Does Stock Forecasting Work?
Remember Yahoo, Gordo. It’s like Abracadabra.
In the time travel movie Frequency, this Yahoo stock tip was passed through time to the six-year-old Gordo via a mysterious interplay of a ham radio and the aurora borealis. This small bit of incomprehensible information was not only retained by Gordo, but later, when he grew up and became a stock trader, it resulted in him not only being fat, but quite happy as well.
The power of knowing the future is profound. Just imagine, for a moment, if you were given the privilege of seeing stock market results one year from today. A resourceful individual could easily parlay that knowledge into profound wealth. It is no wonder that economists, stock traders, fund managers, and financial advisers alike are desperately trying to find a way to peak around the corner of time to anticipate what the markets will do.
Forecasting markets is not for the feint of heart. Take, for instance, the recent housing bust and subsequent recession. Top economists and investors alike failed to see it coming. Ben Bernanke, the Federal Reserve chairman, testified at the Financial Crisis Inquiry Commission (FCIC) that, “We knew all those numbers, of course, but a lot of smart people, including people like Paul Volcker and others, . . . got it wrong. It is just another example of how difficult it is to predict.” Furthermore, Alan Greenspan commented, “We all misjudged the risks involved. Everybody missed it—academia, the Federal Reserve, all the regulators.”
It was not only the economists that failed to see the crisis coming, but leading investors as well. Take George Soros as an example. He became one of the world’s richest people by predicting the UK currency collapse and betting accordingly, and yet he took an ill-fated stake in Lehman Brothers just before the bank failed in 2008. Likewise, Warren Buffett, the Oracle of Omaha, lost billions in the downturn and testified before the FCIC that “no one saw the housing bubble.”
But just when you think that such foresight is outside the reach of common man, some prognosticator emerges with a specific contrarian view and then with eerie accuracy hits the nail on the head. It’s as though he found his own flux capacitor-equipped DeLorean and sailed from the future to the present with otherworldly insight.
Take for instance, the small group of esteemed economists and financial managers that called the housing crisis. There is Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, D.C., who in the August 4, 2004 issue of The Nation gave a detailed warning concerning the coming housing crisis in an article called Bush’s House of Cards. His predictions were five years early and largely ignored. Then there is Med Jones, the president of the International Institute of Management (IIM), a U.S.-based research and education organization. Although Jones is less known, he turned out to be the most accurate in predicting many of the downturn’s details.
Nouriel Roubini, an NYU economics professor known as Dr. Doom for his wild and dire predictions, became a media darling because of his accurate foretelling of the crisis. More bearish still is Peter Schiff, who now famously predicted the housing collapse in nationally televised debates. Although ridiculed by experts, he showed great courage, and his detailed analysis proved right in the end.
It is these types of expert forecasts that make investors seek the next accurate prediction. Think of how you might have managed your portfolio differently if you had only listened to these warnings before the housing crash. Furthermore, today, there are forecasters out there who are nailing their predictions right before our eyes. A year from now, many will lament the fact that their laser-sharp predictions were carelessly ignored.
So how does an investor know which forecasts to follow and which to ignore? The first thought that comes to mind is to follow the predictions of those that have gotten it right in the past. This method, however, proves to be ill fated. Take, for instance, the four gurus that called the housing crisis. Since that time, each of these prognosticators has supplied a long list of additional predictions. Sadly, the overwhelming majority of them have been tragically afield. In a famous prediction from 2002, Peter Schiff asserted that the Nasdaq would hit 500 and that the Dow would crash to 4,000. If you had followed his advice, you would have lost your shirt.
Nouriel Roubini has made over 30 economic predictions since 2006, with 22 coming up wrong and seven still awaiting fulfillment. Well, at least he got one right—the housing crisis. Whereas Med Jones seems to have a better batting average, Dean Baker’s predictions are about 50/50.
In the end, stock forecasting seems to be a bit more Abracadabra than most investors would prefer. As much as we would like the aurora borealis or at least something or someone to whisper an accurate stock tip that would leave us fat and happy, we are left with the harsh reality that forecasters often flop.
With no real way of seeing around the corner of time, smart investors are left with the proven methods of global asset allocation, low-cost indexing, and disciplined rebalancing. This proven approach may not provide the wonders of time travel, but it does provide a nice bounty to the principled and disciplined—over the long haul.
What Makes You Trust Anyone’s Investment Advice?
It is well documented in surveys and studies by financial institutions that when we seek investment help, we make choices based upon one major criterion: trust. It all boils down to this one word. Who is giving me the advice? Can I trust them?
If you are a hard-core do-it-yourself investor who loves to day-trade, you may trust the Motley Fool or the Daily Options Trader based upon the success of their recommendations. If you delegate your investing, you may trust your friend’s son who works at Smith Barney. You know, the one who got his Wharton MBA and plays with your kids.
Conmen and Ponzi scheme operators know how to get our trust by playing with our fears and our greed. The SEC knows it can’t regulate trust, but it does regulate how advisors engender it. Thanks to laws from the 1930s, an investment advisor cannot advertise testimonials from other clients. That’s why you never see advertisements showing celebrities like Oprah crowing, “Joe Morningstar is my favorite money manager! He helped me buy this estate in Maui!” In fact, social networks are panicking many investment advisors today. We wonder: If a client “likes” you on Facebook, is he endorsing your service and leaving you open to an SEC investigation?
We may look at past performance from mutual funds for trust. But this has been proven fallacious at best; thus the fine print noting that “past performance is no indication of future results.” And as we’ve written many times, the game of performance reporting is rigged. A bad mutual fund can buy up a high-performing one and just assume the latter’s track record.
But when it gets down to it, we must trust someone or something before handing over our dough.
Unfortunately, most investors fly blindly without ever thinking through the question of, “Who should earn my trust and why?” We continually encounter investors who own a variety of mutual funds, pay enormous fees, and have no idea that they are engaged in “active” investing. They believe that if they are buying products from a large institution, then they’ll achieve their goals. We meet investors who have delegated managing their money to an individual because he was on the Barron’s “Top Financial Advisors” list. Others find status by being able to say, “I’m a Goldman client.”
Giving our trust is a complex emotional dynamic that we’ll leave to the shrinks to articulate. But what can we learn about trust from the smartest investors in the world? Do the trustees of Yale sit with prospective hedge fund managers, look them in the eye, and then have a discussion about who has better eye contact and a more confident handshake? No. They develop investment trust, not by emotions or instincts, but through a logical evaluation of three dimensions in the following order:
1. The process. First and foremost, smart investors invest with an investment methodology. They adhere to a philosophical approach that they believe to be true about investing. For instance, Warren Buffett fans believe in buying out-of-favor, inefficiently priced stocks and holding them until everyone else changes their opinion. At MarketRiders, we focus on finding the right asset allocation and then recommending low-cost ETFs and a consistent rebalancing protocol. Vanguard fund owners have generally bought into the idea that low fees will make them more money, so they like passive investing instead of active investing. Whether or not you know anything about investing, you need to spend some time learning about the various investing “religions” and developing your own point of view.
2. The institution. Institutions come and go, as we’ve seen with Lehman Brothers and Bear Stearns. A “Wall Street Legacy” is an oxymoron. The names come and go. But doing business with a firm with a culture and track record of delivering on your process is nonetheless vitally important. The firm needs to be solid and have checks and balances and high standards of compliance. Why does Vanguard have over a trillion dollars under management? Because Jack Bogle’s original vision to help working Americans by building a not-for-profit organization has remained intact. Vanguard continually lowers its fees as it adds assets, and it adheres to its process of passive investing.
3. The person. If you have a belief in an investment process and have found an institution that embraces that process, then trusting the individual with whom you work becomes the last piece of the equation. You can make sure the individual has not been sanctioned by regulators and ask for background information. But make this is the last piece, not the first, for establishing trust. Trusting people and institutions before you’ve first developed a core belief about investing gets the whole thing backwards. Spend the time to understand the various investment philosophies and then develop your own point of view. Then look for people and institutions to help you implement it.
Are You the Dumb Money?
In the hit comedy, Dumb and Dumber, Jim Carrey and Jeff Daniels play two guys that are so utterly moronic, that their inanity actually becomes their best asset. Without knowing it, their stupidity guides them past unperceived dangers and smack dab into the middle of unsuspecting success.
If only life worked so charmingly. But in the cold world of Wall Street, the dumb are preyed upon, while the dumber quickly become extinct. Not only is this true, it is actually celebrated as fact by financial mavens and the media alike who have captured this ethos through their invention of the terms smart and dumb money.
In closed-door discussions from the venture capital industry, through the hedge fund industry, past leveraged buy outs and all the way to traders of simple stocks and bonds, those in the know whimsically discuss what the smart money is doing to get rich, and of course, how the dumb money is helping them get there.
And in the event that you are late to the conversation, in their mind at least, you may be the dumb money. More specifically, the dumb money is the individual investor who watches CNBC for stock tips. It is the investor that gets a hunch, or better yet, at stock tip from a friend and acts upon it. The dumb money is the lemming like masses that plunge off the bluff and into the sea when despair is on tap, and double down on their investment when a sector is running hot.
Like the ocean tides that move in and out with shocking continuity, the pros believe the dumb money to be so predictable, that these hawks consider it a contrary indicator of what the markets are about to do. When the dumb money is rushing madly into gold, the smart money starts writing shorts. When the dumb money is sure that the S&P 500 is dog meat and is running for the door, the smart money grins and starts moving in.
Fear, Greed and the Dumb Cycle
Dumb investors get caught in a dumb cycle—buying high and selling low. As ridiculous as this behavior sounds, a closer look reveals how the strong emotions of fear and greed can drive even the most determined investor towards this sadly dim-witted behavior.
In any intellectual exercise, like a crossword puzzle, knowledge wins. But in the real world, behavioral scientists have demonstrated that a primal need for rewards and security give tremendous platform to the emotions of both fear and greed.
To understand the dumb cycle, you simply need to understand the role of fear and greed in driving investment decisions. When an investment is returning nicely, the greed gland kicks into overdrive commanding us to buy more of what is working. The investor then sells his poorly performing asset classes and buys more of his winning investment. Likewise, when all hell breaks loose, the fear gland begins to repetitiously squawk like a malfunctioning fire alarm within the investor’s mind. Sell, sell, sell is it commanding instructions. Run for the door.
A simple analysis of inflows and outflows of capital to and from the mutual fund industry easily illustrates this point. In 2000, the dot-com hysteria had people so frothy that they were dipping into their home equity lines to double down on the new gold rush. The NASDAQ ran up to 5,000 and had a one-year return of a shocking 80%. The greed gland was pumping out its buy commands and the masses were moving in perfect harmony. Then, by the fall of 2002, the NASDAQ party came to a crashing halt, plummeting quickly to half it value. Fear was the order of the day and as money rushed out of tech, it moved quickly into bonds that predictably were at a record high. The dumb cycle was complete.
You Don’t Have to Be Dumb
Although Wall Street might look at you as the dumb money, you can in fact become the smartest money of all. To overthrow fear and greed’s reign of terror, the smart investor must develop principles and policies that will usurp the primal impulses that otherwise lead inevitably to the investment funny farm.
By rooting your portfolio management in highly researched and scientifically demonstrated principles of global asset allocation, disciplined rebalancing and especially staying the course when others are loosing their cool, you become a member of the smart money club.
In seasons of wild market swings, investing takes faith—faith that stocks will do better than bonds, and that bonds will do better than cash, just like they always have. It requires faith that via diversified participation in the global free market, you will benefit from the rigors of millions of workers and thousands of companies striving daily to do well.
While Dumb and Dumber provides a great laugh on the sliver screen, being the smart money provides the best laugh of all.
How Politics Affect Your Portfolio
The markets shuddered last week when the Bureau of Labor Statistics announced unemployment remained stalled at a dismal 9.1 percent. While this news launched a wave of rhetoric from politicians on potential solutions, for the layman the meaning and impact of such numbers can be deceiving. A deeper dive into the unemployment report, as well as other statistics, such as the inflation rate and mutual fund performance, reveals some shocking facts.
Unemployment. The U.S. government uses dishonest statistical skullduggery to calculate the “official unemployment rate.” Lying with statistics is easy. It is not how you count, it’s how you define what to count, and over the years both political parties have used this trickery.
When the government reports unemployment, it understandably excludes people that are under 16, institutionalized (in jail, hospital), are in the military, or retired. What many do not know, however, is that the government also excludes discouraged workers—people who want to work but have not been able to find a job and have given up looking after four weeks or longer. In this economic climate, there are many citizens who want to work but have taken an understandable hiatus from pounding their head against the wall of employment rejection. But by excluding all unemployed people who have not applied for a job in four short weeks, the unemployment rate is dramatically skewed downward.
A simpler way of looking at the unemployment story is through the often-overlooked employment-to-population ratio, or how many able-bodied adult Americans actually work compared to those that don’t. You may be shocked to learn that this number stands at just over 58 percent. There are many stay-at-home parents and others who are not interested in employment who should not be considered as unemployed, but to think that more than 4 out of 10 able-bodied Americans simply don’t have work is eye opening.
Inflation. What about inflation? Could it be that the governmentskews inflation number downward, too? The Consumer Price Index (CPI) is calculated monthly based on a basket of 84,000 goods. This sounds straight forward enough, but there is a twist. New methodology was introduced in the calculation of the CPI in which goods and services in the defined basket could be substituted. Some argued that if beef, for instance, goes up in price, consumers may switch to something cheaper like chicken. Therefore, items that are actually moving dramatically higher in price are switched out for “similar” items that are not inflating at the same dramatic rate.
Although there is a debate among economists on this new methodology, the renowned economist John Williams described this change as manipulative and suggested a return to the more honest and accurate fixed-basket methodology.
Why might the government prefer reporting a lower inflation rate? Could the fact that the government must make inflation adjustments to pension benefits, government entitlements such as Social Security, and even the returns on Treasury Inflation Protected Securities (TIPS) based on the CPI number? A higher number means much higher government expenditures.
Because the CPI is artificially skewed downward, it makes sense for investors to respond by adding to their TIPS allocation and other commodities such as gold and energy that help protect a portfolio from the actual rate of inflation.
Mutual fund returns. It is not just the government that may be trying to play you by the numbers. Take a closer look at your investment adviser and the mutual funds he may have sold you. When you receive your annual performance report from your adviser, note that most do not report the 1 to 1.5 percent fee taken from your portfolio annually.
Unfortunately, the story gets worse. Although mutual funds report performance after mutual fund fees, such reports do not take into consideration taxes—a kind of invisible fee. Although churning is against SEC rulings, according to Vanguard founder John Bogle, the average turnover for actively managed funds increased from 65 percent in 1975 to 90 percent in 2000. This buying and selling may help the fund report a higher return, but for the unassuming investor, the result is much lower performance.
Many of these churned stocks will create tax liabilities, some at short-term interest rates, reducing the performance of the fund significantly. When you add the invisible fee of taxes to adviser fees, it’s no wonder index funds and ETFs with low fee structures and tax efficiency are rapidly becoming the preferred investment choice for so many.
When it comes to investing, it pays to know the real numbers both in your portfolio and the economy. By having honest reporting, you can make informed decisions that protect and guide your retirement future.
Are You Gambling or Investing?
Are you saving money to travel, buy things you want, help the charities and people you love, send kids to college, stop working, or just plain relax?
If so, consult your favorite Wall Street broker, mutual fund, or become a stock picker yourself. Either way, within 20 years, say goodbye to 33 percent of your money and many of those dreams.
How could this be true? Most people confuse investing with gambling. Gamblers try to “beat the house.” Investors want to be “the house.” Imagine a casino in Las Vegas called World Markets Casino. World Markets offers all kinds of gaming options—blackjack, poker, roulette, craps, slots—along with great food, entertainment, and well-appointed rooms.
Guests have a lot of fun at World Markets—the excitement of gambling, the thrill of winning and losing. Some come in with various “systems” like statistical models and card counting systems to beat World Markets. Others talk to God. Poker players have their favorite seat.
There was a Grandma who dropped a quarter in a slot machine and won $250,000. Another person who had never played blackjack hit 21 in his first hand, made $50,000, and proposed and married his girlfriend all in one great evening.
It’s fun being at World Markets—just look at the posters and marketing brochures.
But most guests don’t just play, win, and leave. They continue playing and that’s what World Markets counts on. Like all casinos, it has special “house” odds. Sooner or later World Markets will win more money than it will lose due to human nature and statistics. Depending on the game and how wagers are placed, the casino earns up to a 35 percent commission from the winnings. It is impossible to do consistently, but guests come year after year to try to beat the house.
Suppose you buy stock and invest in the imaginary World Markets, Inc. (WMKTS). Investors care about one thing only: making money. They’re not concerned with having fun or discussing the night they had the “hot dice” at the craps table. They could care less if they ever hear the noise of a winning pull at a slot machine. They just want to know that they’ll make money year after year after year.
World Markets investors never know from night to night where they’ll make money. Some nights there’s a guest with a streak of luck on the craps table and the casino loses money there. But that same night, perhaps World Markets is making money on blackjack. On nights where guests are beating the house on all tables, the casino is still picking up antes from the poker tables, and making money on food, hotel rooms, and entertainment.
World Markets investors are “the house,” and ultimately those investors always make more money investing in the house than its guests who are trying to beat the house. It’s just a statistical fact.
But how is it that most people invest their own money as if they were gamblers at World Markets, instead of investors?
Most investors attempt to “beat the house” of world asset markets—U.S stocks, bonds, real estate, foreign stocks, emerging market stocks—by picking stocks on their own, giving their money to a broker who they believe is a good “stock picker,” or investing in a mutual fund that has a great track record.
But reams of studies from experts have confirmed that investors do worse than the house by the money they spend trying to beat it. Investors leave an average of 2 percent of their money every year at World Markets and pay more taxes because buying and selling stocks creates taxable income. Over time, due to mathematical laws such as compound returns, investors can lose 33 percent of their money over 20 years—just like a guest at World Markets Casino.
So how do you become an investor in World Markets instead of a gambler? Buy and hold a collection of exchange-traded funds (ETFs).
For every $100,000 invested, you’ll pay $200 in yearly fees, instead of $2,000 in fees to money managers, financial advisers, and broker commissions. You can invest like smart investors and endowments at Yale, Harvard, Princeton, and Stanford. You’ll never have to pick a stock or mutual fund again. And you can dial the risk levels of your portfolio up or down to whatever level you feel comfortable.
Be the house, not the guest.
How to Manage Your Investment Anxiety
As uncouth as it may be, worrying about one’s investments seems to be the order of the day. And it’s no wonder. As the markets careen to and fro, publications are replete with stories of advisors and Wall Street pros dumping their stocks in favor or bonds and cash as they scurry to the sidelines.
And, as usual, the average retirement investor feels caught off balance and a few steps behind the curve. What is the ordinary investor to do? It does feel a bit like 2008 again, doesn’t it? Is it too late to take a cue from the pros, pull up stakes on a long-term investment mentality and find a nearby bunker to hunker down in with a bag of bonds now returning less than the rate of inflation?
At times like these, simple positive thinking doesn’t seem to extract the thorn of worry from the back of the investor’s mind. As much as he conjures up Bobby McFerrin’s “Don’t Worry Be Happy” chorus or hums a bar of “Hakuna Matata,” the worry seem to still creep in at unexpected moments like a terrible and relentless rot.
Investment anxiety, however, can be tamed. They key is having a clear understanding of those things that should and should not be on your list of worries. Let’s begin with what not to worry about – the direction of the markets.
I Don’t Know and I Don’t Care
The famous financial columnist, Jason Zwieg, once wrote powerfully about how index investing liberates the investor from the anxieties of trying to predict market movements. His words from 2001 are as relevant today as they were then:
Indexing enables you to say seven magic words: “I don’t know, and I don’t care.”
Will value stocks do better than growth stocks? I don’t know, and I don’t care – my index fund owns both. Will health care stocks be the best bet for the next 20 years? I don’t know, and I don’t care – my index fund owns them. What’s the next Microsoft? I don’t know, and I don’t care – as soon as it’s big enough to own, my index fund will have it, and I’ll go along for the ride.
Indexing enables me to say, “I don’t know, and I don’t care,” liberating me from the feeling that I need to forecast what the market is about to do. That gives me more time and mental energy for the important things in life, like playing with my kids and working in my garden.
When it comes to worrying, one should only worry about what he or she can control. Although countless have tried to control the public markets through worry filled hours of mental consternation and sleepless nights, markets rarely, if ever, obey. Therefore, the current vagaries of the market need to be ignored in exchange for the science of long-range planning based on hard, cold investment facts. It may seem like the world is falling into a hole, but investment science indicates otherwise.
Those who have the courage to ride the markets through the ups and downs, holding their course over decades, will be handsomely rewarded.
I Do Know and I Do, In Fact, Care
There are some aspects of investing that, in fact, are worthy of serious retirement investor’s attention. Two elements within the intelligent investor’s control are asset allocation and investment costs.
While millions of Americans tune into Jim Cramer’s Mad Money to watch him race about with his shrieks, squeaks and squeals, proclaiming what stock to buy or sell, the intelligent investor understands that the research is conclusive – 90% of investment returns are rooted in asset allocation, not stock picking. Therefore, the intelligent investor focuses his energy on identifying six or seven asset classes, with as little correlation as possible – U.S. equities, foreign developed stocks, emerging markets, commodities like gold and energy, real estate investment trusts, inflation-protected Treasuries, bonds and possibly more.
The investor then works carefully to identify, based on his risk tolerance, time horizon and other factors, the appropriate mix of theses assets classes for his portfolio. Once the portfolio is constructed, the investor rigorously maintains his allocations over the years, making adjustments only when his needs dictate a need for investment policy changes – not because Cramer bonked his bonker or because of any other market madness.
Finally, the intelligent investor overcomes investment anxiety by driving all unnecessary investment costs far from his portfolio. While market movements cannot be controlled, costs can be. Therefore, the investor makes sure to use low cost index funds and ETFs as essential building blocks for a diversified portfolio. Instead of paying one to one-and-a-half points for mutual funds the intelligent investor is able to achieve global diversification for around one fifth of one percent annually.
Additionally, by removing all unnecessary intermediaries that stand between the investor and his money, agency risk is dramatically reduced. The investor no longer needs to fret that some money manager is going to go AWOL with his retirement dollars or that he is going to become an unwilling participant in the next episode of the ongoing Wall Street saga of investor meets crook.
Like Wilkie Collins, the famous English novelist, once said, “Peace rules the day when reason rules the mind.” By accepting your inability to control or predict the markets, and embracing your ability to drive down fees and construct wise allocations, you too can shirk Wall Street madness and say goodbye to investment anxiety.
Remember the Law of Compound Returns
When the markets get turbulent as they are today, investors get emotional. We want to react. Today is a fear day, but last month there were greed days. On fear days, we react. We wonder, “How much more money can I lose? Should I be getting out?” On greed days, we get excited and after looking at what we “shoulda, woulda, coulda” done, we get anxious and may buy into a rising tide.
But what is the purpose of investing? It sounds like a stupid question, but ask 10 investors, and you’ll get a surprising variety of answers. Is there an answer that allows us to conduct ourselves in a rational way that is not influenced by fear and greed?
Try this out. A recent biography on the world’s most famous investor is titled “The Snowball—Warren Buffett and the Business of Life.” The term “snowball” is a metaphor for a core investment concept: the law of compound returns. Understanding it is critical to your success as an investor and should be at the center of all your investment decisions.
Think of the law of compound returns as a force of nature that describes how wealth grows. A small snowball rolling down a hill will gather weight, which increases its speed, which keeps increasing its size. Wet snow and a long hill are the conditions that turn a snowball into a very large boulder. Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.
Trading, taxes, and fees. Management fees and taxes dry out your snow. A small difference can mean the difference between having a boulder when you retire, or a snowball. Have you checked the taxes you’re paying on your mutual funds? It’s probably taking 1 to 2 percent off your returns because managers change all the stocks out an average of once every 18 months. Mutual fund charges, broker, or advisors fees on portfolios average 2 percent. But index funds and ETFs run about 0.25 percent. You might not think that’s a big difference.
But here’s how it is. Take a $100,000 portfolio. Using the market’s long-term average growth of 10.4 percent a year, compounding your gains over 20 years, and deducting the 3 percent in fees and taxes, you’d have $287,928 after taxes. But if your fees and taxes were 0.25 percent instead of 3 percent, you would have $607,465. That’s over a 100 percent difference! That’s double your money. All based upon a tiny difference in fees and taxes of 2.75 percent.
How quickly will your money double? Einstein’s “Rule of 72″ says if you take your yearly percent return and divide into 72, you get the number of years it takes to double your money. Let’s start with $100,000. If you have a 9 percent return (divided into 72), your money will double in eight years ($200,000). In another eight years, you would have $400,000, and so on. But if you get a 6 percent return (divided into 72), your money will double every 12 years ($200,000). Within 24 years, someone getting 9 percent will have twice as much as someone getting 6 percent.
Here’s an answer to the initial question. Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming. Then you must help the law of compound returns work its magic. It is not to compete against the stock pickers and market timers on Wall Street—or even hire one to manage your money.
No one can give you a longer hill—your age and personal working situation define your time horizon. But you can keep your snow wet. Taxes, trying to time the market, paying large investment fees, and making investment mistakes interrupt the law of compound returns and lower your returns. They dry out your snow.
So when the market has ups and downs, remember that if positioned correctly, your portfolio will grow over time—capitalism demands a return. Your job is not to react to your fear and your greed, but rather to stay out of the way, remove the obstacles to the law of compound returns, and let this force work its magic on your money.
How to Invest for the Long Run
Well, we’re scared, but we ain’t shakin’
Kinda bent, but we ain’t breakin’ in the long run
Ooh, I want to tell you, it’s a long run in the long run
The Eagles, The Long Run
The Eagles understood something about relationships that many investors have yet to learn about portfolio management. Success is measured in the long run.
In both romance and investing, bright beginnings inevitably turn to tougher times that test our metal. What we do in such moments as investors will significantly impact our retirement outcome and reveal if we are the type that runs for the door or hangs tough to see a better outcome.
The principled investor buys equities based in policy driven portfolio management, not inspiration. With cold-hearted accuracy, these investors know that as soon as they make their purchase, their investment is as likely to go down as up. They don’t care. They are thinking about a five, ten, twenty, even thirty-year time horizon.
The inspired investor, however, is in a sense looking for a touch of magic in their purchase. It may be the investments PE ratio, technical characteristics or even an insightful analysis from a trusted expert that makes this investment irresistible. There are countless reasons the inspired investor falls in love, but in every case, the same expectation is shared – that this new object of affection will break free of the market’s gravitational pull and float skyward towards unfettered wealth.
When such an investor finds his special equity, he can’t help but feel a smidge of infatuation with his new purchase. In this early phase of the investment cycle, the investor is dancing with Cinderella under the stars in all her glory. But even for Cinderella midnight must eventually come.
When that inevitable moment strikes and sends his darling plummeting, the inspired investor is gripped with horror as he watches his Cinderella like vision of beauty and grace turn into a soot covered house cleaner tumbling down the boulevard like a tattered pumpkin towards what appears to be an ignominious demise. At such a moment, we learn if the investor is merely a one-night stand specialist or a truly inspired prince who is in it for the long run.
Are U.S. Companies Really Worth 15% Less Than One Week Ago?
Infatuated investors are also those that suffer the greatest whipsaw effect. As the fret mongers and deep-dive analyzers abounded this week decrying the demise of American ingenuity and business, their dour chorus crushed many an investor’s inspiration, turning it to disillusionment. As quickly as these inspired souls rushed in, they now in turn rush out with similar enthusiasm.
This whipsaw effect was sadly illustrated once again in this week’s market crash. And strangely, this crash was accompanied by the pundit’s singular focus on the bad news leaving the story about corporate earnings mostly unnoticed.
It is early in the second quarter earning season with just 143 of the S&P 500 firms reporting. And the reports are promising. 75% of firms have reported earning above expectations. 13% have met expectation and a mere 13% have missed targets. Historically, only 62% beat expectations.
Furthermore, the earnings details are also quite encouraging. Average earnings for those reporting is 9.2% over last year – good but not shockingly good. Take into consideration, however, that Bank of America had to settle a lawsuit that represents a one-time, non-recurring expense, remove that singular expense from the calculations, and earnings skyrocket to a very encouraging 15.2% over last year.
More firms must still report and surely it will not all be good news. But apart from the dour media makers, reality tells us that U.S. companies are essentially earning 15% more while the public markets just decided that they are worth 15% less.
Buy, Hold and Rebalance
Buy low and sell high. It is a simple principle to understand, but much more difficult to follow, especially in times like these. We can all look back at ’08 and recall the many testimonies of those that ran for the door when the DOW was at 7,000, just to in turn stand on the sidelines, paralyzed, as the markets moved back up to 12,000. Don’t be that investor. It is easy to get out but very difficult to know when to get back in. If you miss a few critical days of market movement, you miss most of your portfolio growth. As others run for the door in fear, follow Buffett’s famous adage and be bold to buy. For the flint-jawed long term investors, now may be the perfect time to trim winners and buy losers in principle driven rebalancing act.
When all hell broke loose for Prince Charming, he knew that the slipper in his hand belonged to a woman he was not going to let go of. As an investor, do you know that your investments are worth holding onto? If in fact you own a globally diversified portfolio of low-cost index funds or ETFs, you can rest assured that today’s pumpkin will in fact transform into tomorrow’s carriage, yet once again.
Phyllis Borzi Wants to Save Your IRA
Just when you think that our government is full of incompetent career politicians who can’t get anything right, a real hero rides in.
You’ve probably never heard of Phyllis Borzi. She is an assistant secretary at the Department of Labor and she’s helping you and our country in ways few will ever appreciate.
We’ve written extensively about the inherent conflicts of interest when you trust someone with your money. In finance circles, it is called “agency risk.” Yes, your broker, or mutual fund manager may not fully put your interests ahead of their own. These conflicts almost define how the investment management business operates and is regulated.
Borzi runs the Employee Benefits Security Administration (EBSA), which “pursues policies that encourage retirement savings and that promote retirement security for all working Americans.” Our retirement security depends in large measure on the sound investment of more than $11.2 trillion in pensions, 401(k) accounts, and IRAs. To guide our decisions, we get advice from trusted experts.
But a flawed 35-year-old rule gives brokers a loophole that allows them to skirt these fiduciary standards. Under her stewardship, the Department of Labor has been pushing through regulations that would force service providers to disclose fees and limit conflicts of interest.
“The law on its face is simple enough: advisers should put their clients’ interests first. But as always the devil is in the details – in this case, in the question of what constitutes paid investment advice,” Borzi said last week before a House committee. “(We) will amend a flawed 35- year-old rule under which advice about investments is not considered to be “investment advice” merely because, for example, the advice was only given once, or because the adviser disavows any understanding that the advice would serve as a primary basis for the investment decision.”
When it comes to your retirement savings, fiduciaries who advise you have a duty of “undivided loyalty” to your interests, to act prudently when giving advice. You can sue a fiduciary personally for any losses arising from breaches of such duties.
But the 1975 laws were made before 401(k)s and at the inception of IRAs. The loopholes and technicalities let brokers easily dodge fiduciary status. Borzi has reams of evidence showing that because of this, IRAs are dramatically underperforming 401(k)s.
“For additional evidence, consider the underperformance of IRAs relative to plans, the size of the gap is troubling,” Borzi said. “IRA holders do not have the benefit of an employer to represent their interests in dealing with advisers. From 1998 to 2007, the average annual returns for IRAs were 4.5 percent, compared with 5.4 percent for 401(k)s. IRA holders often pay fees that can be two to three times higher than the fees paid by employee benefit plan participants.”
Borzi believes that Americans with 401(k)s and IRAs are entitled to receive impartial investment advice and wants to ensure that you can see the fees you are paying. Her new proposals would protect us and our IRAs from conflicts of interest and self-dealing by correcting outdated 1975 rules.
The brokerage investment community is having a fit because many IRAs today are held by brokers, not advisers. Brokers do not have to live up to a fiduciary standard and can get paid for advice by commissions for trades and by getting a piece of the fees you pay to mutual funds. Brokers claim they are not fiduciaries because they “disclaim any understanding that their advice might constitute a primary basis for the IRA holders’ investment decisions.”
If brokers become fiduciaries, they could not accept commissions or revenue sharing payments. To do so would constitute “fiduciary self-dealing,” which is prohibited. They would have to be transparent and show you what you are paying.
They have submitted hundreds of comments, even going so far as to claim that Borzi’s proposals would increase costs to the investor.
Borzi is on a mission to change the system so anyone getting advice on IRAs could receive an extra 1 to 2 percent return by eliminating the conflicts. Fees would go down and investors would retire with more. There are 75 million IRA accounts with $4.7 Trillion invested. If she impacts half of that and help investors keep another 1 percent, that’s almost $24 billion each year that will stay in our pockets.
Americans are More Indebted Than the U.S. Government
You may remember J. Wellington Wimpy, more commonly known simply as Wimpy, Popeye’s beloved friend from the iconic comic strip. Wimpy was soft-spoken and intelligent, but also cowardly, lazy, stingy, and gluttonous. A true scam artist, Wimpy usually finagled his favorite meal, a hamburger, from some unsuspecting patron at the local diner. Wimpy’s parsimonious ways included his famous con line, “I’ll gladly pay you Tuesday for a hamburger today.” Decades later, this character, created in 1932 during the Great Depression, has become a symbol of fiscal irresponsibility.
Today, the United States is facing its own Wimpy-esque moment in the form of the debt ceiling. The free burgers have flowed for sometime now, but the patrons have grown wise to the scam. The pitch of pushing off today’s payment until some future Tuesday has become a bit haggard and worn thin for many in America. Simply look to Greece, Portugal, Spain, and others to see what it is like to have one’s hamburgers taken away—and the forced diet does not look pretty.
Strangely, as the U.S. citizenry passionately criticizes their government for running up the budget deficit, a greater irony is afoot: When it comes to debt management, Americans are sadly worse than their government.
While government debt sits at 94 percent of national revenue, U.S. household debt sits at a whopping 107 percent of personal income. The household balance sheets of Americans are in worse condition than anytime since the Great Depression. The ratio of household debt-to-GDP is greater than anytime since 1929. And while we all are trying to comprehend a poorer nation, many American’s have not yet comprehended their own personal poverty.
A burger today? From the early 1940s through the late 1960s, an ethos of saving before spending ruled the roost. If you sought to buy a house, 20 percent was required for a down payment. Similarly, substantial savings were required to buy a car, and home furnishings, clothing, and more were paid for primarily with cash. By the 1970s, however, rampant inflation helped form a debt culture that found footing and gained steam.
If you saved, inflation threatened to erode the value of your savings, while the price of your desired purchases continued to rise. What was the point of saving when individuals could buy with little to nothing down, deduct interest from their federal tax obligations, and have those things they longed for?
Over the coming decades, American household debt ballooned, eventually doubling from $7 trillion to $14 trillion between 2001 and 2007. Debt fears, however, were assuaged by the rapidly growing value of real estate as homeowners used equity lines to buy more property, cars, and pay for vacations and toys. Burgers were flowing for all.
Then in 2008, the sudden and violent decline in house prices revealed just how bad the debt binge had been. Tuesday had finally arrived and like Wimpy, our wallets were a bit too thin to meet our obligations.
Feeding the furnace or building an engine. Criticizing government fiscal irresponsibility should in turn lead us to honest self examination. At the heart of this audit should be the confrontation of personal debt and the embracing of basic investing disciplines.
Each person must make a decision to feed the debt furnace or build a retirement engine.
Like Wimpy, we all experience the gnawing hunger to consume more than we need. Each time we reach out, through credit, for a burger today, we take our future dollars and throw them into the blazing furnace of consumption. The heat of the moment is delightful, but the end result is the poverty unfolding before our nation.
When we behave like wise and disciplined investors, we resist our pulsing appetites, take our hard earned dollars, and direct a predetermined portion to smart, long-term investments. In doing so, such investors build an engine through the miraculous power of compounding interest. Unlike Wimpy and other debtors, this interest works in your favor. Ben Franklin understood that for such savers, “Money can beget money, and its offspring can beget more.” Einstein called compounding the “eighth wonder of the world.”
Those who reject debt and invest wisely create a powerful engine, so that Tuesday’s obligations can be fully met on time, leaving a few burgers to spare.