This Time it's Different

When people viewing the market say "this time is different," it is generally met with a chuckle and a look that says the speaker is naive. In many cases, for good reason. The most recent example was 2000 where bricks and mortar were declared dead because all businesses were going on the internet. Never mind that p/e ratios were sky high. Old valuation methods were obsolete-"this time it's different." We know how that turned out.

Before that, it was Japanese equities that became overvalued. It was said that, in contrast to the West, they took a longer view. Again, the old way of valuing equities was obsolete - "this time it's different." Today, as we look back, their economy and markets have still not pulled out of their tailspin.

These experiences could get one to easily dismiss the thinking that things might be different. After all, "There's nothing new under the sun" seems to be a widely held belief.

I think we have to be careful here. I think there are times when things are different and investors need to be alert. Consider the housing bust. Most investors fell woefully short of seeing its final severity. Why? Because things were, in fact, different. We've had real estate market downturns before. In many instances, as Greenspan and Bernanke argued, they were localized. Furthermore, the economy snapped back as Fed policy was eased.

This didn't happen this time because banks created toxic securities, put them off balance sheet, and received triple A ratings by an insurance industry that went wild insuring derivatives. This time it was different. Significantly different.

Today
Looking at today's recession, a voice in the back of my head is saying that it might be different again. Simply, when we have been in similar economic situations in the past, we could see it as an investment opportunity because Fed policy and fiscal policy were aggressive in the background and would, in effect, bring a diving airplane out of its tailspin. We felt confident that investors who were negative on the market were making the mistake of looking in the rear view mirror where all the news was bad.

To put it mildly, this doesn't seem to be happening today. Congress passed a massive stimulus program and, in the process, drove the deficit to $1.4 trillion; and the Fed pushed short-term rates to practically zero. Bernanke has promised to keep the Fed balance sheet at unprecedented levels and still - no sign that any of this is having an impact. In fact, it looks like we may be rolling backwards down the hill.

As we look back at history, today's prices in the equity market have to be viewed as attractive. Bond yields appear to be at levels where investors could be hurt badly.

But the question is : "Is this time different?"

The Wizard Behind the Curtain

Please help me. Does anyone know how long we're going to be in Oz? Is Jackson Hole Wyoming Oz? The Chairman says that the Fed maintaining its balance sheet by purchasing securities involves a lack of “very precise knowledge” of the impact of the buys and the possibility that increasing the Fed’s balance sheet further “could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time."

Here's just one little question that happened to pop into my mind-IF THE PUBLIC'S CONFIDENCE IN THE FED IS ALREADY ZERO, CAN IT DROP FURTHER?

A second possibility, according to Mr. Bernanke, would be to tell markets that the Fed will keep its fed funds target rate low for a “longer period than is currently priced in markets.” Does the Fed know the length of the period that is currently priced in? Do they think that pushing around fed funds futures is the way to go?

What are they smoking in Jackson Hole? Can it be any clearer that the Central Bank is clueless?

Bond holders today have no purchasing power because the Fed has driven short-term rates to zero. In some people's minds, this lack of purchasing power is a problem. In Bernanke's mind, the solution is to inflate the economy and thereby lessen the value of savings even more.

Isn't it time to send Chairman Bernanke back to academia and get some hard money advocates at the Fed? Somebody needs to stand up and proclaim that the printing presses are being shut down and the days of the Greenspan/Bernake Fed controlling the price of money are over.

Interest Rate Watch - 7 Year Treasury Auction

By now this is routine. Using the method described in Monday's post, we can go to Bloomberg site and the economic calendar. They assess the auction as follows:

Highlights
The 7-year auction proved the best in a week of heavy supply in light holiday conditions. Coverage of 2.98 is up from last month's 2.78, both auctions $29 billion in size. Buyside interest was solid with non-dealer bidding at 65 percent vs. a 62 percent average. With a high yield of 1.989 percent, the auction stopped out one basis point below the 1:00 ET bid.

Clearly the results were strong and Treasury was able to move in excess of $100 billion in Treasury notes at low yields. Note that the strongest leg of the three-part auction was the longest maturity.

Now all eyes turn toward Jackson Hole Wyoming to listen to Fed Chairman Bernanke to garner clues for the Fed's plan to get us out of this mess.

Interest Rate Watch - 5 year Treasury Auction Results

Continuing with the Treasury auction results, going to the Econoday calendar at the Bloomberg site as described in Monday's post, we get the following comments on yesterday's Treasury note auction. This is the second leg of a three-part issuance, totaling in excess of $100 billion.

Highlights
Thin late August markets are making for soft Treasury auctions. Coverage for today's $36 billion 5-year auction was solid at 2.83 but the offering size was the smallest of the year at $36 billion. The auction shows a one basis point tail, posting a stop-out rate of 1.374 percent vs. a 1:00 bid of 1.365 percent. Buyside participation was respectable with non-dealers taking 57 percent of the auction, only slightly lower than the July auction. The Treasury closes out another heavy week of supply tomorrow with a $29 billion 7-year auction.

It looks like non-competitive, non-dealer buying was a bit heavier, indicating that individuals are stretching a bit for yield. Still, at 1.375% yield, the after-tax real yield (subtracting for inflation) is negative. This issue came with a coupon of 1.25% and, therefore, because it had a yield of 1.3774%, was sold at a discount. This is now the so-called "on-the-run" 5-year Treasury note. Using the same drop down list as for the calendar and clicking on "Rates & Bonds" gets you to a complete list of on-the-run issues and what is called the "Treasury Yield Curve": Click Image to Enlarge. Note the discounted price of the new 5-year and its yield-to-maturity of 1.37%.

Interest Rate Watch - 2 year Treasury Auction Results

If you followed Monday's post and went to the Bloomberg site as explained, you saw that "...dealers were forced to take down 59% of the month's $37 billion offering" of this month's
2-year Treasury note auction. This, of course, is not good because it indicates that non-competitive bids were weak. As we know, individuals have been pouring into bonds. This could be an indication that this may be nearing an end.

The Bid/Cover ratio was 3.12, which was assessed as "respectable".

The stop-out rate, which indicates the highest rate the Treasury had to pay, was .498%. The Treasury starts with the lowest yields, takes the non-competitive bids next, and then the higher bids (in terms of yield, remember higher yields mean lower prices in bond land!).

Today's auction is for $36 billion of 5-year Treasury notes. Results will be available on the Bloomberg site, or CNBC, shortly after 1 pm.

A couple of extra points to note on the process. You may have wondered about the possibility of the embarrassing situation of the Treasury not being able to attract enough bids for its auction. You can stop worrying. There are 17 designated primary dealers. They have to bid on the auctions. If prior to 1 pm Treasury had not received enough bids, they would do another round with their primary dealers and tell them to increase the amount they are bidding on.

Secondly, a good way for individuals to participate in these auctions ( although I'm not sure why they would want to at these low yields) is to go to Treasury Direct - a site where they can open up an account and participate commission free.

Finally, note that the Treasury is doing the auction. It is the government's bank. To the extent that the Federal Reserve (the Central Bank - a completely different entity) buys and sells Treasury securities, it is changing the reserves in the banking system and thereby changing the nation's money supply (especially when banks are in the mood to lend).

I sure this is more than some of you cared to know about this process, but happy Treasury auction following!

When Will Interest Rates Rise?

Probably the main question do-it-yourself (DIY) investors are asking today is when will interest rates rise? ;Nobody, of course, knows when but we do know what investors look at. One is the Treasury auctions. To the extent they go well, it indicates a strong appetite for U.S. debt and indicates that investors are comfortable with yields. This has been the case of late to the chagrin of many professional investors including Druckenmiller. Sometimes a strong appetite indicates investors are afraid to invest in anything else.

How can DIY investors follow the auctions? One way is provided by the Bloomberg site. There, the drop down list under "Market Data" includes an economic calendar produced by Econoday. The calendar includes Treasury auction dates and information along with commentary after the auctions. Commentary is also provided by CNBC for those who prefer that route.

Click Image to Enlarge
As you can see in the write-up, the important factors are the coverage, the rate, and the indirect bid. Coverage indicates the size of the bid. ,If the auction was for $2 billion and bids totalled $4 billion then coverage was 2.0. Thus, if the coverage is weak (i.e. surprisingly below average), or the rate is much higher than expected, or if non-professional bids are not robust, then it is time to start worrying.

This week we have 2-year, 5-year, and 7-year Treasury note auctions for a total of $102 billion. The economic calendar referred to above looks like this:

Click to Enlarge Notice that the auctions take place at 1 pm. If you want to get bids in, you have to put them in before 1 pm. Clicking the link after 1 pm will get you the results of the auction. Notice also the 2-year is auctioned first, on Tuesday, followed by the 5-year on Wednesday, and then the 7-year on Thursday. If the shorter maturities have a lackluster auction, it typically doesn't bode well for the longer maturities.

Worth Thinking About

One of the reasons do-it-yourself investors should "buy the market" when investing is the importance of being invested in those companies that do the best over the long term.
Suppose the market is comprised of 10 stocks. We might expect that 2 will do really well, 2 will be duds, and the rest will achieve market performance.

What about the 2 duds? Let's assume they are really bad and go to zero - think Fannie and/or Freddie. What about the 2 that do really well? They are likely to go up 3 or 4 times (or much more, especially over the long run) their purchase price - think Apple or Price Line.

So the most you can lose in the duds is 100%, but the upside is unlimited for the winners.
To prevent misunderstanding, I am advocating buying the market. The 10-stocks example is for illustrative purposes only. Buying 10 stocks can be highly detrimental to your financial health!

Searching For Mr. Yield

Are you a do-it-yourself investor searching for yield? Jump in the boat with everybody else. Let's take a look at trust preferreds. Trust preferred yields today exceed 6.5%.

Trust preferreds are equities with fixed income characteristics. They pay dividends quarterly, have a par value, typically are callable, and are rated by the major rating agencies. Their dividends can be cumulative or non-cumulative. The best resource for getting information on trust preferreds is at Quantum Online. CLICK TO ENLARGE THE GRAPHIC and you'll see information on a trust preferred issue for Ford. This page was brought up by typing F-S (a small irritant is that different financial sites have different ticker symbols for trust preferred issues) into the ticker symbol box. If you scroll down the page at the site, you'll see the ratings and other information. As you can see, there is a lot of information. You'll want to note when the issue is callable and at what price. Whether or not the dividend is qualified may be important to you. Do your homework!

If you scroll down, you'll see a link that will take you to a price graph where you can view the 12-month price chart. Today the shares are trading around $47/share, and last year this time they were bouncing along around $30/share - there is some volatility.

Worth Considering
You may be asking yourself whether it is worthwhile taking on such a risky position for more yield. First off, we know the continuing back story on Ford and GM. If you believe a double dip is imminent, you may want to hold off a bit until the haze clears. If you subscribe to the slow recovery view, some exposure may be worthwhile. No matter what- putting more than 5% in an issue like this is asking for trouble. Furthermore, for Ford and other widely held issues, you would want to make sure it is not held in other places in your portfolio. Always keep diversification in mind.

A way to get around the individual issue constraint is to buy an exchange traded fund that is indexed to this market. A candidate is PFF. If you go to Yahoo Finance, put in its ticker symbol and click "holdings" on the left. You'll see:


Note that Ford is the second largest holding. Again, do some research. Check out the price action. This ETF has been highly volatile. On 3/9/09 it traded at $15/share. Today it is around $40. You'll recall that 3/9/09 was the time of maximum pessimism in the market. Fears of dividend cuts and suspensions were widespread. It is not surprising that trust preferreds were hit especially hard.

I believe that those who have a decent risk tolerance might consider up to 5% of total assets in a fund of this type. Combined with a short-term corporate fund (example: CSJ), it can contribute meaningfully to overall portfolio yield. Understand that risk with any type of higher yielding issues needs to be carefully managed.

As always, investors should do their own homework or consult a professional to ascertain the appropriateness of investments for their specific situation.

Favorite Blog of the Week

My favorite blog of the week was the post of the TED talk at Biz of Life's site by Matt Ridley. This talk covered a lot of material I go over each semester with my Econ 101 students. They, along with most Americans, have never given any thought to how wealthy they are or how the U.S. became so wealthy over such a short period of time. Most have never heard of David Ricardo and the theory of comparative advantage. Most have never thought about the benefits of exchange.

David Ricardo is interesting in that he argued against his own self interests (very rare in economics). He argued against the Corn Laws which in turn held up the value of land and thereby protected wealthy landowners--of which he was one. Considered by many to be the greatest economic theorist of all time, he actually had no formal training in economics. The story is that he was at a seaside resort, was bored, and happened to pick up a copy of Adam Smith's Wealth of Nations. The joke among students ever since has been that Ricardo began reading economics because he was bored and ended up boring generations of economic students with his theories!

The TED talk covers the benefits of the exchange of ideas, but there is also a downside. Simply mentioning the possibility of a "double dip" can morph into a serious concern and has the potential of self-realization as the idea spreads, and it scares people.

Double Dip or Not?

Double dip or not - what's your take? While you're thinking, enjoy Merle Hazzard's latest release - sure to go to the top of the charts.

Treasury returns versus maturity

Many DIY investors are not really comfortable with bonds and how they work. This is unfortunate because bonds are obviously an important component of the portfolio and become more important for most DIY investors as they age.

How Bonds Work
Simply, bond prices and yields move in opposite directions. Because longer maturity bonds tend to have more future payments, their price tends to move around (i.e. is more volatile) more than shorter maturity bonds.

Total return over time includes the change in price plus the interest earned. Total returns for various maturity Treasury issues are shown in the graph (Click Graph to Enlarge)produced by Econompicdata . The bottom solid line is called the "yield curve". The yield curve is a snapshot at a point in time that shows the yields, by maturity, for a given class of bonds. For example, instead of Treasury issues, a yield curve could be drawn for single A corporate bonds. Typically, the curve slopes upward as shown in the graph. This reflects the greater volatility of longer maturity bonds. If the curve slopes downward, it is called an "inverted yield curve" and usually presages an economic downturn.

Year-to-date Results
The interesting part of the graph produced by Econompicdata is the returns by maturity. As a benchmark, the yield on the 10-year maturity U.S. Treasury note dropped from 3.84% to 2.70% for the period shown. This produced a total return in excess of 14% for the 10 year maturity - great offset to a weak stock market environment and definitely helpful for giving investors a good night's sleep. Notice that the longer maturity issues had greater return--that is, the more risk you took in the bond market, the greater the reward.

Kudos to Econompicdata for this chart.

Two Quotes to Remember for Investors

Two of my favorite investment quotes are as follows:

1) John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."
2) Baron Rothschild: "The time to buy is when there is blood in the streets."

Keynes, of course, is the most well-known economist of the 20th century. In "The General Theory of Employment, Interest, and Money" published in 1936, he proposed a new theory on how the macroeconomy worked, which provided a policy to lead the nation out of the Great Depression. What many don't know is that Keynes was a remarkable investor (the Warren Buffet of his day) and also a speculator who made and lost enormous fortunes. To me, the quote applies very well to today's bond yields. Many investors are scratching their heads wondering how yields can be so low given the humongous supply coming over the next few years. Furthermore, the low yields can be said to be a bubble, which is another way to say that the market is severely irrational.

Baron Rothschild is the figurehead of the contrarian school of investing. One can imagine that, if he was around today, he would view the present negative environment as a potential great opportunity. He made a killing by buying British bonds after Napoleon's defeat at Waterloo. It is ironic that he bought them because he had inside information - he knew ahead of everyone else that Wellington had won the battle.

What is your favorite investment quote?

Is There a Limb Getting Ready to Break?

The investment pros have been wrong along with most everyone else, except maybe for the small investor, in predicting a rise in interest rates. The yield on the 10 year Treasury note has fallen to a 16 month low. Amid the pros continual tsk tsking, the small investor has continued to pile into bond funds. Although this extreme drop in rates could very well be a bubble and come back to severely punish the small investor, it has been a very rewarding move up to this point.
In my experience, when these kinds of moves take place, there is the potential for a big accident. Simply, when the pros believe a move in prices is a sure thing (i.e. a drop in bond prices), they bet heavily on it. Unlike you and me (hopefully), they don't just put their money on i-- they borrow to the hilt and put it into the pot. For example, Paulson bet heavily on the housing bubble and won - from a no name hedge fund manager he vaulted to guru du jour. The rest of the banking system made leveraged bets on mortgage backed securities and insuring various instruments - and the American tax payer lost big time. Long-Term Capital Management bet heavily on mean reversion for global spreads and lost--the Fed had to be called in to engineer a bailout.

Very likely there is a trader somewhere - in a hedge fund or in a bank - who has made a heavy leveraged bet on rising rates and who is bathed in sweat night after night praying for rates to rise. The limb is bending mightily. To say the least, if it does occur, the timing couldn't be worse. The Fed is out of ammunition, basically proclaiming this past week that the printing presses are going to remain wide open.

Just some thoughts.

Favorite Blog of the Week

My favorite blog this week, "Why the Economy is Not Relevant to Investing", came from Million Dollar Journey authored by Ed Rempel. I came across the site as I trawled Biz of Life's Blogroll.

Ed Rempel presents a pretty forceful case. I have long thought that the mathematics of investing has a certain fuzziness about it that prevents us from getting a clear picture of what is happening in the investing world and prevents anyone from coming up with a system to "beat the market." My field in graduate school was econometrics, and, in studying mathematics and statistics and econometrics, there comes a point where you realize that people try to fit the real world into the math in a simplified fashion. Specifically, assuming the real world is linear is real convenient.

In fairness, some relationships are linear. For example, if you collect data on grade point average and hours studied, you get a fairly linear relationship. Go beyond simple cause and effect situations, however, and, again, it gets non-linear real fast.

Where's the Fuzziness?
Think about this. Suppose there is value to the stock investor of knowing GDP - the broadest measure of economic output. First off, GDP is difficult to forecast - especially at turning points. Even the Bureau of Economic Analysis (the entity that decides the economy is in a recession) can't really decide a recession is in place until sometime after the fact. Secondly, GDP is reported with a significant lag and revised twice after that! This doesn't include the periodic longer-term revisions that take place. Finally, we have to get "news" out of the information - i.e. we need to know how we differ from expectations. All of this compounds the fuzziness. But suppose we had perfect information. Suppose we knew that GDP was going to be +3.2% this quarter, an increase from 2.1% the previous quarter, and suppose we knew this on day 1 of the quarter? Would this information be valuable? I realize that stocks are affected by more, a lot more, than GDP. But this just adds to the fuzziness. For instance,if GDP ratchets higher and at the same time the Fed makes a surprise policy change, then clearly all bets are off. The reader can think of a million examples like this.

Mr. Rempel's post got me to wondering if a game using real-life info along these lines couldn't be set up and his thesis examined statistically. Suppose we draw cards and they have two pieces of info: the amount real GDP is going up (or down) this quarter versus last quarter (we're assuming we know a lot more than we really know in the real world) and the level of the S&P 500 on the first day of the quarter. As an investor, we decide to increase or decrease our allocation from 50/50. Would we be able to add value?

This easily could be extended. Add in the unemployment rate for each month of the quarter, assuming we had the perfect crystal ball. Add in Fed policy in terms of the target rate for the federal funds rate.

It seems to me that an energetic person could run with this and set up an interesting game/experiment along these lines. Maybe two or more "investors" go at it at the same time, as in the real world, adding another layer of fuzziness: people reacting differently to the same info.

Anyways, I enjoyed Mr. Rempel's post and I think he has given us and those who stay riveted to CNBC plenty to think about.

No Matter How You Slice It!

Expense ratio or Morningstar stars - which do you want to know when you consider buying a fund?

Russel Kinnel, Morningstar's director of mutual fund research, just completed a study and found the quintile of lowest expense funds beat the highest quintile every single time and lowest expense funds beat the star system more than half the time. The results show that the differences are significant.

Investors are getting the message. The Journal of Financial Planning, July 2010, reports that investors put $1.1 trillion in funds that had expense ratios at least 20% below average and pulled $86 billion from funds with expense ratios 20% above average over the 5 years ended December 2009.
The message that the single best predictor of performance is expenses and costs is slowly but surely crystallizing in the minds of investors.

Matt Hougan, IndexUniverse blogger, says Morningstar's stars are still widely used because "... they’re easy to understand and make for good advertising." In other words, it’s style over substance; and it has cost investors a lot of money over the years."

The Mouse Says the Economy is Recovering

On Wall Street earnings continue to come in better than expected - especially by big media including CBS, News Corp, and Time Warner. Last night Disney reported net income of $1.3 billion for the quarter, better than expected and up 40% versus last year. Movies sales were up 30% on the back of Toy Story 3, Alice in Wonderland, and Iron Man 2. Historically, movie sales have tended to do well in weak economic environments going back to the 1930s. Advertising revenue from ESPN was strong - helped by the World Cup. The weakest sector, and this may be the real economic indicator, was theme parks - revenues up only 3%.

It is encouraging to view the positive results versus a year ago, but keep in mind that last year was the depths of the recession.

Full disclosure: I saw Toy Story 3 and liked it a lot. I don't own the stock but wish I had.

Barbecue Chatter

Five years ago the block barbecue discussion du jour was how much the house prices on the block had risen and how everybody was going to be rich. Today, assuming your neighborhood isn't sprinkled with foreclosures, the discussion has morphed into whether we will keep our jobs and how low yields are on our investments. So that you can keep up with the discussion and aren't forced into playing guitar hero in the basement with the kids, here is a listing of yields on various instruments along with some associated exchange traded funds. Nothing here is recommended. Some stuff is risky. In fact, a basic tenet of investing is that, if you are getting extra yield, you are taking on extra risk. The auction rate securities crowd never really got this. See your advisor or get an MBA before touching these investments! The framework here was inspired by Kiplinger's "Pocket Extra Income" p. 31 in the September issue.
Real Estate Investment Trusts 8.21% REM
Utility Stocks 4.14% XLU
Dividend-Paying U.S. Stocks 3.64% DVY
10 year U.S. Treasury Note 2.81%
Money Market Funds .04%
High Yield Corporate Bonds 10.8% JNK
Foreign Bonds 3.7% (yield reported by Kiplingers) IBND
Emerging-Market Bonds 5.15% EMB
Investment Grade Corporate Bonds 5.44% LQD
Investment Grade Municipal Bonds 3.6% MUB

When an Advisor May Not Be Acting in Your Best Interest

Fee-only registered investment advisors like to puff themselves up and proclaim how they are different from brokers. They emphasize that they are fiduciaries: they are "on the same side of the table as their clients". Really?

Many also manage assets. In fact, managing assets is typically their primary profit center. Watch them closely when they ask you how much in total assets you have to be managed. You'll notice their eyes narrow a bit and their lips purse out somewhat as their brains mentally calculate what they'll make off of you.

Let's break it down in simple terms. If an advisor charges 1% of assets (this is at the lower end), then he gets $10,000/year to manage $1.0 million. If you buy an annuity for $500,000, say, then obviously his compensation (his annuity, you might say)is cut in half to $5,000/year.

For many clients, handing over all of their money to be managed in the risky asset markets is not in their best interest. It is, however, clearly in the interest of the advisor.

In fact, we know from surveys that the number one fear of retirees is that they will run out of money. In most instances, it is why people do a financial plan in the first place. To alleviate this fear, the planner should, as a fiduciary, show people how to intelligently buy an annuity.

The bottom line is that people may want to separate the financial planning function and asset management function. At least then they'll know incentives aren't misaligned.

Related post: http://rwinvesting.blogspot.com/2010/07/single-pay-immediate-annuity.html

Brett Favre: Please Make a Decision

Since this week has been about some behavioral science/decision making stuff, I couldn't pass up this Dan Ariely guest post on Brett Favre's retirement decision process at Econgirl's site. Sports fans will enjoy the interactive graphic.
Those who haven't seen it should watch the 17-minute TED talk by Dan Ariely where he asks "Are we in control of our own decisions?"

Winners and Losers

Suppose you bought two stocks in 2007: Fannie Mae and Apple. Fannie Mae had a near monopoly on packaging mortgages to sell into the bottomless pit of demand for mortgage-backed securities. It was bumping along at $60ish/share. Apple had started the year at $85 and ended at $94. It had a reputation for coming out with "cool" products and being totally in tune with design. It did have the lingering questions of Steve Job's health.

We know the outcome. Today you need to tack on .ob to get a quote on Fannie Mae. It is trading as a penny stock around $.30/share. Apple, on the other hand, has gone on a moon shot in a very difficult market environment and is close to $250/share.

A big winner and a big loser. How would you have played it if you would have bought them? Everyone knows the dictum, first offered by a voice from the past: Edwin LeFevre- "Let your winners run and cut your losses quickly."

We have an indication of how the average investors handle winners and losers. Along with other evidence, Jason Zweig in "Your Money & Your Brain" reports that

"A look at more than 97,000 trades found that individual investors cashed in on 51% more of their gains than their losses - even though they could have raised their average annual returns by 3.4 percentage points (and cut their tax bills) if they had held on to the winners and dumped the losers."

Psychological Basis

Why do investors act exactly backwards and hold on to losers but grab profits too quickly? There's a psychological basis. Sell a loser, and the awkward possibility exists that it could immediately turn around - the mistake is compounded. In fact, anyone with any market experience knows the evil "Mr. Market" is lurking behind the bush just waiting for us to hit the sell button. Psychologically, taking action and it being wrong is more devastating than committing an error by not taking action. This is where the brain is playing tricks. So we hold on to the loser. The same effect takes place for our winners but in reverse. Taking a profit is a reward- a "pat on the back" as Zweig puts it. And we all like "pats on the back!" Especially when "Mr. Market" isn't being pleasant.

All of this is pretty much known by students of the market. What may not be appreciated quite as much is that the same behavior is likely at play when it comes to firing a poorly performing advisor. The same psychological factors are likely in play as clients hang on too long with poorly performing advisors and actively managed mutual funds for that matter. The possibility of making two bonehead moves is a restraining influence. And so both are held on to too long. At least that's my take. What's yours?

A Well Known Fan of ETFs

Karen Damato has written a nice profile, "A "Dilbert" Guide to Funds", on Scott Adams, the creator of the Dilbert comic strip.
Scott Adams has an MBA and is a financial analyst. Thus, when he has Dogbert make fun of the mutual fund business, people take notice; and those in the investment community relate. The article also reveals a distaste for active management: "But Mr. Adams has sworn off using professional advisers to oversee his money." For several years, Wells Fargo & Co. managed half of his portfolio, and he says he ended up with a "shockingly" large sum "in companies that weren't even real companies, like Enron and WorldCom."(My bolding.) In fact, Scott Adams did better as a do-it-yourselfer.

Ms. Damato emphasizes that Scott Adams expresses his approval of exchange traded funds by avoiding them in the strip. He says, "...from his perspective as a cartoonist, "there has to be something broken in order to get a joke out of it."
This is an excellent piece to copy and give to friends who are skeptical of the do-it-yourself approach and exchange traded funds.

If you have an advisor who picks individual stocks for you, the question you have to ask yourself is how well does your advisor understand the companies he is investing in. Like Scott Adams, many investors ended up holding Enron (and employees lost their life savings) despite the fact that they were clueless about what the company, and especially Mr. Fastow, were up to. Many self-proclaimed stock pickers got caught up in the hype. This isn't what people need for their retirement funds.

Coping With Emotions in a Volatile Market

Yesterday's post elicited a comment from Shawn in which he asked "...I do wonder how investors can deal with the emotions of the roller coaster ride we have been experiencing." This is the most important question facing do-it-yourself investors and the present environment is a great test. One day the market is falling off a cliff, all the news is negative, and doomsday commentary is everywhere. You feel like the character in Edvard Munch's painting. It makes a normal person want to cash it all in and sit on the sidelines.

The next day we get a piece of positive news: different commentators argue that the economy is in a recovery mode and that the worst possible scenario is a slowdown - not the dreaded double dip.

In the background, the news du jour is the sub-par long-term under performance of stocks. Over the last decade, investors were not rewarded for taking on risk which, of course, undercuts one of the main tenets, supposedly (actually investors can expect higher returns for incurring greater risk), of investment theory. Then there is the ongoing argument that a bond bubble is building.

All of this, as Shawn implies, is causing the arrow on the emotions meter to register in the danger zone. Again, how does the do-it-yourselfer cope?

Well (I'm taking a big breath here), we do know a couple of things. First, the average do-it-yourselfer is not going to do well in this environment. Simply, some who are completely out of stocks today will dive in aggressively if the S&P 500 rises 400 points. We know that there are diyers who capitulate every time the stock market drops by triple digits and then jump in when it's up a couple hundred points. DIYers like to buy high and sell low and tend to chase the best performing sector. Today that's bonds.

This behavior is the result of DIYers focusing on prices and not on the underlying businesses. Simply, if DIYers are not going to put in the time and resource-consuming effort they need to understand individual businesses, they need to index and capture market returns. Focusing on the erratic day-to-day price movements of individual stocks in a volatile market would even drive the Fonz to lose his cool.

Secondly, the last 10 years have been highly unusual. Ten years ago was near the end of the best 3 years in the history of the stock market! It was the most bullish environment ever experienced in the U.S. Valuations were skyrocketing, investors were convinced that old valuation metrics were irrelevant, and the bubble was wildly over inflated. We're not in a stock bubble today. In my view, it is a mistake to fixate on the last 10 years.

Thirdly, it is easy to emphasize what we can see; and it is impossible to see what is around the corner. Typically, on the business front, positives have been around the corner.

Some perspective: when I was the age of many of today's personal finance bloggers, I had to carry boxes of punch cards to the computer center at the university and get my results the next day. If I had a question about house prices over the past 20 years, I went the library; I didn't google "house prices." Businesses didn't have PCs on every desk. People had to actually answer their phones and, if you wanted to see a TV show, you had to be there when it aired.

Today's world is completely different. And it will be very different in 25 years. In terms of products produced by businesses (notice I'm steering clear of politics and the fiscal mess we are in!), it will likely be much better. We'll have completely different automobiles, medical technology will be much improved (and may actually lower medical costs), and, yes, today's computers will be like "pong" is to today's games.

Thus, for me, when I put all of this together, I go 100% with the advice offered by the school of thought that emphasizes low-cost indexed investing. Give a lot of thought to risk tolerance, how much you need to reach your retirement goals, and structure assets accordingly. Then live life - don't let the ups and downs of daily stock prices on the computer screen mesmerize you. To me this is how the DIYer copes.

"Adam Dunn's due"

I love it when announcers say a player is due. For example, Adam Dunn, the prolific home run slugger of the Washington Nationals, has averaged a 4-bagger every 14 times at bat. Naturally then, if he goes 20 times at bat without a moonshot, the announcers will say he's "due" and viewers will edge a bit forward in their seats expecting this time at bat to be more likely than others to produce a shot over the wall.

This, of course, is "the gambler's fallacy" in disguise. The gambler sees 3 heads in a row and immediately announces that a tail is due and steps up to bet on a tail, as if the coin has a memory. The odds of a tail aren't, of course, affected by what came before just as Mr. Dunn's odds of hitting a home run aren't affected by the previous at bats.

In the world of investing, the gambler's fallacy causes investors to stay with losing positions too long. The voice in the back of their head says the stock is "due" to turn around. In fact, if they had a recent turn around situation, this can increase their perception that the odds of the stock going up have increased.

Awareness of "the gambler's fallacy" is a step in the right direction in improving investment performance. In fact, the best way to avoid the trap is to take a long-term perspective, invest in low cost index funds, and look at your portfolio less often. Instead, enjoy a ball game and root for Mr. Dunn and the Nats!