimated to be 67% overvalued, the two ranges do not seem materially different until 5- or 10-year predictions, so we can only consider Q ratios to be helpful when predicting returns over such long time periods. For short-term predictions, Q unfortunately joins P/E in the unreliable category.

However, the historical relationship between Q ratios and returns does tell us that we should expect lower returns than what’s typical over the next 10 to 20 years.

Related Blog Posts

• Predicting the Stock Market Using P/E
• 2011 Year-End Valuations
• Stock Market Experts of the 1930s

This is the latest post in a series covering investment selection. Each post covers an asset class, highlighting selection factors to consider and listing filtered investment options.

“Is the market up or down today?” A question like this implicitly refers to the US stock market, not the market for German government bonds or crude oil futures, because when people think of investments and the financial markets, most naturally think of US stocks. US stocks are, and should be, a core holding for most investors.

Although the S&P 500 and the Dow Jones Industrial Average are the most popular US stock indexes–there are dozens, if not hundreds, of funds that track them–I tend to prefer indexes that are less popular to avoid market effects that can reduce performance.

When investing in US stocks, you can concentrate on large companies like the two indexes above, or you can cover the market as a whole. The funds I list below are of the total market variety.

As with other asset classes, I prefer buying index funds and ETFs that hold hundreds of stocks instead of buying individual stocks myself, keeping costs low and diversifying as much as possible. So here are some of my basic requirements when selecting an investment for a given asset class:

• Does it represent the asset class I’m looking for? The investment I select should give me exposure to all US stocks, beyond just large companies.
• The investment should be low-cost. Obviously looking at the expense ratio is a great start. Additionally, a high turnover ratio can indicate excessive trading that incurs unnecessary transaction costs and capital gains taxes.
• The fund manager must be committed to the product long term. ETF’s and index funds come and go all the time, so it’s best to stick with companies with a history of managing indexed investments. At the very least, make sure the investment you select is popular enough that it is an unlikely candidate for closure.

The following is a filtered list of ETFs and index funds that satisfies the criteria listed at the end of the post. Another factor to consider is that certain investments are commission-free depending on the broker you use. For example, if you have a Fidelity account, you can trade Fidelity funds and certain iShares ETFs without a commission.

Criteria

• Fund size of at least $250MM
• At least 1,000 holdings
• Net expense ratio of 0.25% or less
• Turnover ratio of 25% or less
• Minimum initial investment of $10,000 or less
• Available to the public without an advisor

Related Blog Posts

• Investment Options: Foreign Developed Market Stocks
• Investment Options: US Treasury Bonds
• Investment Options: US Real Estate

From the November 2010 newsletter:

As you feast on turkey and Black Friday sales this weekend, you may wonder what investing tasks you need to take care of before year-end. Okay, that’s not going to happen, but here’s a list anyway. Happy Thanksgiving!

All Investors

• If you expect your 2010 tax rate to be lower than usual (due to starting a business, unemployment, attending school, etc), converting IRAs and old 401k’s into a Roth IRA could be a smart move. The deadline to convert is December 31.
• An easy way to reduce taxes is to realize capital losses in taxable accounts (“tax loss harvesting.”) You can sell investments that have dropped in price and replace them immediately with something similar, but not the same. Your portfolio remains effectively the same, but now you have a tax deduction. The deadline to sell is December 31.
• If you are looking to sell appreciated investments within the next few months, you should consider selling them this year instead of next because the tax rate on capital gains may go up in 2011.

Parents

• If you plan on paying for your child’s college education, 529 plans are a great way to save for those expenses. The deadline to open accounts and make contributions for 2010 is December 31.
• Already have a 529 account opened and funded? Remember to use your annual trade by December 31 if you are not using an age-based option.

Business Owners / Self Employed Workers

• If you are self-employed or own a business without full-time employees, Individual 401k’s are a great way to save for retirement. The deadline to set one up is December 31.
• Depending on how your business is taxed, the deadline for employee contributions to an Individual 401k can be as early as January 15, 2011. Speak to your accountant for your specific limits and deadlines.

Philanthropists

• Make your donations by December 31 to deduct them for 2010. You can even donate appreciated assets to avoid the capital gains tax.
• If you want to donate in 2010 to get the tax benefits, but you are not ready to decide on a charity, you can open a donor-advised fund. You get the tax deduction when you contribute, and you can decide which charity gets the money later.

Related Blog Posts

• Newsletter: December 2011
• 3 Money Tips for Entrepreneurs
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From the November 2010 newsletter:

As the year comes to a close, you will without a doubt see financial magazines and newspapers predicting what the markets will do in 2011 and suggesting what you should do about it. Most will be supported by a good story, not necessarily evidence.

We already know that successfully predicting stock market movements is extremely difficult–just ask mutual fund managers, Wall Street research analysts, or even your grandparents’ market experts. So if you want to consider it, whether for fun or for profit, you need to be particularly skeptical and careful with your research.

To see what we’re up against, let’s try to estimate future stock market returns using one of the most popular valuation metrics: the P/E ratio. First, take a look at the historical relationship between the P/E ratio (using 20 years of earnings) and the following returns over 1 and 20 years (annualized and adjusted for inflation.)

The two sets of data look completely different. 1-year returns (in blue) are not only highly volatile, but the relationship with P/E ratios does not look very strong. The 20-year annualized returns (in red) are more stable as expected, but they also show a stronger relationship with P/E ratios. It looks like P/E ratios–even when using 20 years of earnings–are not very helpful in predicting 1-year returns. Keep this in mind as you read those 2011 forecasts, especially if they rely on P/E ratios.

So when are P/E ratios useful? Let’s evaluate the benefit of using P/E ratios to predict returns for the next 1 to 20 years starting at current market levels (S&P index = 1219.) The lines below show the range of predicted returns (plus/minus two standard deviations) with and without the use of the P/E ratio.

The two blue lines show the typical range of returns calculated simply from historical returns. The two red lines show the range of returns predicted by the P/E ratio when using 20 years of earnings. The two ranges do not seem materially different until 10- and 20-year predictions, so we can only consider P/E ratios to be helpful when predicting returns over such long time periods. For short-term predictions, our search for a useful metric continues.

And based on the historical relationship between P/E ratios and returns, it looks like we should expect returns in the lower part of the typical range, particularly over the long term.

Related Blog Posts

• Stock Market Predictions Using Q
• Stock Market Experts of the 1930s
• 2011 Year-End Valuations

The November 2010 newsletter is out!

Related Blog Posts

• Newsletter: December 2011
• Newsletter: March 2011
• Newsletter: September 2011