Should You Index?

The question of whether an investor should index at least part of his or her investment assets or go the actively managed route can be approached from a number of different angles. You can look at performance numbers, the upfront costs and hidden costs, impact on taxable accounts of excessive trading on the part of actively managed accounts, and on and on.

To DIY Investor, any way you look at it, indexing makes the most sense, especially over the long term. Especially today, when you can get index exchange traded funds at such a low cost and in many different areas of the market.

DIY Investor's interpretation of the data is that, if you feel lucky, then go with active management. Essentially it boils down to trying to draw one of the 20 red marbles out of 100 marbles in the fish bowl. All I can say is "good luck". Economists have shown that most people are "risk averse." To DIY Investor this means that, even if people had a 50% chance of not coming up with a red marble, when it comes to their retirement assets, they would choose indexing.

But the active management community came up with an excellent ploy several years ago. They labeled the indexing approach as "passive management" and played on the idea that "passive" has a negative connotation. After all, they said, hard work, analysis, and brains will pay off in the investment world like it does elsewhere. Passive investing accepts the mediocre. Touche! My guess is that pitch has cost investors more in total than even the highly-publicized Ponzi schemes in recent years. And it has enriched Wall Street. Managers who underperform on an ongoing basis routinely receive 7 figure payouts. It led Fred Schwed to famously ask, "Where are the customers yachts?"

DIY Investor calls indexing "evidence based investing" for the simple reason that the evidence points to its superiority for most investors.

But when it is boiled down to the bottom line, what is the best evidence? What is the question that people should ask the advisor who directs them to actively managed funds or who claims they can pick stocks or even time the market?

To DIY Investor, the very best evidence is to ask what professionals do who are responsible for managing humongous pools of assets.

Bill Schultheis provides indexing information on some of the nation's largest pension funds in his recent book The New Coffee House Investor.

The important point here is to understand that these funds have large staffs of well-compensated analysts from the best business schools in the nation. What message does this send if they are indexing the bulk of their assets?

In a previous life, DIY Investor was an advisor at one of the nation's largest union pension plans. We picked managers with the best track records, etc. and told them to go out and beat the S&P 500. When the dust cleared, and the longer term results were tallied up, they pretty much matched the market. It didn't take an Einstein to recommend to the Trustees that the Plan index and achieve the same result with a lower cost.

So, when you meet an advisor who claims he or she can beat the market and wants to charge you 1% to 2% of assets. ask him or her why the large pension funds index form the bulk of their assets. While you're at it, you may also want to ask the advisor why Warren Buffet says that indexing makes sense for most investors.

Zecco versus Schwab

DIY Investor has never used Zecco and has no clients who use Zecco, so he's running a bit blind in this post--sort of like Pacino driving the Ferrari blind in "Scent of a Woman."

Zecco had offered zero commission trades as noted by MoneyCone and now is charging $4.95/trade. Understandably, this has some people upset.

This would not be something that would affect DIY Investor because he minimizes trading and, in many instances with the likes of Schwab and Fidelity, uses commission-free trades. Still, DIY Investor wonders how Zecco stacks up against the likes of Schwab, so DIY Investor visited the Zecco site to see what was offered. DIY noted right off the bat plenty of resources for the trader - screeners, alert centers, "QuoteStream," etc. - the kind of tools that are definitely needed for jumping in and out. Zecco actually says "Markets move fast. You need the tools to move faster."  As an aside, this gets at the crux of differing investment philosophies. If you've ever played racketball, you understand that chasing the ball all over the court is futile and just wears you out. You need to understand that the ball mostly comes back to the center of the court, and a key is playing the angles and minimizing your movements.

So, definitely not DIY Investor's cup of tea. DIY Investor moves slow. In fact, as the years have gone by and experience has been gained, DIY Investor has moved ever slower.

What DIY Investor doesn't see at the site (and maybe they are there somewhere) are asset allocation tools, models to determine the appropriate risk tolerance structure for investors, or performance software that enables the investor to compare how they are performing compared to a benchmark  index. Is this the cost for low-priced trades?

Zecco clients must get analytics elsewhere, or maybe they are on the site but DIY Investor just didn't come across them. Or maybe clients watch CNBC and Cramer and sort of shoot from the hip. DIY Investor is going back to watch Pacino drive that Ferrari again.

Indexers are Human Too

Get an appropriate asset allocation and index.  This is a key to controlling emotions in volatile markets. And we are in a volatile market environment.

Indexers can make this look robotic. Many have conquered the emotional side of investing. They are like the soldier running up Mt. Suribachi lobbing grenades as machine gun fire is raining down the side of the mountain. Are they superhuman investors? Don't they have emotions? How are indexers able to hang in and ride out the market turbulence?

The Secret

I'm here to let out the secret. Yes, we have emotions. Yes, we get nervous when we hear tornado sirens go off. Yes, our minds try to play tricks with us. We are, in fact, human.

DIY Investor looks at today's market and cringes. The media is playing up many disaster scenarios. Brush fires are all over the place. What happens if the unrest in the Middle East spills over to Saudi Arabia? In fact, it appears that the Saudis are the key to us getting out of this alive. If they don't push up oil production closer to capacity, oil prices will spike further, pushing U.S. gasoline prices sharply higher and killing off the nascent U.S.economic recovery. Revolutions are nasty.

DIY Investor looks at the Middle East power struggles and is fearful for the simple reason that the U.S. isn't in control. It reminds him of late season drives by the Washington Redskins, who could only get into the playoffs with an improbable chain of events--requiring other teams winning and losing particular games. You could only sit there and wring your hands once your fate was out of your hands.

Then there are the budget fights with public unions taking place in a number of states--another contagion type development that has the potential to spread.

Add to this that the budget limit is close to being broached and that our politicians at the national level care more about vote getting, posturing, and playing to the cameras than taking courageous action that benefits the country.

All of of this and much more weighs on the minds of indexers as it does most investors. What, then, prevents the indexers from pitching all the cargo and jumping overboard?


Controlling Emotions

First,  indexers are probably a bit older than the average investor. In fact, I would like to see survey data on this, if anyone knows of some. It is hard not to get a sense of deja vu for those of a certain vintage. Secondly, indexers (even the younger ones) are knowledgeable about the history of markets. This is a real key. Take 9/11 as a fairly recent example. After the immediate horror sunk in, investors looked at markets and heard pundits proclaim people would never fly again.  Expectations were rampant that further attacks would occur, and economic forecasters predicted disaster.

The S&P 500 hit a new peak six years later.

The recent example, of course, is the housing crisis of 2008. It looked as if the whole banking structure of the U.S. was going under. The potential for massive money market fund liquidations brought to mind the bank runs of the Great Depression. The bond rating agencies were exposed as incompetents and, to boot, it became unnervingly obvious that the top people at the Federal Reserve were clueless on the economic economic impact of the housing crisis. On March 9, 2009 the S&P 500 stood at 676.53; today it is at 1319.88.

Out of 26 investment management clients, I had 2 who totally "freaked out" (to use an up-to-date expression)  and asked to put everything in money markets in early March 2009.  They said that all the news was negative and they didn't see anything that could be positive for stocks. This, of course, is the best time to invest, as Buffett et al. have long argued.

The bottom line for indexers is that we have been through this before, we understand that emotions will be high, but, importantly we know that these situations offer opportunities. But, again, investors have to be allocated appropriately. It is important to understand the difference between the stage where an investor is accumulating assets and where assets are being drawn down. The investor building up the nest egg can confidently say that, from the perspective of several years down the road, this period will be seen as an opportunity to have added funds to the portfolio.

The bottom line is very simple. For most people, if they have an appropriate asset allocation and forget trying to time the market or pick stocks or even pick the sectors of the market that will provide the best performance, they will find they can control their emotions and be well positioned for calmer markets. Otherwise, IMHO, they shouldn't be in stocks at all. And that's OK.

LEAP Options (Part II)

On Sunday, DIY Investor introduced readers to LEAP options, longer term option contracts that give the owner the right to buy (calls) or sell (puts) shares at a specified price (the strike price) over a given period of time (time to expiraton).

The post was motivated by the negative news and the potential for a Black Swan event. In recent days, the price of oil has skyrocketed and the markets have been pounded. This after a prolonged up period for markets which produced nice gains.

Events have presented  DIY Investor with an excellent teaching moment.

Let's revisit the SPY (S&P 500 indexed ETF) Decmber 2013 100 put. To review, this put allows the holder to sell SPY at $100 anytime between now and December 2013. It was priced as reported in the post at $7.26. Last night it closed at $8.64, a gain of 19%! To find the price, retrace the steps described in the last post.

You can see two things from this:  these derivatives (yes...they are derivatives) can be used to gamble. Many people use options to outright gamble - take highly leveraged positions with a relatively small amount of money to bet stocks will move one way or the other in  a given period of time. This is, IMHO, not something hopefully DIY Investor's readers would consider.

The other point is that LEAP options can provide a type of insurance to lock in gains against a "Black Swan" type of event.

In any event, these are instruments that some (they are definitely not for everyone) DIY Investors should have in their tool kit. Following them on paper is free and interesting in volatile markets. Be my guest.

This post is not a recommendation. It is for educational purposes only.

Reading Between the Lines

You ever come across something you can't figure out and you just can't get it out of your brain? It just goes around and around and pops up at the weirdest times, and you find yourself thinking about it.

For example,  recently I was reading the story of James F. Parker in Empire of the Summer Moon by S.C. Gwynne.

Gwynne's book is a fascinating history of the Comanche nation and, in particular, Comanche chief Quanah Parker. It turns out that after Cynthia Ann Parker was captured as a young girl by the Comanches, her father made several trips by himself into the Comanche nation searching for his daughter. James's adventures later became the the basis for The Searchers starring John Wayne.

Anyways, at one point James Parker was on foot in the wilderness and had gone six days without food and was able to survive by finally strangling and eating a skunk. This is the part that kept playing over and over in my mind. I can't help but think it has to be humanly impossible to strangle a skunk with your hands. Out where I live skunks get run over all the time, and it's not easy riding past them in a car with the windows rolled up - if you get my drift. The only thing I can figure is that James Parker must have caught the skunk with a small trap that he was able to tighten at a distance.

In any event, in exactly the same way, it is puzzling to me how financial anecdotes are sugar coated and presented in the popular press. In reading them, I'm forced to stop and ask why the author wrote it in a particular way. And I wonder further how it is subconsciously affecting our thinking and eventually our behavior. An example will help you see what I mean.

On Yahoo! Finance today is an interesting piece contributed by the E.S. Browning of the Wall Street Journal, "Retiring Boomers Find 401k Plans Fall Short". This, of course, is the story du jour.

The very last example in the piece is about Patti and Bob Webster. In 2007 they had a "...six figure balance in their 401 (k ) accounts and building a dream house in North Carolina ...."  They planned to retire in about a year.  Then their savings fell 40%  because of the downturn in the stock market and, in total, it looks like they will have worked 4 years longer than they thought.

This little vignette is headed by "Some people were done in by the twin collapses of the housing and stock markets."  Wait a minute. Granted that the stock market got beat up badly, but being down 40% tells us something. In particular, Patti Webster is wrong when she goes on to say  "When the bottom fell out of the market, it kind of fell out of our perfect plan as well."

First, theirs was far from a perfect plan; and this isn't just hindsight talking. To be down 40% even in the debacle of 2008 and early 2009  meant they had a poor exposure to the stock market - either too much or too concentrated. My guess is it was probably both. In their 60s and within a year of retirement, they had far too great of an exposure to stocks. In other words, Patti and Bob Webster had no plan at all. They could have gone to the race track as far as that's concerned.

All of this isn't unusual. People get greedy, they get overly aggressive as markets are doing well, and then they blame the market when they have a set back. In most stories, if you read between the lines, you find that mistakes were made - it wasn't the market's fault  no more than Steve Irwin's death was the fault of the stingray.

I have to say that even the headline irks me. Don't blame the 401ks. Maybe a better headline, IMHO, would be "People Make Dumb Mistakes."

The Broker Did What??????????????

DIY Investor is an unabashed fan of Dan Solin. I  just want that out front. In fact, when I detect a person is searching for a DIY investment philosophy or even when I feel they would benefit from considering a different approach to investing, I strongly recommend Solin's The Smartest Investment Book You'll Ever Read.  The book can be read in a weekend and presents the case for low-cost indexing. For those who don't like to read, DIY Investor directs them to Solin's talk on YouTube as part of Google's author series.

Solin stands out from the "how to invest" crowd because he is a securities arbitration lawyer. He has seen first hand the portfolios and lives destroyed by unscrupulous brokers.

One of the cases he has come across  is presented in this post from Arianna Capital Management. The Salomon Smith Barney broker took a conservative portfolio of muni bonds and used it as collateral to buy stock on margin. In the process, he lost over $2.0 million for the client. The interesting point is that, for an account that had an average value of $3.6 million, "...the brokerage firm gained $1.3 million (in commissions and margin interest) for “managing” this portfolio."  Although admittedly an extreme case, Solin points out this is how wealth is transferred from clients to brokers.

It is also well worth noting that the $1.3 million portfolio would have been worth in excess of $5 million, on a conservative estimate, if it had been managed with low-cost indexed funds.

T. Rowe Price Retirement Study

T. Rowe Price has produced an important study entitled "Dismal Decade Offers Cautionary Lessons for Retirees" that DIY Investor believes all who are interested in a comfortable retirement should read. If you are within 5 years of retirement or in retirement, then read it now. Otherwise, copy it, put it in your "stuff to read when I'm 60"  folder and go back to building your nest egg.  As I remind my community college students (this is actually news to some of them), "you are allowed to read stuff more than once." Read this short - 3-page study - until you "get it."

The T. Rowe study examines different responses to a downturn in the market at the time of retirement. Consider that you have just retired with a fat nest egg and the market goes off a cliff twice in the next 10 years while you're trying to manage withdrawals from your nest egg. The case study is those who retired in 2000. Prior to that time, the stock market had been exceptionally generous. From 1995 through 1999, as the study points out, stocks achieved gains exceeding 20% each year. Subsequently, the decade following, which we have just finished, saw one of the worst performances ever as it experienced two serious downturns.

The study looks at 4 possible nest egg withdrawal responses on the part of year-2000 retirees and addresses the #1 question of retirees:  what are the chances of running out of money - incidentally, the #1 fear of seniors.  I'm not going to reveal the outcome because everyone should read this study; but I will reemphasize that this is very practical information that potentially could save people's retirements, depending on where markets go from here.

As a practical matter, DIY Investor believes that nothing is really lost if you skip the explanation of the Monte-Carlo analysis. As I tell my students "this part won't be on the test."  Those with a mathematical bent will like the Monte-Carlo explanation, but suffice it to say that T. Rowe looked at a lot of different possible paths in generating their results in terms of where the market goes in the future.

I do want to put in one picayune sort of point that emphasizes that retirees need to keep an open mind and examine possibilities even their financial planners might not consider or present. Financial planners are human and, like the rest of the world, emphasize the recent past. But the recent past, as market observers know, isn't always a good guide to the future. With this in mind, let's go back to 1/3/2000, after the stock market has gone on a tear and investors are sitting on fat portfolios. At that point, the yield on the 10-year U.S. Treasury was 6.58% . Today that yield stands at 3.60%, i.e.yields were considerably higher. A good recommendation on 1/3/2000 would have been for the newly retired to consider putting up to one-third of their fat portfolio into a single premium, immediate pay annuity. This would have locked in an income stream that would have covered some of the basic needs of the newly retired and, thereby, brought down the stress level that the market ahead was going to produce and greatly change the results in the T. Rowe study. That is - the probability of running out of money in the four scenarios would have been greatly reduced.

Granted, this is offered with the benefit of perfect hindsight; but the purpose is to keep an open mind. We very well could be moving into a higher interest rate environment that could offer annuities at attractive levels.

A second point I can't resist is that readers of this blog know not to just take a percentage of portfolios as a withdrawal strategy in retirement. This subjects the retiree to the negative impact of "reverse dollar cost averaging."  Having a withdrawal plan in the decumulation stage would lessen the negative impact found in the T. Rowe study.

Disclosure:  I don't sell annuities or receive any compensation for any type of financial product. I am fee-only and the only compensation I receive is that paid to me by my clients.

What is a LEAP option?

A "LEAP" option is a long-term equity anticipation option. It is a contract. A call option allows the holder to buy shares at a given price over the term of the option. A put allows the holder to sell over a particular period at a certain price. Option traders who believe prices are going up buy calls, otherwise they buy puts.

To begin to understand these instruments, go to Yahoo! Finance, put in "SPY" in the quote box, and click "options" in the right hand column. SPY is an exchange traded fund (ETF) indexed to the S&P 500. You can either buy the ETF outright, or you can buy options that allow you to buy or sell the ETF over a given period.

You come to this:  note the price of SPY circled toward the upper right and the circled 2013.

Source: Yahoo finance

  Click to Enlarge Click "2013" and come to the options that expire in 2013.

Why we would care about these instruments? Let's consider a scenario.

Suppose you read the opening article this week in BusinessWeek. It talks about food prices rising in emerging economies, social unrest, inflation on the verge of picking up. Further in the magazine, you read about the impact of rising interest rates on the federal deficit. And you begin to think, "Holy cow, we're going down the same road as Greece." You begin to wonder how you can protect the gains you have in your stock portfolio and, at the same time, you don't want to lighten up just yet because you feel there may be some upside left.

Stay with me. You've clicked on "2013" and you've come to a list of options. Heading the list is calls - these are what investors buy if they believe prices are headed higher. We're interested in protection against falling prices, so we scroll down to the puts.
We come to

Source: Yahoo finance

CLICK TO ENLARGE Consider the strike price of 100. The price is $7.26. For $726, we could buy this contract to sell 100 shares of SPY between now and December 2013 at a price of $100. This is an out-of-the money option. In fact, it is pretty far out of the money given that SPY is currently at $134. It will go "in-the-money" if the price falls below $100 before the expiration date.

Hopefully, you can see that, for a relatively small amount, LEAPS provide portfolio insurance. If the market collapses and SPY goes to $80, say, the contract would have a value of at least $2,000.

                                     
Two really good examples of how they have paid off big-time are available. The first comes from The Black Swan by Nassim Taleb. In this book (the most widely read book on Wall Street a few years ago, actually), Taleb describes a hedge fund approach that is based on extreme events - 40% drop in stock markets in one year, dot.com busts, housing crisis etc.) on the supposition that extreme events are underforecast.

The second example was briefly mentioned in a previous post about two investors who foresaw the housing market crisis and used LEAP options to take a small Schwab account to multi-millions. This story was told in The Big Short by Michael Lewis (#9 on New York Times best seller list).


How would a DIY investor get to understand these instruments? First of all, I want to make clear that I am not recommending options but instead am introducing them as an educational message. They very well could be a tool some DIY investors would want in their tool boxes, after study and consultation with an advisor.

In this spirit, I would recommend an interested investor buy contracts on 100 shares - of a stock or index. It can be a call or a put, for that matter. By actually buying an option and following it, the DIY investor will quickly learn how the time value of money comes into play, the varying risk premium depending on recent volatility, etc.

As a further caveat - it can seem very easy to make money with these instruments when you are on the right side of the market because of the leverage factor. As a result, it is easy to get carried away. Caveat emptor!

All 401(k)s Aren't Created Equal

The Department of Labor is on a mission to improve retirement opportunities in the U.S.  This is sort of a closing-the-barn-door-after-the-chickens-have-gotten-out initiative; but at least it is useful going forward, at least in my view.

Today we are on the verge of the so-called gray tsunami wave of baby boomer retirements. And. many baby boomers aren't positioned financially to retire. They were given control of their retirement assets as companies moved from defined benefit plans that provided a pension to direct contribution plans like 401(k)s, where workers were responsible for deciding how much to invest and how to invest it.

Workers didn't save and invest nearly enough. This, of course, is the story du jour.

Looking ahead, the Department of Labor has cracked down on defined contribution retirement plan providers by emphasizing the need to offer appropriate investment choices and opt-out provisions that automatically enroll new employees unless they opt out, by increasing participation rates, and by requiring plans to disclose all costs in a manner that participants can actually understand.

It will be interesting to see how the latter requirement is implemented. Disclosing costs in the investment business reminds one of a diner choking on a turkey bone. There may be ample opportunity to practice our Heimlich maneuver.

In previous posts, I have discussed the BrightScope site that rates 401(k) plans relative to their peers. They have recently updated data through the end of 2009 from Form 5500 for many of the plans they follow. If you haven't checked your company plan rating in a while, you may want to bring it up.

Participants can use this data in a couple of ways. If, say, their plan's investment menu is rated "poor" relative to its peers, participants should ask the plan administrator (human resources) why. This goes for the other categories as well. In fact, if the participation rate is low, the head of the company should be asking why before the Department of Labor pops in and pops the question.

Secondly, as I have posted before, a married working couple should compare each other's plans. One may have a superior plan and that should be maxed out, after the match is taken advantage of. In some cases it will make sense to forego the company plan and open a traditional IRA or Roth on the side. From a longer term perspective, putting retirement savings in the right place makes a big difference.

I.B.M.'s Watson

For those out of the loop, The Grouch at Biz of Life has posted  the NOVA program on I.B.M.'s Watson, the IBM super computer entry that took on and beat the top Jeopardy contestants. The ability of the computer to parse sentences, figure out nuances, and weigh different answers at lightening speed amazed the nation as well as DIY Investor.

DIY Investor has mixed reactions. Market observers know that computers are trading the market, making split second decisions, and attempting to capture market anomalies. Studies of market inefficiencies have long found that some exist that happen so quickly that humans are too slow to exploit. Computers on the other hand, as mightily demonstrated by Watson, are fast!

But Watson missed some easy questions. For example, one question had to do with airports in a U.S. city and Watson's answer was Toronto. The audience laughed; but, in fact, Watson had little confidence in the answer . DIY Investor's feeling, though, is that, if computers trading the market  make a poor "judgement,"  you could get a "flash crash."  And the humans stand around dumbstruck - not sure of what happened.

Secondly, the University of Maryland and Columbia University are collaborating to add voice recognition and produce a physician's assistant service. To DIY Investor, these are the types of developments that are difficult to foresee but are the reason for investing. At any point in time, there are always many reasons of why we shouldn't invest. The negatives are clearly foreseen and reflected in prices.  The key is to understand that innovation will bring forth new products that we can only begin to imagine. DIY Investor watches the Jeopardy challenge and recalls playing "Pong" on a small black and white TV.

Now, if only the University of Maryland could  clone a Watson with a 3-point shot, we'd really be in business.

Performance of 5 Most Widely Held Mutual Funds-AAII

The table below shows the performance (through the end of 2010) of the 5 most widely held no-load or low-load mutual funds as reported by the American Association of Individual Investors. I have added expense ratios from Morningstar. Two of the funds of the top 5 are index funds - in fact, the 6th largest fund was the Vanguard S&P 500 Index fund.
New entrants into the labor force who started work 3 years ago came into a great environment. They started contributing to their 401ks at severely depressed stock prices throughout 2008 and early 2009 and picked up stocks on the cheap. That's the good news. The bad news is that because they were starting out they didn't have much invested and most weren't contributing much  :)
Those who were within 3 years of retiring and were pouring funds into the market and taking advantage of 401k catch up features did well. Those who retired exactly 3 years ago went through a rough period. It is why decumulators need to plan on how to draw a paycheck off their nest egg.

Source:AAII Journal Vol. XXXIII,No.2/Morningstar

The Best Mutual Funds vs. The Worst Stocks - an Experiment

Regular DIY readers know it's impossible to prove a theory. The best you can do is accumulate evidence in a theory's favor or disprove it. Find the black swan and you've disproved the theory that all swans, by definition,  are white. So evidence is continually collected to see if there is any evidence disproving a theory. You never know - there could be a black swan out there.

What investors need to know about probability.

 
The theory tested here is that professional investment managers tend to produce subpar performance after fees are accounted for over a longer period of time. Mountains of evidence have been amassed examining past mutual fund performance, over long periods of time, and none has shown the pros beating indexes after fees and expenses.

The evidence offered today is real world and comes from Andrew Hallam, author of the forthcoming The Millionaire Teacher to be published by Wiley. The experiment is real world and ongoing. A year ago he asked readers to name their best mutual funds and their worst stocks. The professionally managed mutual funds for which investors pay a lot in fees and hidden expenses would surely outperform the worst stocks, right?  In fact, it is difficult for DIY Investor to think of a way to set the bar lower for professional managers.

DIY Investor suggests that you read Andrew Hallam's post to see his results.  Beyond his results, the list of worst stocks is interesting and informative. Look at some of the names:  Kimco Realty, Ford, Alcoa. Out of 23 stocks, 6 had returns of more than 20%. But these are stocks DIY Investor would never choose, and he is sure his readers would never choose. The news on these stocks a year ago was horrendous. Recall that auto companies were on the verge of going under and banks were imploding. DIY Investor would have LOL at a Krispy Kreme recommendation (+44%).

Very few people would choose to hold these stocks. In fact, they were probably held by people so shell-shocked in recent years they couldn't hit the "sell" button.

But here's the kicker:  if you invest in the total stock market, you would have a position in the stocks that you wouldn't choose and apparently the professional managers didn't choose. These are stocks that, at a given point in time, have been driven down by bad news. In  fact, the news for most of them has been so bad that it has to get better. Nevertheless, very few investors can stomach buying them. Instead, human nature leads investors to buy stocks where the news has been surprisingly good. But...their prices have been pushed higher by the good news.

But buying and holding them is what is rewarding. The best way is with a low-cost, index fund. At least that's DIY Investor's take.

What say you?

The Downfall of a Market Guru

DIY Investor has mentioned in past posts the travails of former super guru Bill Miller of Legg Mason. Bill Miller had outperformed the S&P 500 15 years in a row. He appeared to be invincible. Clearly highly intelligent and super connected with an outstanding track record, he attracted money like a beautiful summer weekend attracts beach goers. And then 2008 came along, Mr. Miller stuck with some stocks that went into a tailspin, and he ended up at the very bottom of the performance heap. Market guru worshippers left in droves - rats jumping a sinking ship.

A vivid description of events at ground level is presented in The Big Short that is worth repeating. DIY Investor feels strongly that a huge jump is taken in investor sophistication when the risk of handing funds to a proclaimed market guru is fully appreciated.

March 14, 2008 Steve Eisman, vocal critic of the subprime mortgage market, is invited to speak on a panel which included Bill Miller. Miller explained why Bear Stearns was a good investment - delivering his panel presentation sitting down. Mike Mayo, bank analyst, introduced Eisman as "...our bear."  Although intended to be a sit-down panel discussion, Eisman headed for the podium. His speech was titled "This Time Is Different."

Right after Bill Miller had argued that Bear Stearns was a good investment, a press release was put out proclaiming Bear Stearns wasn't having liquidity problems.

At 9:49 Eisman is at the podium, Bear Stearns is trading at $47. It had been at $53 the day before.
Eisman: "If (the U.S. financial system) sounds like a circular Ponzi scheme it's because it is."

9:55 Bear Stearns at $43.

Eisman: :"The banks in the United States are only beginning to come to grips with their massive loan problems. For instance, I wouldn't own a single bank in the State of Florida because I think they might all be gone."

10:02 Bear Stearns at $29.

A kid in the back of the room, described as maybe in his early 20s, had been punching up his Blackberry the whole time the speeches were going on. He pointed out that Bear Stearns stock had dropped 20 points since Miller had started talking. He asked Miller if he would buy more. Looking stunned he replied "Yeah, sure, I'd buy more here."

Bear Stearns was eventually sold for $2/share. (p. 230-235, The Big Short, Michael Lewis). DIY Investor feels strongly that, in addition to reading a book on how to invest, books on market history should also be read in the quest for investment knowledge. The Big Short, by Michael Lewis,is one of the best in this genre.

401k Rollovers

Yahoo Finance has an excellent article this morning for DIY investors on how to rollover a 401k. Like many things in personal finance, it is something most people will do, possibly several times (it must follow a definite process), and not doing it right can be costly. I recommend the article be printed and saved to read in the future when the time comes.

The essentials are to be sure you have an IRA account opened up first, do a trustee-to-trustee transfer, and, if you have company stock, consult a financial advisor before doing the transfer. Sometimes considerable taxes can be saved by transferring the company stock to a taxable account. Again, consult an advisor.
I recommend transferring the assets in kind so that you aren't subject to the risk of being out of the market. This typically takes a couple of weeks and you don't want to be in cash for a couple of days when the market is on a tear.

Also, if you will need or want the money before you turn 62, consult an advisor. Some plans allow withdrawals before then without having to pay a 10% tax penalty.

Monthly Meeting - AAII/Baltimore-Alternative Investments

Yesterday's presentation on alternative investments at the American Association of Individual Investors/Baltimore was by Stephen Ross, financial advisor with Merrill Lynch. It was the largest attendance I have seen at these meetings in some time, and it clearly evidenced a desire on the part of DIY investors for ideas on how to pick up yield and find opportunities in today's markets. And Mr. Ross covered a lot of bases.

At the beginning of the presentation, Mr. Ross put a plug in for "Merrill Edge," the platform from Bank of America/Merrill Lynch for DIY investors. I will be reviewing it in the near future. It appears to offer a number of free trades as long as you maintain a high enough balance across  Bank America and Merrill accounts.  At first glance, it appears to offer many of the analytics DIY investors need.

Mr. Ross read quite a bit from Merrill's research reports and recommendations. He presented a useful chart in his handout of high quality, high dividend stocks, both U.S. and foreign. Many DIY investors today are attracted to these in lieu of low-yielding bonds. He also recommended Master Limited Partnerships as a source of yield for the taxable portion of the portfolio. Other areas included the usual:  high yield funds, emerging market bond funds, preferreds and REITs. Many of these sectors performed well on a relative basis in 2008 as the stock market plunged.

One participant asked about fees on the funds, and Mr. Ross said that fees ranged as high as 4%, although performance numbers he quoted were net of fees.

One area that made me cringe a bit was hedge funds. He presented a chart that showed hedge funds have done well since 1993 versus stocks and bonds, but I had questions about the data. I'm sure that the data didn't include Long Term Capital Management, the largest hedge fund in the industry that had to be rescued by a Federal Reserve bailout in 1998. In fact, I had to point out that I believe his chart suffered greatly from "survivor bias" in that a lot of hedge funds don't last long.

In any event, I, for one, had to take his recommendation on hedge funds as a potential investment a bit cautiously. I would recommend that investors get professional help and do a considerable amount of research before going down this path. I'm sure Mr. Ross would agree.

He also recommended long/short funds. Again, this is a tricky area. In this sector, he liked the funds managed by Highland Funds. I have to say that I am always skeptical when advisors recommend actively managed funds for the simple reason that they are choosing those that have done well in the recent past. Go back 5 years and their recommendations would have been different. What I'm always asking in the back of my mind is how the funds he recommended 5 years ago have done. I asked if he knew how the long/short fund group had done, and he said the data was available on Morningstar.

For those not familar with the long/short concept, let me offer the following. Let's assume you are a stock picker. I give you a list of 50 stocks and you analyze them. Take the 10 you like the least and short them (i.e., borrow them and sell with the idea of buying back at a lower price). With the proceeds from the sale, purchase the 10 stocks you like best. Clearly, if you have any ability to pick stock, this is a great strategy. In fact, you don't have to put up any money!

When people invest, you actually can buy more of the long position and thereby get leveraged. Sometimes this is promoted as a market neutral strategy - make money no matter which way the market goes.

Suffice it to say that stock pickers aren't as talented as they think, and the market neutral strategy hasn't always been market neutral.

As readers of this blog know, I am not a fan of actively managed funds. In fact, I feel Mr. Ross presented a chart at the beginning of his presentation that should have raised some eyebrows on the whole subject of Wall Street strategists. His chart showed that in 2008 the Dow Jones Industrial Average dropped 38.5% and the average "strategist" predicted a change of +12.5%. Yikes!

At the bottom of the chart is the following quote: "Economic forecasts are like cross-eyed javelin throwers; they don't win many accuracy contests, but they certainly keep the crowd's attention."-Anonymous.

"Making Change" is Making Change in Howard County

The numbers are in from last Saturday's "Passport to  Financial Literacy" event at Howard Community College presented by "Making Change" and Marlena Jareaux. Michelle Glassburn, president of Making Change, gives these details on the numbers:

Nearly 500-people who came to experience the event. There were moms, dads, grandpas, little sisters, and interested folks from all around the community. Some were moms with kids, who couldn't attend, but came to get the information to share back home. There were dads who brought one child and went home to get the other (more reluctant) one to be sure they took part too. It was a large crowd - but full of great families with wonderful stories!
210-teens who completed the interactive financial simulation. These kids ranged from 9 to 19. Some came in excited to learn. Others really would have preferred to stay in bed on a rainy Saturday morning. By the end of the experience though, most agreed that they learned something valuable - and had a little fun too.
55 - community members on site who helped us make the event a success.  We had financial professionals, career experts, educators, real estate professionals and volunteers from teen organizations. We had six high school teachers and eight student volunteers.  It was a wonderful mix of people that worked tirelessly, patiently, and enthusiastically to help the kids along.
15 - sponsors whose financial support made the event possible.  From small local businesses to concerned citizens to large financial institutions - the support for this event (and the financial cause in general) clearly strikes a chord with many.
1 - day we spent working hard, having fun, and doing some good for a lot of kids!

"Making Change" is definitely making change in Howard County.
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Where are we on the roller coaster?

Source: Blue Marble Research

Click to Enlarge Last year this time there were many blogs talking about avoiding the market. This is understandable because we were only one year into coming off a severe bottom. On the chart we were at the right hand side, probably in the "hope" region, though still many had given up on the possibility that we would ever recover what had been lost.

Here, a year later, and the market is its second recovery year and chugging ahead deflecting all sorts of what seems to be negative information. Where are we now on the cycle chart?

I think most people would agree that we are on the left hand side - probably between "optimism" and "excitement" and, who knows, maybe a bit past "excitement".  Those who had a plan and stuck with  it have fully recovered from the downturn.

We are not yet at the point of "Euphoria" although another 15% and we could be there. Believe it or not there are "investors" still who are mainly in cash after the 2008/early 2009 blowout. Another 15% and you can expect them to show up.Why will they show up? Because, for some inexplicable reason, they like to buy at high prices.

You'd probably be surprised how often I am asked if now is the time to get in. Its gotten to the point that, if I could fit a turban and a crystal ball into my brief case, I think I would. My response is that investing isn't about timing the market.

Here is a quote from Benjamin Graham, the father of value investing: “If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

Thinking about where we are on the roller coaster of investing is a fun exercise but the bottom line is that we never really know where we are and how long it will stretch out. As always the DIY investor is best served by sticking to a well thought asset allocation plan and executing that plan with low cost investments.

Winners and Losers in '08

The odor from '08 won't go away. It's an episode that has been brushed aside but the stench is still there - at least for those who don't suffer from ADHD, which admittedly includes much of Wall Street.  Those who were dead wrong about understanding the markets and the unfolding events  and who were in position to take steps  to lessen the pain and punish the wrong doers remain in charge and tell us that the biggest deficit in history is manageable, that they will right the ship, and get us back on course. All of this is eagerly lapped up by our legislators who themselves will go down in history right up at the top of the list of financially inept rulers - a group it's not easy to climb to the top of!

The problem is well put by Michael Lewis in The Big Short as he mulls the end result in talking with former Goldman Sachs CEO John Gutfreund. As a matter of background, Lewis's theory is that the problems began with Goldman and other Wall Street firms going public. As a public company, the risk of their trades was transferred to their shareholders. He argues that the partners of a privately held company would have never allowed the leverage that Goldman and others took on during this period. This, of course, is a moral hazard issue - if you win the bet, you get the winnings; but if you lose, others pay.

The crux of the issue is explained by Lewis (bolding is my emphasis):

"The people on the short side of the subprime mortgage market had gambled with the odds in their favor. The people on the other side - the entire financial system, essentially - had gambled with the odds against them.  Up to this point, the story of the short could not have been simpler.  What's strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich. Steve Eisman and Michael Burry and the young men at Cornwall Capital each made millions of dollars for themselves, of course. Greg Lippmann was paid $47 million in 2007, although $24 million of it was in restricted stock he could not collect unless he hung around Deutsche Bank for a few more years. But all of these people had been right; they been on the winning side of the bet.  Wing Chau's CDO managing business went bust, but, he, too left with tens of millions of dollars - and had the nerve to create a business that would buy up, cheaply, the very same subprime mortgage bonds in which he had lost billions of dollars (my comment: this isn't unusual - we saw it in the S&L crisis - the people who were the problem come in for the clean up) worth of other people's money.  Howie Hubler lost more money than any single trader in the history of Wall Street - and yet he was permitted to keep the tens of millions of dollars he had made. The CEOs of every major Wall Street firm were also on the wrong end of the gample. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government.  They all got rich, too. (p. 256,257 "The Big Short, Michael Lewis).

There is a saying that has to do with a zero sum game that I paraphrase:  if you're at the table and you can't identify the mark, then you are it. In this particular game, the American taxpayer, once again, was it. We see it in the monthly unemployment report, the record foreclosures, and the potential retirees whose plans have been put on hold. Allowing  the moral hazard game to continue sets the stage for a bigger bust down the road.

The Killer Trade

When people think of trading and the stock market, especially these days, they tend, I think, to think of day trading - in and out quickly and going home at night with no outstanding trades. I can't think of anybody off hand that succeeds at this, although I know there must be at least some because there are seminars and places you can go to do this type of trading.

But there is another type of trade that is put on by big players that requires a long term outlook, a special talent for going against accepted thinking, and the patience of a saint. This is the long-term "bet" that the rest of the world is wrong, based typically on a top-down broad view of economies and markets. Soros et. al. are famous for this type of blockbuster billion dollar trades. This is the kind of trade described by Michael Lewis in The Big Short.  Lewis describes a number of individuals who put it all on the line and bet big against the housing market and conventional wisdom. They believed that the rating agencies, the investment bankers, and even Alan Greenspan and friends were all dead wrong. It is a must read for any student of markets.

Michael Burry is one of the traders profiled. After it was  all over, he writes:

"I must say that I have been astonished by how many people now say they saw the subprime meltdown, the commodities boom, and the fading economy coming," Burry wrote, in April 2008, to his remaining investors, "And if they don't always say it in so many words, they do it by appearing on TV or extending interviews to journalists, stridently projecting their own confidence in what will happen next.  And surely, these people would never have the nerve to tell you what's happening next, if they were so horribly wrong on what happened last, right? Yet I simply don't recall too many people agreeing with me back then."
 (p.246, The Big Short, Michael Lewis)

 Two more investors in the book were Jamie Mai and Charlie Ledley, two 30-year-old men, working out of a friend's garage in California in early 2003 with a $110,000 Schwab account. They called themselves Cornwall Capital Management, and Wall Street called them "Cornhole Capital."  They were only able to find one Wall Street firm that would do business with them - you guessed it, Bear Stearns.  They turned the $100,000 into $30 million by forseeing the meltdown of the U.S. housing market and learning how to put on the short trade.

Lewis' description:

"Jamie Mai was tall and strikingly handsome and so, almost by definition, had the art of a man in charge - until he opened his mouth and betrayed his lack of confidence in everything from tomorrow's sunrise to the future of the human race. Jamie had a habit of stopping midsentence and stammmering - "uh, uh, uh" - as if he was somehow unsettled by his own thought,  Charlie Ledley was even worse. He had the pallor of a mortician and the manner of a man bent on putting off, for as long as possible, definite action.  Asked a simple question, he'd stare mutely into space, nodding, and blinking like an actor who has forgotten his lines, so that when he finally opened his mouth the sound that emerged caused you to jolt in your chair. It speaks!". (p. 108, The Big Short, Michael Lewis).

As an academic exercise, suppose you feel very strongly about something that the rest of the world doesn't see. How would you go about putting on a trade to profit from your perceived insight? That was where Jamie and Charlie stood in early 2003 with their $110,000. They had no idea of how to put on a trade to make money from a collapsing housing market. They set out to learn how. Along the way, they kept asking people what was wrong in their thinking. After all, if 99 people out of 100 said that housing prices must continue to rise, how could one person say they were all wrong?

What is Fundamental Indexing?

The DIY investor readers of this blog know the basic argument for low-cost, indexed ETF investing. Basically, professional investors are, pretty much, the market. As Bogle points out, they mathematically are going to achieve, on average, the market return because they are the market. Take out between 1 and 2% management fee, and the average professional investor is going to be behind the market. Many incur, of course, even greater costs because they use mutual funds, which in turn, charge approximately 1.3% on average. For a short period , 1 -3 years, it is possible that many will outperform on an after-fee basis because they are smart people. But as the investment horizon extends, more will fall back because the cost mounts. So, in the end, the evidence shows that 70 to 80% of actively managed, professional money underperforms low-cost indexing. Market timing doesn't work, stock picking doesn't work, and even tactical asset allocation doesn't work.

The low-cost indexed approach focuses on asset allocation, establishing an investment plan and continuing to contribute as markets drop. In fact, falling markets are embraced as opportunities.

There is a potential way to improve on this approach in using "fundamental indexing."  The logic goes like this: the indices we are seeking to match when we index the S&P 500, for example, are market cap weighted. This means that, as companies do better, they have a greater weight in the index. For instance, if Best Buy doubled in price, it would have a greater weight.

We know this can be successfully counter traded in rebalancing a portfolio on a sector basis. For example, when rebalancing, we lighten up on the sector that has done the best (become over-weighted) and booster the underperforming sector. In other words, we sell high and buy low, at the margins. Why not do this with individual companies in the index? 

Fundamental indexing is the brain child of Rob Arnott, a brilliant researcher and founder of Research Affiliates. His insight was to think about weighting stocks not by market cap but some other fundamental measures. For example, what about weighting on the basis of a company's revenues? This approach has outperformed even the market using both past data and real time data.

Rob Arnott explains his approach in this video:

What are Bank Loan Funds?

Many DIY investors today feel their biggest challenge is in the fixed income arena. Yields are historically low and likely to rise and, in the process, push bond prices lower. One part of the fixed income market worth considering, for at least a small portion of funds, is the bank loan funds sector. Bank loan fund offerings carry credit risk, and some allow withdrawals only on a quarterly basis - you have to manage your withdrawals ahead of time. The big positive is that, because they are comprised of floating rate issues, they will adjust upwards in a rising interest rate environment and thereby avoid the interest rate risk problem.

Source: Kiplingers March 2011 p. 29

This table was derived from Kiplinger's "The Biggest and Best Bond Funds and ETFs" article in the March 2011 issue. #  in the "expense ratio" column indicates a sales charge. I would tend to prefer FFRHX off of this list, despite the lower 12-month return, because of the lower expense ratio; and I don't like to pay sales charges. Remember, higher return typically means higher risk.

On the risk front, it is worth noting that in 2008 the fund was down more than 16%. You can see this by going to Morningstar and typing in the symbol and then clicking the "performance" tab. Also, the fund has a redemption fee if redeemed within 60 days, and there is a minimum investment. I would limit investment exposure in this particular asset class to 5% of total investable assets.

Disclosure:  This information is for educational purposes only. Investors should do their own research or consult with an advisor before making investment decisions.

Howard County's 2nd Annual "Passport to Financial Literacy"

This past Saturday I participated in the "Passport to Financial Literacy" event at Howard Community College and have to say that I was very impressed with the turnout and the results. Kids had fun, and I believe learned a lot in the hour or so it took to go through the stations. They learned about getting a job, different salaries, the cost of college, buying a car, renting an apartment, and the trade-offs involved in making financial decisions. Along the way, they learned how to keep their balance in their check register. hocoblogs@@@

I manned the car-buying station and explained the various choices of automobiles, ranging from a used Mercedes at $37,000 to a used Honda Accord at $6,200.  Kids learned the concept of a down payment and how a bigger down payment gave them a smaller monthly payment on the loan. The down payment was duly recorded and subtracted in their personal check register.

Each student also borrowed at a different rate of interest determined by choosing tokens. They learned, by seeing explicit dollar amounts, that the better their credit the lower the rate of interest they paid on their loans.

In many cases, parents helped the kids make decisions on such things as what type of car to buy, how much to put down, etc. It was obvious that these discussions would continue long after the event was concluded as kids and their parents go through the real world and make real financial decisions which, in the end, is a big part of the mission of the project.

From my perspective, I have to say again that I felt it was a huge success, that it was a step up from last year, and that it enforces my belief that improving financial literacy is possible without spending huge amounts of money. Too many times when financial literacy is mentioned, people start talking about training teachers and buying expensive software, etc. and the perceived financial commitment snowballs. In the end, thumbs are twiddled and nothing gets done.

Kudos to Michelle Glassburn at makingCHANGE and Marlena Jareaux, author of the book, 26 Financial Things to Teach Your Parents, for putting on an exceptional event.

 

Rent or Buy?

 Khan Academy ( Bill Gates said the Salman Khan was his "Favorite teacher") YouTube video that does the math on buying a house versus renting:

What I like about this video is it lays out the analysis in a straightforward way and gets us to question conventional thought. Most people believe that buying is always better than renting and don't bother to do the math.

30-Day Personal Challenge

I guess everybody has activities they would like to do that they start and then give up - sort of like New Year's resolutions. For me, it's doing crunches etc. I mean to do them, do them for several days, and then it sort of tails off. There are certain types of exercising I like (for example, basketball) and other types I don't. Crunches fall into the latter category.

Like most men, 30 seconds doing crunches is probably my most profitable use of 30 seconds.

To combat the inevitable crunch inertia, I set up a 30-day personal challenge - 100 crunches/day for 30 days. I started with 4 sets of 25 and alternate between the basic simple crunch for the first set and the bicycle-type leg-pumping type of crunch for the next set. It  takes all of 2 minutes plopping down on the floor to do a set. I throw in a plank from time-to-time and have a set of dumbells near by that I do 1 set of either curls or standing rows, alternating every other day. All of this takes longer to explain than to do. I'm on day 17 of the challenge and it's becoming a habi,t and I'm pleased to report it is making a difference in that most challenging anatomical area for men as they age.

Now I know some of you are thinking that this is piddly and that you have elaborate programs that would put this to shame. I know some of you are thinking that 30 days is not long. This is all somewhat true, but the point is to carry it out. Guess what? Now I'm averaging about 160 crunches/day because it is easy to do 40 in a set. The same is true with the curls as I've gained strength.

 30 Day Financial Literacy Challenge

Let's shift gears, and look at this from a financial literacy perspective. You and I run into people who want to gain financial literacy, but finance and investments is not their cup of tea. Speaking for myself, my idea of a good time is reading Kiplinger from cover to cover or working on portfolios. For some, that's not their idea of a good time. How can the 30-day personal challenge help these people who don't especially enjoy financial topics?

Here is a link titled "Money 101: 40 Financial Lectures to Prepare You for the Real World" produced by Accredited Online Colleges. Many of the lectures are videos. Some are by Salman Khan, who Bill Gates once said was his favorite teacher. Others are TED talks which are presentations from some of the nation's top thinkers and writers. If you like to learn and you haven't seen these two sources, you are in for a real treat.

The 30-day personal challenge is to watch one lesson per day - your pick. The preferred approach would be to move among the various categories so you gain exposure to different areas.

Hopefully, like my crunch challenge, the personal finance/investment odyssey will extend beyond 30 days.

"Big Short" Author "Screwed" by Merrill Broker Turns to Indexing

In this video Michael Lewis talks about his most recent book, The Big Short ( I'm half way through it now), and bond trading. Michael Lewis was a former bond trader.

In the second half of the video, he reveals that he had a bad experience at Merrill Lynch. He said he just didn't want to be bothered with thinking about his own money management. A Merrill Lynch broker, a family connection, invested his assets in auction rate securities and Lehman preferred --both of which imploded. He then went to Schwab and now has most of his money indexed.

He joins a list of people who know Wall Street and have learned the hard way the wisdom of indexing..

 Michael Lewis is one of my favorite writers. I loved Liar's Poker,  The New New Thing, Blindside, Moneyball, and now The Big Short,.

In my investment management/advisory practice I come across people who just "don't want to be bothered."   And I understand. I feel the same way about plumbing. The faucet starts spraying water in all directions, and my inclination is to ignore it until  my wife spots it and then I just want to call a plumber.

The same attitude, as  pointed out by Lewis, can be costly in the money management arena.

Again, the second half of this video is worthwhile.

Hernando De Soto Explains Egypt

Hernando De Soto has an editorial in the Wall Street Journal talking about property rights and the turmoil in Egypt.

Who is Hernando De Soto? He is an economist from Peru who heads up The Institute for Liberty and Democracy. He is an unusual economist in that he actually talks to people and he has talked to a lot of people in the 3rd world. His research has found that the 3rd world has wealth but is unable to use it for economic purposes because they lack property rights and the basic forms of identification that are taken for granted in the West. He is author of the widely acclaimed Mystery of Capital--a must read if one wants a good understanding of how and why most of the world struggles economically.




You can begin to understand Hernando De Soto's views by watching this YouTube:

Where Did You Come From?

If you were in my economics class, this is a question you would be thinking about. People, especially young people, tend to be, IMHO, narrowly focused. They don't often step back and look at the big picture. Thinking about where you came from  is a big picture exercise. I ask them to think about what it would be like if they could meet and talk to their family from, say, 300 years ago.

Students tend to fall into two categories. One is those who have spent much of their lives in Howard County or a similar "wealthy location." Many times they have difficulty understanding how well off they are. They have an advantage in the class because they have spent their lives in a free market capitalistic economy. To them, it is perfectly natural to be able to choose their occupation and to see the free market operate around them. Their disadvantage is that they don't understand that most of the world is not as well off as them.

The second group has lived in or near serious poverty. They've seen people drinking rain water out of the gutter and crammed into one-room apartments. Some have difficulty comprehending the free market, capitalistic economic system.

Thinking about our stories and where we came from brings us a bit closer despite our widely different backgrounds.

I share my story, at least what I know it to be and what I perceive it to be, with the class. I know my grandfather came from Krasnopol, Poland in 1900. Krasnopol is in the northeastern part of Poland near the Russian border. I was told my grandfather, as a young man, had a choice: be drafted into the Russian army or go to that place that was creating a buzz throughout Eastern Europe and much of the world - America. What created this buzz? Why was America attractive compared to Poland in 1900?

But going farther back, I can surmise that there was a family a couple of hundred years ago near or in Krasnopol, with a woman from whom I am directly descended. Historians tell us that this family probably never traveled more than a 150 miles from where they were born. They tell us that the family likely lived in a small windowless hut and was self sufficient - they raised their own food, made their own ragged clothes, and worked hard from the time the sun came up until dark. Frankly, they were probably pig farmers.

Fast forward a few hundred years, and here I am. Highly specialized,  managing investments and teaching economics, I  having most of my wants and needs produced by others (many, actually, in 3rd world countries!)--although I do have a small garden. I buy my clothes, am highly entertained, and have traveled and lived in other countries. Clearly, a poor Polish family of a few hundred years ago  would not be able to relate to the lifestyle I live today.

The purpose of this exercise is to get students to write (the school is a "writing intensive" school) and to begin thinking about economics. And their stories are fascinating. I get students who have lived much different lives than those who have lived in the U.S. all their lives. This semester I have a student from Bosnia and one from Burma. I learned that "akwaaba" means welcome in Ghana. A few years ago I had a student from Ethiopia. In one class, we listed the requirements for economic growth. The last item listed was "political stability." She came up after class and said, "Mr. Wasilewski, political stability should be listed first. Without it, the other requirements don't matter." I, of course, was teaching out of a book. She had lived it. Ever since, "political stability" has been listed first.

This year, I will have the students view Hans Rosling's very creative presentation on the impact of the Industrial Revolution to get another way of viewing economic progress:



Where did you come from?

Were You In the Right Sector in 2010?

A good way to think about this question is to look at "The Callan Periodic Table of Investment Returns."  The table ranks, on an annual basis, returns of nine sectors of the market. For 2010, it shows Growth stocks as having the best return at 29.09% and bonds, as represented by Barclay's Aggregate Index at the bottom, with a return of 6.54%.

A huge take away from the Table is that predicting the best performing sectors is, to put it mildly, very difficult. Consider the last 3 years. In 2008, Emerging International stocks were at the bottom--down 53%; in 2009, they were at the top with a 79% return; and in 2010, fourth from the top at 19.20%. The best approach for most investors is to diversify among the sectors on the basis of a well thought-out plan.

As we know, many don't follow this path. In 2010, in fact, individual investors poured money into bonds at a record rate.

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