Preparing For Market Panic
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
This quote from Benjamin Graham means that over a long period of time, investors will analyze companies’ financials, competitive strengths, and management and accurately “weigh” what a company is worth. But in the short run, markets rise and fall, and investors experience emotions like relief, panic, and joy. In the short run, buying based upon these emotions is “voting.” During the dotcom bubble, investors voted stocks way up, and over time they weighed their value to bring stocks back down to earth.
As Facebook nears its IPO, the analyst and investment community will be busy weighing the value of its shares and trying to judge investor sentiment to arrive at a share price between $35 and $55. Over the long term, Facebook shares will receive a proper price, but in the short term, investor emotions will impact pricing.
What if computers could be made to read human emotion? Since most of us can fall prey to our emotions as we watch the market, what if we could measure market emotion and be ready for market swings? Look no further than the “VIX” index. VIX is a ticker symbol that you can track like a stock. Put it in your Yahoo finance ticker symbols and start watching it. VIX has a complex-sounding definition, but in layman’s terms, it measures fear in the market by the price of puts and calls on the S&P 500.
Consider insurance as a great metaphor. If you are older, term life insurance is more expensive than if you are younger because the risk is greater for the insurance company. Mutual and hedge fund managers make less money when they have big swings in their portfolios. Unhappy investors pull their money out of funds that have big ups and downs, which reduces assets and lowers fund manager salaries. They want to take their investors for a ride in a quiet, smooth Lexus, not around the track in a high-performance Porsche. So they buy insurance (puts and calls) to smooth out the ride. If the stock market is worried about Greek debt, U.S. deficits, and other matters, the price of puts and calls (insurance) goes up. That’s what the VIX measures.
When investors are incredibly relaxed without a care in the world, the VIX can get down around 10, as it was in 2007. During the height of the financial panic, it reached an unprecedented 80, and then it fell over a year following March 2009 to around 15 in May 2010 until the flash crash happened, and then it spiked back up to 45. It slowly declined to about 15 until last August when the world freaked out about the European debt crisis and our government’s impasse on the debt ceiling. The VIX has since calmed down and has slowly fallen back below 20.
In times like these, when the VIX goes down, it usually goes back up based upon a random and unknowable event. For the third time since the 2008 panic, the VIX has fallen down to a point where investors are so relaxed that they’ve left the office, gone to the spa, and are laying on a massage table. We don’t bet on markets, and our investment strategy is never to time the market. But if you want to get yourself emotionally prepared for swings, watch the VIX. If the past is any indicator for the future, we’re set up for another roller coaster ride soon.
Should You Have Alternative Investments In Your Portfolio?
So you have discovered the merits of dumping your high-priced money manger and his ineffective mutual funds in favor of low-cost index funds allocated across stocks, bonds, and cash.
You have diversified your portfolio to reduce risk and increase your likelihood of a good retirement. Congratulations! By focusing your attention on what matters most—finding the right mix of stocks, bonds, and cash—and keeping your allocation on target through steel-veined rebalancing, you have elevated your portfolio into the top 10 percent and are enjoying the company of the top endowments and of wealthy families. You are no longer the stock market’s dog taking its daily beating.
As you have grown in sophistication, you have also become aware that the big players use alternative investment vehicles—hedge funds, private equity deals, absolute return strategies, and venture capital—to further increase diversification and elevate returns.
Take a look at Yale’s endowment manager David Swensen. One of the leading evangelists for low-cost index investing across stocks, bonds, and cash, Swensen follows a different path for the endowment he manages. In his portfolio you will find a hefty allocation to alternatives, namely 50.6 percent across absolute return strategies and private equity as of 2010.
Why does Swensen make so much room for alternative investments? There are several reasons. One such rationale is that alternatives provide real diversification within the university’s portfolio. While equities from the United States, foreign developed countries, and emerging markets sometimes seem to move in lockstep, alternative investments are more likely to zig when corporate stocks zag. That accomplishes a big goal of diversification. Another reason is something called risk-adjusted returns. For just a little more risk, Yale is able to increase its returns over a ten-year period by approximately 4 percent annually. That’s a bet they want to take.
So to truly follow the endowment model, you would think that alternatives should be represented in your portfolio as well. Additionally, in recent years, a new class of mutual funds has emerged, giving regular investors access to alternative deals that they were once locked out of. Is it time for you to board the alternative investment train?
Probably not. Here are four reasons the average guy should be cautious:
Qualification. The SEC has set rules about who can participate in alternative investments. Because alternative vehicles do not fall under the same SEC regulations and oversight as public stocks, and because there is a history of volatility and increased risk, the rules now state that to participate, you must be an accredited investor who has earned $200,000 annually for the past three years or who has a net worth, excluding home equity, of $1 million or more. The assumption is that a person with those assets is more sophisticated and more able to assess and survive the risks involved. And if you are not bringing a minimum of $500,000 to the game, there is no need to apply. Most funds set that amount as the minim hurdle for participation. Alternative investment mutual funds, however, have removed qualification barriers by allowing average investors the opportunity to pool their funds and participate.
Quality. Access is one thing, but quality is the bigger issue when it comes to alternatives. It doesn’t help to gain access to alternatives if you’re buying into the leftovers and walking dead, as the VC world calls them. Access to the best managers and funds is highly sought after, and a serious competition rages between endowments and wealth managers commanding billions of dollars of assets. Your little alternative mutual fund is the yapping Chihuahua that is fighting for his chance at the dog bowl while the pit bulls ravish the meal.
Fees. Even if you do luck out and find your way into a quality alternative fund, beware of the fee structure. While the institutional investors are able to knock down fees, the average Joe can expect to pay a 2 percent annual management fee and another 20 percent on all profits before he gets money out. Under the mutual fund model, add another onerous layer of management fees, usually around 2 percent annually, plus marketing fees and sometimes additional loads. Your underlying investments better include the next Facebook if you expect to see stellar returns.
Visibility and transparency. Finally, there is the issue of the visibility of your investments and the transparency of management. If David Swensen calls up ACME Enterprises to get an update on his European private equity holdings, his call will be taken and the discussion will be deep and wide. If you call your mutual fund provider to find out about how your investment in XZY Ventures is going, you will be put on hold until you go away. You have no shot of really understanding anything that is happening with your investment dollars short of what the mutual fund managers provide in their polished quarterly reports. And if the house starts to burn, count on being the last dog out the doggie door.
Big, smart money has ways of accessing alternative deals the average guy has a hard time understanding, let alone selecting. Alternative investment mutual funds can provide access to some high-priced leftovers. Smart access to alternatives comes in the form of index funds pointed at real estate through U.S. and international REITs and commodities in the form of U.S. and global energy and precious metals investments. These alternatives technically fall outside the typical stock/bond mix and provide real diversification via low-cost and reasonably transparent investments. Include these alternatives in your portfolio mix. If you try to play in the alternative world with the big dogs, you’re likely to end up with leftover dog meat that will leave you growling.
Confessions of a Former Stockaholic
Several years ago, our firm retained Miller McMillian, a copywriter, to help us with our website. Little did we know, he began investing using the methods we’ve been espousing in our newsletters and blogs. He asked if he could share his experiences.
First of all, I am not a professional stock picker. I am an independent investor who never studied business and never knew what he was doing in the stock market – except saying to myself, “I’m not paying some broker to do this for me and charge me on the front end, the back end, and every in and out in between.
Back to my story.
I used to think there were two options for my IRA: mutual funds and individual stocks. Bonds were out of the question. One of my friends told me, “Just say no to bonds.” And I figured bonds were for people 65 and over who had “retired” from trying to make enough money to retire.
I tried mutual funds for several years, and from 1994 – 2000 I did well. Looking back, it was a no lose environment. You could throw darts at the charts and hit winners. Janus, T. Rowe Price, Mutual Series – it didn’t matter!
But along the way, addiction set in. Those 20 – 30% profits were not enough. I got caught up in the exuberance of technology. I craved the highflying funds that were amped up on tech stocks. Well, around 2001, things went south and I lost big time.
Along the way, I had ventured into individual stocks. I reasoned, “Stocks can go up 5% in one day. That’s more than a lot of mutual funds accomplish in a year. This is a no brainer.” I paid for the price for that, too. Clearly I did not have the genetic makeup to do well in the stock market.
Eventually, I came out of denial. It was time for recovery. No, I didn’t go to Betty Ford. I went to the sidelines. I dried out. Went into cash and some of the most boring big companies I could find. I thought dividends were better than nothing, so I tried parking in places like Procter & Gamble, AT&T, Boeing – you know the names. That was a step in my recovery. Then I had a financial awakening.
Around 2007 I learned about ETFs. “Wait. These are just index funds with a fancy name. I don’t have any trouble falling asleep. No Ambien in my medicine cabinet. Why would I go the route of index funds and commit my IRA to years of sloth and boredom?”
Then I learned about asset allocation, spreading my money around to various asset classes and periodically rebalancing. I found out about the law of compound returns and that it works if you stop trying to beat the market — lower fees and fewer mistakes! Is this really how it’s done?
I learned more about the ups and downs of ETFs – how owning a basket of stocks made sense. After all, market movements make money for managers, not individual stocks. That was an awakening for me. And I learned how markets moved in opposite directions. So if US stocks were on the outs, other indexes would probably be moving up.
So I tried this new approach, cautiously at first. Just a few ETFs. Although I had never fretted over my IRA at 3 am, I noticed that I was not so preoccupied with my IRA. “Mad Money” was less interesting than the Lakers’ game. The Wall Street Journal was still interesting, but I was not reading the financial pages first. I wasn’t checking my portfolio two or three times a day.
Okay. My name is Miller and I’m a stockaholic.
I still own a few large stocks. I admit it –– I am not fully recovered. I still have a stash of McDonalds, Apple and a couple of other anonymous stocks.
But on the bright side, I am 90% in ETFs. I have US stocks: small, medium and large. Bonds: short, intermediate and long. Europe (bad for the moment), Asia, Canada. TIPS (which performed remarkably well last year) emerging markets, REITS, global real estate, gold and energy. I am diversified big time, with allocations appropriate for my risk tolerance, age and when I will retire.
I feel very comfortable with this arrangement. I don’t worry about the market. When I do check my portfolio, the “reds” are offset by “greens.” When one market is having a bad day, invariably the bonds or other markets pick up the slack. I’ve given up stocks for ETFs and gotten back my sanity.
Free Your Portfolio By Freeing Your Mind
“Free your mind”
These words from the cult classic, The Matrix, were spoken by Morpheus in an attempt to guide the newly delivered Neo away from the deception of the Matrix. The Matrix depicts a future where reality as perceived by most humans is actually a computer simulation created by intelligent machines to subdue humanity while their bodies’ energy is used as a power source for the ruling computers.
As macabre as this theme sounds, the Wall Street machine of big money management isn’t much different. This matrix works overtime through incessant waves of paid media to hypnotize ordinary investors into accepting a false investment reality – that active money management benefits investors. Sadly, like the sentient machines mentioned above, the Wall Street matrix deceives investors so that they can in turn suck the energy out of their portfolios in the form of hidden fees thereby feeding there ravenous appetite for profits and wealth.
Sounds strange? You don’t have to take our word for it. Instead, you can look to the Morpheus’ of our age – academic scholars, Nobel Laureates and enlightened practitioners who have broken free of the Wall Street systems and are guiding investors to a real and happier end through low cost index investing. If you remain unconvinced, you owe it to yourself to learn more by reading one of our top five recommended books below. If you are convinced but haven’t read these titles, then you should pick a few for this year’s reading list as a commitment to discipline your mind and resist the hypnosis. The Wall Street matrix never sleeps. If you want to free your portfolio to truly perform, begin by freeing your mind.
The Investment Answer – Daniel Goldie and Gordon Murray
MarketRiders’ investment book of the year is The Investment Answer by Daniel Goldie and Gordon Murray. Take a Wall Street veteran who learns he has inoperable cancer, a mere six months to live, and an aching desire to expunge his conscience from participating in big money management’s abuse of the average investor, and this is what you get – a ruthlessly honest five step program to protect and grow your retirement wealth. Here you will find an eminently valuable primer which can be read and understood in one sitting, and has advice that benefits you, not Wall Street and the rest of the traditional financial services industry.
A Random Walk Guide To Investing – Dr. Burton Malkiel
Possibly our favorite book at MarketRiders, A Random Walk Down Wall Street, is a concise guide by influential and irreverent author and Princeton professor, Dr. Burton G. Malkiel. Malkiel takes the mystery out of personal finance by outlining a ten-point plan for success. Easy to read and easy to follow, this practical book aimed at everyday investors cuts through the jargon to give readers the confidence and knowledge to make wise investment decisions that will provide consistent returns. This book may be the best possible starting point in an investor’s education.
The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns – John C. Bogle
The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns – John C. Bogle (http://www.amazon.com/Little-Book-Common-Sense-Investing/dp/0470102101/ref=sr_1_1?s=books&ie=UTF8&qid=1326428452&sr=1-1)
If you haven’t familiarized yourself with John Bogle, then you can look forward to a real treat. Bogle is the world’s greatest modern day financial hero who has spent his life defending the interests of the common investor. Having come from the bowels of the Wall Street machine, Bogle walked away from untold wealth to start The Vanguard Group, a non-profit money management company based on index investing, low fees and transparency in an effort to serve hard working people in search of a reliable retirement. From being one of the first revolutionaries in indexing to growing the most disruptive firm Wall Street has ever encountered, Bogle should not be missed with this book being an excellent starting point.
Unconventional Success: A Fundamental Approach to Personal Investment – David F. Swensen
Everybody likes to hear from the top expert in a given field. In the area of wealth management, you would be hard-pressed to find someone more renown than David Swensen, the Chief Investment Officer of the thirty plus billion dollar Yale Endowment. Praised worldwide for his shockingly good track record of portfolio returns in the high teens for over a decade, Swensen is the finance industry’s Michael Jordan.
Imagine how exciting it would be to garner a private hearing with Mr. Swensen to discuss your own private portfolio. Imagine no longer. Simply pick up a copy of his book and learn why Swensen’s approach also found at MarketRiders is right for you.
The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money – Carl Richards
Released just this past month, Carl Richards book, The Behavior Gap, explores the fascinating and exploding field of behavioral finance. Richards describes a strange but true phenomenon – that year upon year average investors successfully underperform the index by several percentage points. Why? Because of something he calls the behavior gap, the difference between what we should do and what we actually do as emotions usurp our portfolio plans and dictate or investment decisions. To successfully execute the management of your MarketRiders portfolio, you will have to gain mastery over your emotions. Mr. Richards can help you get there.
PickPockets: How Wall Street Steals Your Money and What to Do About It
Coming soon is MarketRiders first book, PickPockets. This exposé uncovers the shocking truth behind the Wall Streets’ big money machine and provides an action plan for success. A compilation of Mitch and Steve’s finance columns from U.S. News and World Report, this whitty and easy to read tome provides a good chuckle as well as a good plan for your financial future. Keep an eye out for its release in the months ahead.
Do You Pass the Investment Test?
Like a volcano, markets go through phases: they do very little and then suddenly they spit fiery lava. With new problems being introduced each day, be it Greek debt or the survival of the Euro, political bickering or Middle East uprisings, the markets are trying to figure out what stuff is worth.
Volatility was up in 2011, and brought out all of the “forecasters” in droves predicting which way the markets will blow. Most have been wrong. Bill Gross, who runs the largest bond fund in the world bet against US Treasuries, which was the top performer in 2011. Famed investor Meredith Whitney predicted the demise of municipal bonds. Following her advice would have been devastating as munis rallied after her “insights.” Hedge funds that focused on picking stocks were down 7% in 2011 with a Dow up 5%.
One of our members asked, why we recommended Vanguard’s Exchange Traded Fund VGK an index made up of the largest 482 stocks in 16 European countries when “everyone knows” that Europe is in trouble. VGK was down nearly 18% last year, while the S&P was flat.
First, think of the thousands of investors all around the world, who deeply understand the economic circumstances of every country in Europe, focused every second on figuring out what every one of those 482 companies are worth. Is your opinion on VGK’s price better than theirs? Second, VGK belongs in a globally diversified portfolio, because we care about the long term. Europe will recover. In 10 years, VGK’s price today will likely look cheap because those 482 companies will be more valuable. When CNBC says “Europe” remember these are real global businesses making money, employing millions of workers.
A year ago, when TIPS were selling at a high price, one of our members declined to include it in his recommended portfolio because in his opinion “it was over valued.” TIPs were up over 12% last year.
Trying to time and guess the market’s direction is futile for most mortals and investment professionals. It’s during times like these, that you can really appreciate the calming logic of a simple and disciplined asset allocation investment methodology. Since we never know how one particular asset class will perform –own them all at a very low cost, in proportion to our risk tolerance. Then rebalance them as the markets shift.
Sounds easy to “buy low and sell high” doesn’t it? Would you buy more Europe now if you were under-allocated? We certainly hope so. Is your asset allocation right? This market provides you with a litmus test. If you have been feeling panic lately, then perhaps your stomach lining isn’t strong enough for amount of equities in your portfolio. It may be time to consider whether you should increase your exposure to bonds and TIPs.
Markets like these test you. Stay the course and take a gut check. Keep rebalancing and make the market’s volatility your friend. If your allocation is right, you’ll be able to keep your mind off the stock market, keep CNBC off and focus on the rest of your life.
Congressional Insider Trading and American Hypocrisy
Have American politics finally become as debauched as the late Roman Empire?
A recent exposé by 60 Minutes on Nancy Pelosi’s insider trading activity and the resulting media storm have left much of America agape. Can it really be that the same congressional leaders that have established laws to firmly punish insider traders such as Martha Stewart, the insider king Raj Rajaratnam, and just this past week Diamond Back Capital and Level Global, are themselves exempt from the rules? Sadly, under the status quo, they are.
According to reports, former House Speaker Nancy Pelosi bought stock in an initial public offering that earned hefty returns while she had access to insider information about pending legislation likely to impact those values. Additionally, just days after a private committee briefing during the 2008 financial crisis, Spencer Bachus purchased stock options that proved quite profitable through the downturn. The irony that Mr. Bachus is currently the chairman of the House Financial Services Committee is palpable.
And if you have doubt that this problem is widespread, all you have to do it look at the results of a recent study that reveals the average portfolio returns of congressmen and senators. As reported in the Wall Street Journal, these leaders consistently outperformed stock indices like the Dow and the S&P 500 and the returns of professional money managers.
In academic studies from the Journal of Financial and Qualitative Analysis, statistically significant results demonstrate that both Republican and Democratic politicians are outperforming the market, with the Democrats enjoying a whopping 9 percent annual outperformance. Senators were the biggest winners, displaying Houdini-like magic and beating the S&P by 12 percent annually. These results are not due to luck or financial acumen, but are rather the result of trades based on non-public information that these politicians are privy to in closed-door sessions. For the rest of us hard-working and investing Americans, this type of advantage is called insider trading.
Obviously, behavior that is criminal for everyday Americans should not be okay for lawmakers who have the power to gin up laws that affect companies while simultaneously keeping an eye on their own spreadsheets and brokerage accounts. Sadly, however, this is in fact the case.
Congressional immorality seems to extend beyond this insider debacle. Recent reports have revealed that Countrywide provided special VIP loans with publically unavailable discounted interest rates to representatives. There was even a rumor this past month concerning student loans given to congressional family members that are later forgiven. Further research by Snoops.com and others revealed that these forgiven student loans are just for a limited group of staff members who work for our elected officials. Well, there you go; finally some moral fiber. It leaves those of us struggling to get our retirement portfolios on track to wonder if there is a way to pick up one of these staff member positions, or better yet become a lawmaker to get to the real juice.
Some may be old enough to recall Newt Gingrich and Dick Armey’s Contract With America. Amongst such common sense things as a balanced budget amendment, congressional term limits, and “loser pays” tort reform was a cornerstone section that stated: “All laws that apply to the rest of the country also apply equally to Congress.” Here is something that should unite Tea Party members right through Occupy Wall Street protestors: legislation that requires lawmakers to play by the same rules as the rest of us.
Now, due to this dust-up, Congress is pursuing legislation to address the insider trading problem. The STOCK Act seeks to require lawmakers to publicly report all trades within 90 days. Those in the know say this law does not go far enough and that immediate and transparent reporting is necessary on all trading. Unfortunately, the real answer should be moral rectitude in the form of public servants constrained by an internal sense of conviction that they must serve the country and not themselves. This conviction should second nature, but it is no longer clearly evident in congressional behavior. The fact that we have to codify this ethic in writing shows just how bad Washington has sadly become.
On the one hand, lawmakers have been passionate about confronting corruption on Wall Street. From Sarbanes-Oxley to Dodd-Frank, politicians have sought to weed out the next Enron, stop the next Madoff, and avoid the next Lehman collapse and MF Global bankruptcy. All the while, as they slap the hands of others, they too are burying their hands up to their wrists as they riffle through the cookie jar.
While index investing cannot hold a candle to the results these insiders enjoy, this mess underscores why a passive approach to your portfolio is the smartest way forward in this unfair world. While it is hard enough to build a smart and globally diversified portfolio, it is virtually impossible to compete with those who enjoy their insider advantage. By keeping your investment costs down and your bets widely spread across many markets, you will enjoy the rewards of long-term and tax-efficient market growth. If you want to jump into the ring, one hand tied behind your back, and fight the pros with insider insight, then good luck.
If You Can’t Beat It, Join It
We frequently write about the uncontested fact that most stock pickers, professional or amateurs, don’t consistently beat the market.
We know that rock-star stock pickers like Peter Lynch in fact used to be able to outperform markets years ago. But global stock markets have changed dramatically over the last fifty years, making it nearly impossible to find mispriced stocks. Markets are now considered “efficient,” meaning that whatever a stock is selling for is probably close to what it is worth. Here are five reasons that have contributed to market efficiency:
The rise of institutional investors. In 1960, only 10 percent of all investors were considered professionals. They were like foxes in the hen house of amateur investors. Professionals could get an edge because there was only one of them to every nine amateurs. TodayL, that ratio is reversed. Out of ten trades, nine come from professionals. These pros are certainly frantically trying to get an edge through trading. Back in 1960, only two million shares traded daily on the New York Stock Exchange. Today, there are over four billion shares traded daily.
Concentration of professionals. While there were few pros in 1960, today they are highly concentrated. In fact, the top 50 fund companies generate 50 percent of all commissions on Wall Street. That means when an analyst at Merrill Lynch gets a great idea, or finds out some important factoid that no one knows, he calls those firms first and then publishes his research report a day later. That information is quickly priced into the stock. Those top 50 firms get the edge because they pay for it.
Derivatives. The ability to buy and sell puts and calls (also known as derivatives) is a new invention of the last 50 years. The value represented by these derivatives now exceeds the entire value of the stock market. While these securities allow some investors to hedge positions, their existence creates undue movements in the market, spooking investors and adding to uncertainty.
Certified Financial Analysts (CFAs). Did you know that an entire field devoted to studying the pricing of stocks has developed over the last 50 years? This certification arms the analyst with highly sophisticated tools for studying stocks and analyzing their value. Today there are over 300,000 CFAs all over the world, armed with the IQ points, tools, and training to figure out how a stock should be priced. Their work gets quickly priced into stocks, quickly bidding up the bargain stocks.
Democratization of information. Two major events have made the same information available to everyone: Regulation FD (Fair Disclosure) and the Internet. Until about 2001, analysts and large fund managers would receive “whispers” from company management. An analyst who received a whisper from a CEO was able to inform his clients, who would trade and profit on this information. That’s why analysts were paid way more ten years ago. Reg FD put strict restrictions on insider trading and as a result, there is now little whispering. At the same time, the Internet, e-mail, and even Bloomberg terminals have made information instant and available to everyone. The minute a material piece of information is out, it is picked up by anyone who wishes to buy or sell based upon this new “datapoint.”
If you own Apple or Google because you use the products and think there’s a “long way to go,” realize that you are taking undue risk. If markets are efficient, it means that you’ve bought the stock for exactly what it is worth. You have no edge. And worse, if you pay for a fund manager to make better picks than the overall market, you are wasting your money. You’ll make more in the long run by owning a fund that owns every single stock in a given market. If you want to own emerging markets like Russia, Brazil, India, and China, buy VWO from Vanguard, and own all 900 relevant companies in these countries. Don’t try picking 20 or 30—own them all! This is called investing in indexes, and for these reasons, we recommend only index exchange-traded funds (ETFs) to our clients.
Should You Use Currencies to Diversify?
Whether it’s the ancient Greeks quipping about moderation in all things or a mom telling her kids to eat their vegetables and not just Otter Pops, diversification in life is broadly understood to be a wise principle. It’s especially true when it comes to investing. Asset allocation is often cited as principle number one, accounting for 90 percent of portfolio returns.
While traders fret and squabble over the next best stock to buy or sell, smart portfolio managers focus on the big picture, spreading money across broad asset classes including U.S. stocks, foreign developed stocks, emerging market stocks, real estate, bonds, inflation-protected securities and sometimes commodities. Asset allocation is supposed to reduce risk within a portfolio by spreading bets across investments that move independently of one another. While one part of your portfolio zigs, the other zags, helping you make money (and preserve capital) in all environments.
Recent critics of asset allocation, however, have pointed out that due to factors such as globalization, many assets including stocks now move in lock step. This trend, they say, is illustrated in the 2008 crash when all sorts of assets fell in tandem, supposedly revealing that the benefits of diversification are ephemeral.
A quick look at the core stock classes in 2008 shows that pain was evenly spread across every major category with U.S. stocks down 36.2 percent, foreign developed down 43.4 percent, emerging market stocks 52.9 percent, and even the nontraditional classes of REITS and commodities hit with declines of 37.6 percent and 31.9 percent respectively. Where is the non-correlation in this asset allocation? These facts, the critics point out, prove that the asset allocation models of the past are now bunk and in need of a desperate overhaul. 2008 is said to have sounded the death knell for all of modern finance. In response, one idea that has gained traction among some managers is the notion of adding global currency as a new type of uncorrelated asset class.
Is Asset Allocation Dead?
Did Modern Portfolio Theory (asset allocation) really die in 2008? MPT does not guarantee that an investor will make money every year. It really does not even say that asset classes will always be uncorrelated. What it does say is that on average, over time, asset classes perform differently, and a diversified portfolio will exhibit less variation in returns than a portfolio with one asset class. This diversification should lower risk, help investors stay the course and achieve their goals over the long haul. Did this hold true?
A look at some diversified portfolios shows that it did. In 2008, bonds returned 5.2 percent. Disciplined investors who kept a strong allocation to bonds experienced much less pain during this historic downturn. A 50/50 split between bond and equity allocation would have reduced losses by more than half. Less pain means a lower likelihood that an investor will panic and abandon their planned course during turbulent times. But woe to those who did bail out. In the following year, U.S. stocks were up 25.2 percent, foreign stocks rallied 31.8 percent and emerging markets gained a whopping 82.6 percent.
More diversified portfolios declined less than the markets over 2008 giving diversified investors the courage to stay with their plan. Those who stayed the course reaped a robust reward the following year.
For a dead idea, MPT worked pretty well.
Should You Add Currencies into Your Mix?
Some MPT advocates suggest that currencies as the new answer for a truly diversified portfolio.
Take currency returns over the past year. While Mexican peso was is down 7.8 percent against the U.S. dollar, the Japanese yen was up 7.5 percent and the Swiss franc up 6.7 percent for the same period. A quick study of currencies demonstrates that they are in fact highly uncorrelated to stocks. Should we then conclude that they belong in your retirement portfolio?
For the average investor, the answer is no for two simple reasons:
- A diversified portfolio of stocks and bonds already provides exposure to global currencies. Large U.S. multi-national corporations may trade in U.S. dollars, but they conduct business in foreign lands using foreign currencies. By default they are already affected by currency exchange rates. Furthermore, beware of holding investments that trade in currencies other than the dollar as you are exposing yourself to both the risk of the underlying companies as well as the foreign currency. That presents a lot of risk to understand, let alone manage.
- Currency values are tied more to inflation speculation than economic growth. History demonstrates that economic growth does not necessarily result in a stronger currency. If you think corporate profits are hard to predict, try predicting inflation. It’s a daunting task best left to the pros.
Placing all your eggs in one basket remains as bad an idea today as it did forty years ago when the fathers of MPT first began suggesting diversification strategies. Although 2008 was a rough spot for all investors, those who stayed true to diversification through the tumult are smiling today.
A Great Investing TIP
U.S. investors seem fixated on the S&P 500 and the Dow, as if they’re the only indicators that matter, when discussing the stock market. “Oh boy, the Dow was down over 300 today!” is a common refrain. But investing is not a one-horse race; there are many other asset classes that are of interest. In the homestretch of 2011, with one month left to go, here’s a look at some of this year’s results.
We all know that the gold bugs are crowing like crazy because their beloved metal is up over 22.5 percent. But guess what is number two? A big surprise! U.S. treasuries that will indemnify you against the rages of inflation, also known as TIPS (Treasury Inflation-Protected Securities), are up 13 percent this year.
As of Wednesday’s close, the S&P 500 is about dead even with where it started this year. Smaller companies are down about 1 percent. It has been a wild ride to be sure, but no return has been made owning U.S. companies. Similarly, all the chatter about running out of oil seems to be lost on stock prices. Global energy stocks have been up and down, but they remain flat for the year.
U.S. bonds are up about 7 percent including dividends. Even though we are printing dollars like there is no tomorrow, U.S. treasuries are still considered the safest in the world. Imagine that—the same bonds that have been spat upon by the media for 11 months are generating incredible returns this year.
The 28 emerging market economies have been the worst performers. China, India, Brazil, and Russia are down over 15 percent, giving back last year’s gains of 15 percent. The more mature foreign developed economies, including Canada, Europe, Japan, and the rest of Asia, are down about 10 percent this year. This is largely because the greenback has been appreciating against other currencies. You’d never think that listening to CNBC and the media!
U.S. real estate is up about 4.5 percent, but foreign real estate is down about 10 percent. That’s a big swing and speaks to the problems in the credit markets outside the United States because investors worry that landlords won’t be able to refinance their debt.
Since no one knows which way any of these markets will go next year, we continue recommending portfolios containing all markets and asset classes, in proportions specific to the individual. Our investors are trimming their gold and TIPs and adding to their foreign stocks. We are buying low and trimming high, anticipating that this year’s winners turn into next year’s losers.
As this year ends, you’ll start reading about all the managers who “outperformed their benchmarks,” but statistically, most will fall off the radar in the next year or two. As time goes by and capitalism works its magic, we make money by keeping our fees low with exchange-traded funds (ETFs) and tuning out the noise. ETFs avoid the unnecessary and hidden risks often found in active management, such as hidden leverage, quantitative algorithms predicting market moves, quirky money managers, conflicts of interest, and managers placing large bets with your money.
With one month to go, the markets haven’t yet spoken for 2011. But so far, those U.S. bonds that everyone has forsaken will either win, place, or show in this multi-horse race.
Stop Paying Wall Street to Take Your Money
“Odds are you don’t know what the odds are.” —Gary Belsky and Thomas Gilovich, “Why Smart People Make Big Money Mistakes”
Rule number one for spending your hard-earned dollars—pay for value. This rule is so obvious that it’s almost offensive to mention. When you plop you body down at a Motel 6 for a quick sleep while on the road, you don’t expect to get the Ritz Carlton. And few will complain of spending top dollar for an unforgettable dream vacation spent celebrating one of life’s precious milestones with the ones you love. You work hard for your money and when you spend it, you want value commensurate with cost.
Yet in a macabre twist, millions of retirement investors line up ever day and pay Wall Street to take their money. As ridiculous as this sounds, the facts overwhelmingly and conclusively demonstrate that actively managed money significantly underperforms passive investing over time.
The perfect business model
To put this in context, think for a moment about how corporate boardrooms as well as Silicon Valley start-ups are filled with the same vigorous discussion: how to offer products and services of value to customers that will result in increased market share and profits. While real companies compete to improve their goods and services, the financial industry has pulled the ultimate business coup: They have discovered the perfect business model in which people pay for them to simply take their money. Sound absurd? Take a look at the facts.
In Rick Ferri’s recent book, The Power of Passive Investing, the ineffectiveness of active money management is reviewed going back as far as 1930. As Ferri points out, Nobel Prize winning economists of the likes of William Sharpe of Stanford University and Jack Treynor of MIT; leading researchers like Eugene Fama, Harry Markowitz of the University of Chicago, and Burton Malkiel of Princeton; and the popular writings of John Bogle and many others have all demonstrated that after expenses, active management is a fool’s bet. A study by S&P showed that over a five-year period, nine out of nine equity fund categories underperformed their corresponding passive indexes.
Why does active money management underperform, you may ask? The reason is quite simple: It costs too much. Most active fund managers have to beat their benchmark index by 1-2 percentage points each year just to break even on an after-expense basis. A performance improvement of 2 percent may sound small. But when we remember that the total stock market’s long-term return is only 8-10 percent, it starts to become clear why so few funds are able to perform such a feat over any extended period.
And for some investors, the bad news does not stop here. For instance, investors may turn to advisers who, according to a recent study, charge an average of 1.1 percent annually for further disservice. The net can be devastating. A 2.5 percent fee drag over 20 years can mean retiring with as much as 40 percent less compared to an investor who stayed the course with a passive portfolio. And don’t count on trying to have an honest discussion with your adviser about these facts. As John Bogle, the founder of Vanguard, once said, “It is amazing how difficult it is for a man to understand something when he is paid a small fortune to not understand it.”
How to be the 1 percent
Here is another shocking fact: A study performed by DALBAR, Inc. compared the average investor’s returns with the returns of the S&P 500. Investor returns are quite different from the index’s returns. Why? Because investors, often at the behest of their advisers, buy and sell funds due to such things as market swings or the never-ending search for the next, hottest five-star fund. The study looked at the S&P 500 from 1987 through 2007 and found an annualized return of 11.81 percent. The average inventor’s annualized return for the same period was a shocking 4.48 percent, more than a 7 percentage point difference, or what has been described as the behavior gap.
The problem of active money management is a multifaceted nightmare: money moving in and out of funds, unnecessary and unwanted tax friction, and fees upon fees. Why does any sane investor sign up for such abuse? Those in the know continue to wonder.
Possibly the cause is rooted in the astute advertisements run during the Masters, British Open, U.S. Open, and beyond that get your investment account open and your mind closed. Critical thinking skills can be whisked away by multi-million dollar marketing campaigns targeted to cast their spell. Once an investor buys the commercial rhetoric, a hypnotic trust can hijack critical thought. The hypnotizer can get the otherwise astute subject to perform the most ridiculous behavior, such as paying someone to take his money.
The only hope for the hypnotized investor is that actual facts will provide a benevolent snap of the fingers, awaking the subject to investment realities. By buying and rebalancing a diversified indexed portfolio over decades, you can escape the active management madness, leave the behavior gap behind, and find yourself in the top 1 percent of investment returns. In the end, paying yourself is much better than paying others for nothing.