Investment Help

If you are seeking investment help, look at the video here on my services. If you are seeking a different approach to managing your assets, you have landed at the right spot. I am a fee-only advisor registered in the State of Maryland, charge less than half the going rate for investment management, and seek to teach individuals how to manage their own assets using low-cost indexed exchange traded funds. Please call or email me if interested in further details. My website is at If you are new to investing, take a look at the "DIY Investor Newbie" posts here by typing "newbie" in the search box above to the left. These take you through the basics of what you need to know in getting started on doing your own investing.

Thursday, June 30, 2011

Squelch the Want, Promote the Should

Source: Disney
Rainstone Financial has an excellent post on steps to creating a financial plan, with an emphasis on the difficulty of sticking to long-term goals. The post is based on an important paper,  "Harnessing Our Inner Angels and Demons:  What We Have Learned About Want/Should Conflicts and How That Knowledge Can Help Us Reduce Short-Sighted Decision Making" by Katherine L. Milkman, Todd Rogers, and Max H. Bazerman, that is well worth reading.

A big finding is that people plan for things they should do over the longer term but, in the present, do what they want; and the two aren't consistent:  the angel-and-devil-on-separate-shoulders-whispering-in-the-ears scene. An example that most people can relate to is gym membership. On average, people pay big bucks for the long-term membership but could save by paying a fee based on actual attendance. What they want to do in the long run (the "should") doesn't match what they actually do in the short run ( the "want").

The "should/want" conflict melds the disciplines of economics and psychology and is worth thinking about as it relates to the whole investing process. Too often, academic disciplines don't take advantage of each other's work which, IMHO, is unfortunate.

Wednesday, June 29, 2011

Charlie Rose talks to Alan Greenspan

Charlie Rose:  Do you think any of the decisions you made as Chairman of the Federal Reserve contributed to the financial crisis?
Alan Greenspan:  The '08 crisis? The answer is no. And I wrote a long part of a paper for the Brookings Institution (on this).  If anybody wants to take the paper and tell me where I am wrong. I will listen.
Source: Bloomberg Businessweek, June 27 - July 3, 2011

This was the last question in the interview. It should have been the first. It could have been followed up with: "does controlling prices distort resource allocation?"  The answer is yes - this is Econ 101 week 1, typically demonstrated with an analysis of the minimum wage (causes unemployment among the unskilled) and rent control (see any major long-term rent controlled area in any major city to see the impact).

The follow-up question would be "is the fed funds rate a price?" The obvious answer that even a professional obfuscator on the order of Alan Greenspan couldn't get around is "yes; it is, in fact, the most important price in the economy."  The fed funds rate affects the price of short-term money across the spectrum and even the price of long-term money. That's one reason why it is a 3-ring circus day on CNBC whenever there is a meeting of the Federal Open Market Committee. Interest rates are the link between now and the future. As such, they directly affect the price of housing, automobiles, and even every day purchases in a credit economy.

What decision did Greenspan (and Bernanke) make that not only contributed, but in fact caused, the '08 crisis? They pushed the fed funds rate to 1% in 2003 at a time when the housing market as well as the automobile markets were strong and unemployment was at a level we would kill for today.  They saw deflation lurking in the bushes and around corners and in the shadows. The imaginary deflation they perceived led them to pour gasoline on a roaring fire that raged out of control.

The problem isn't just with this particular time frame, although it is vital to understand exactly what happened in '03 that led to '08. The problem is policy-making in general. Artificially controlling prices via policy actions, both fiscal and monetary, distorts resource allocation. By sharply lowering the price of short-term money, Greenspan and Bernanke pushed the labor force into becoming carpenters, construction laborers, mortgage bankers, and, yes, even securitizers of toxic debt. These are the real effects of artificially manipulating the price of money.  Today many of these workers are superfluous given the ensuing collapse, and Bernanke and Obama wring their hands and wonder why unemployment stays stubbornly high. They don't get that you can't turn a carpenter or construction worker into a health care professional all that easily. It's not just a matter of manipulating prices.

This whole idea of how policy has real effects is apparently beyond the understanding of Congress and many in the press, so maybe a straightforward analogy would be instructive. Imagine (if any members of Congress are reading this please inform them that this is merely a thought exercise and is in no way a proposal!) if we convened a committee of smart economists (hopefully not too much of an oxymoron) to set the price of gasoline on the basis of their macroeconomic forecast.  If they saw a weakening economy, they would set the price at $2 gallon or lower. This would get consumers to drive more, take vacations, provide greater spending power, etc.  Alternatively, if the economy is overheating, the price of gasoline can be raised.

Now imagine our committee of smart economists forecast an economy so weak that they push the price of gasoline down to $.50/ gallon.

This basically is what the Greenspan/Bernanke Fed did in '08 with the price of money. For gasoline, driving the price to $ .50/gal. would have all kinds of unintended consequences - from leading to used car dealers pushing lemons, to gridlock on major roads increasing, to pollution levels rising, etc.  In the end, the policy makers a la Greenspan/Bernanke would come up with all kinds of convoluted reasoning why driving the price of gasoline to below market levels didn't cause the observed effects.

It is clear that Greenspan will never admit his role in the '08 crisis. This is understandable. Fed Chairman are not known for small egos. Still, it is critically important for Congress et al., if they are at all interested (and this is a legitimate question) in preventing the ongoing cycle of financial crises, to get a full understanding of the causes of '08.

For those interested in an econometric take on the period, an excellent book is

Tuesday, June 28, 2011

DIY Investing Wrap-Up

The last four posts have outlined the 3 steps to DIY investing:
  • Pick an asset allocation model - This can be done inside or outside the brokerage firm you use ( assuming they offer it). The advantage of using the brokerage firm model is that everything is in one place.
  • Choose investments - I prefer low-cost index funds but also allow for some individual stock investing. Either way, it is crucial to have a handle on how well diversified the portfolio is and how the investments fit in the overall allocation.
  • Monitor the portfolio - Keep track of the allocation over time. This will enable you to rebalance when appropriate. The rule you use is up to you. At the outside, I rebalance automatically when the targeted allocation to an asset class is 5% away from target.  Monitoring the portfolio also involves tracking performance relative to a well-defined benchmark.
With this basic framework setup, anyone can  manage their own investments without having to make a major time commitment. A huge amount in fees will be saved over the long run which will accrue to the bottom line, compound, and leave  a much bigger nest egg.  Also, you will get a good feel of the overall investment process. Forget scratching your head and wondering why the heck your advisor is holding on to Fannie Mae or what the CTA fund is he or she has invested you  in. Forget wondering why your advisor isn't returning your calls.

How will you do performance wise? Well, no one can guarantee future results; but numerous studies have demonstrated that an approach that minimizes costs and is well diversified has outperformed approximately 80% of active professional managers over the long term, after accounting for all costs. Furthermore, the evidence shows that it is impossible to select the active managers ahead of time that will "beat the market."

There is, of course, more to the financial picture than managing investments. For the additional information, most individuals should consult with a financial planner. A good plan will run about $2,500 and will look at your insurance needs, financing college, estate planning, and even investments. It will go over location of investments, what you need to know to roll over accounts, and things like titling inherited accounts. Once a bit of complication enters your financial life, a plan is worth getting.

For many people, the best route is to pay for the plan and save on the investment management side. A couple of good books for those who like to read up on retirement planning (not a bad idea before meeting with a planner):

Monday, June 27, 2011

Step Three - Monitoring the Investment Portfolio

On Friday and Saturday we looked at asset allocation models - for the American Association of Individual Investors and Schwab, respectively. Asset allocation models specify targeted percentages of asset classes. They are the framework investors use for investing. The breakdown of the percentage to invest in stocks and bonds is the most important step in the investment process. The model is what we need to be able to stick with as the market goes through its fear and greed cycle. Having the right model is crucial in preventing us from succumbing to the emotional ups and downs of the market.

Yesterday we examined Step Two on how to choose investments. We considered sources of exchange traded funds - iShares and broker commission free funds. We also touched on buying individual securities for the small cap sector.

Today we look at Step Three - monitoring the portfolio. I have seen many investors who have an ad hoc investment process primarily because they don't have a means of monitoring their overall portfolio. They have numerous accounts at multiple brokers that they try to track using spreadsheets. In effect, they are using a paper-and-pencil approach that was appropriate 20 years ago but, IMHO, is cave-era stuff in today's age of technology. What is being done by pencil and paper can more easily and efficiently be done with tools provided by brokers.

To see this, let's extend the example used in the previous posts, mentioned above, whereby we picked a model with the Charles Schwab platform and we've made our investments. Where do we stand now?  This is easily answered by using their "portfolio analysis" tool. Here is a  portfolio relative to its model ("Moderate Conservative") showing the actual percentages relative to targeted percentages: CLICK TO ENLARGE

(Source: Charles Schwab)
The beauty of all of this is that accounts can be combined. If you have, for example, a taxable account, a traditional IRA, and a Roth IRA etc., all can be combined and analyzed as one portfolio relative to the asset allocation model you have chosen. Forget spreadsheets and data entry. Once a trade is entered, it is automatically put in its asset class and the analytics are available.

As shown in this table, the "International Equity" sector is below target. By buying the appropriate international exchange traded fund, it can be brought back on target in a matter of minutes. The seasoned investor will quickly see the utility for rebalancing purposes.

Note that the discrepancies can easily be viewed in dollar amounts, which is useful in quickly calculating the number of shares to buy or sell.

Another important part of monitoring portfolios is performance. Schwab provides performance up to the previous trading day for various time periods along with the performance of the benchmark: CLICK TO ENLARGE

(Source: Charles Schwab)

I believe that at least 80% of retirement money should be indexed using low-cost index funds. For those, however, who want to try to beat the market with up to 20% of their investable assets, the performance analytics are highly useful. All they need do is segregate their "play account." Then they will have the performance of their "play account" relative to whatever model they want to choose (including the "Aggressive" model which is 95% stock). It won't take long to see if you're the next Warren Buffett!

With these three steps--choosing a model, selecting investments, and monitoring a portfolio--those willing to make a small time commitment can become a DIY investor and keep a great portion of their nest egg  instead of handing it over to high-priced advisors. Voluminous, unbiased research shows that at least 75% of professionals underperform the market, after fees, over longer periods of time.

For those interested in additional detail , I recommend:

Other more advanced recommended books can be found at the "RW Investing Bookstore" link on the right.

Disclosure: I am not affiliated with Charles Schwab, although I do recommend to clients and potential clients that they consider switching to Schwab because of their excellent analytics.

Sunday, June 26, 2011

Step Two - Choosing Investments

On Friday, we looked at the American Association of Individual Investors (AAII) asset allocation models. This was followed by yesterday's post on the Schwab asset allocation models.

The process of picking an asset allocation model is the first step in the investment process.

So by "hook or crook", as they say, we've arrived at an asset allocation model. Now is the time to take Step 2 in the process: choosing investments.

The model we've selected lists various asset classes and gives a targeted percentage to invest in each asset class. For example, the Schwab "Moderate" asset allocation model shows 10% targeted to "small cap equity."

(Source: Charles Schwab).

Basically there are three ways to satisfy this specification: buy a small cap stock fund, select individual small cap stocks, or use a combination of the two. A good place to start when selecting a fund is at the iShares site and, in particular, their "core solutions":

(Source: iShares)

As shown, there are 6 funds to choose from, including small cap growth and small cap equity. I would suggest the broadest fund - IWM, which is indexed to the Russell 2000. Another source of funds to consider is with the broker. Competition has led many brokers to offer their own commission-free, low-cost indexed funds. If you are using Schwab, Fidelity, or a similar broker, check out their commission-free offerings.

If you like to pick individual stocks, one place to start is by examining the holdings of a small cap stock exchange traded fund. You can find the top holdings by going to Yahoo! Finance, putting in the fund symbol, and then clicking "holdings" on the left hand side:

(Source: Yahoo! Finance)

The final step in the 3-step process is to monitor your investments. We'll look at how this can be done tomorrow.

Some books that can help the beginning investor in the asset allocation process are:

Saturday, June 25, 2011

Picking an Asset Allocation Model

Yesterday's post discussed Step One - Pick an Asset Allocation Model. Many brokers have similar models to choose from. Here are 2 of the 6 models offered by Schwab:

(Source: Schwab)

Again, the main point is to look at the broad allocation between stocks and bonds. If you are in a position to take on risk because you have the capability, capacity, and need then, other things equal, you would choose a higher stock allocation. As is typical, Schwab has an online questionnaire to help select the appropriate model. There are also many tools online to kelp in this endeavor.

Note that Schwab has 6 asset classes and their targeted percentages.

Keep in mind that the objective is to choose a model that you can pretty much stick to over an up or down cycle. Don't just look at the best year's performance--look hard also at the worst year return. It is highly likely that you will experience such a return sometime within the next 10 years.

Picking the appropriate model is a big step in the DIY investing process. Tomorrow, we go to Step 2 for the DIY investor: selecting specific investments to fit the model.

Friday, June 24, 2011

Step One - Pick an Asset Allocation Model

The very first step in DIY investing is to come up with an asset allocation plan. Today this is pretty straight forward because suggested models are easily accessible online with all of the relevant parameters.

Today we'll look at the American Association of Individual Investors (AAII) models and tomorrow we'll consider Schwab's. These are just two of the many available.

Keep it Simple

The first thing to know is that there is considerable value to keeping the whole asset allocation business simple. It isn't as scientific as is sometimes presented by financial advisors.

The objective is to arrive at a targeted percentage to invest in various asset classes.

The simplicity of the process is illustrated by the three models proposed by AAII:

(Source: American Association of Individual Investors).

As you can see, the AAII models suggest 3 categories: aggressive, moderate, or conservative. The aggressive model has 90% stocks, 10% bonds. The conservative model is split 50/50. Note that there are 7 asset classes.

Here are the historical returns of the 3 models:

(Source: American Association of Individual Investors).

As shown, the longer term performance of the Aggressive model exceeds that of the other two. This illustrates the reward for taking on more risk.

Which model should you choose? To help, AAII provides "Broad Allocation Scenarios." This tells you the relevant points to consider:

(Source: American Association of Individual Investors).

Notice that age, investment horizon, and volatility are listed. Notice that the worst year return is given. These are all important in choosing a model. Still, overall, I'm sure you'll agree that the process is fairly straight forward.

Additional Points

A couple of additional points should be kept in mind. First, the model isn't set in concrete. If the market gets you nervous and you are having trouble sleeping at night, by all means get more conservative. What you don't want to do is continually switch back and forth and, thereby, let your emotions dominate the investment process. Secondly, this is where you have some control. I know from experience that many people have a difficulty working with an advisor simply because they feel they are losing control of their money. In my view, this is where to keep control - make sure the allocation model is well specified and that you are able to track it. Then you can have the advisor do the nitty-gritty work of buying and selling of the securities. Finally, recognize that over time you'll likely get more conservative (i.e. increase the bond exposure)in your allocation.

Tomorrow we'll look at Schwab's models. After we're comfortable with model selection, we'll go to step 2 of choosing investments.

Tuesday, June 21, 2011

An Interview Worth Reading-Susan Brunner

"Dividend Ninja" has an excellent 2-part interview with Canadian investor Susan Brunner, a lady with over 40 years investing experience. Ms. Brunner has structured her portfolio so that she is able to live off the interest and dividends it generates.

Although she takes a different approach than is recommended by DIY Investor, I believe her experiences and insights are valuable for DIYers.

Ms. Brunner's approach goes into the "more than one way to skin a cat" file. She obviously enjoys the challenge of finding and researching individual stocks that conform to her investment style and is not so enamored of exchange traded funds.

Also, make special note that she has developed a means of dealing with down markets - something all DIYers need to learn.

Sunday, June 19, 2011

Trust Preferreds - An Opportunity?

In our era of pathetic yields, investors search high and low for extra yield. Most are well aware that more yield generally means more risk. The biggest challenge is to ensure that the incremental yield compensates for the risk and that overall risk is managed.

A segment of the market many are investing in to obtain incremental yield is trust preferreds.

Trust Preferreds

Trust preferreds are a hybrid between stocks and bonds. They are actually preferred stock issues. Most have a long maturity (typically 30 years and longer), are callable at par, and have the ability to suspend dividends. In fact, the bells and whistles attached to specific issues are part of the challenge in assessing trust preferreds.

The attractive feature for investors is the yield. Today that yield is on the order of 6 or 7% for most issues.

To manage the risk, DIY Investor recommends that most investors confine this sector to 5% of total investable assets. For one thing, banks are big players in the market and, thus, these issues get hit when the banking sector weakens. Other risks are mentioned below.

To start with, consider PFF, a well diversified trust preferred exchange traded fund, indexed to the S&P Trust Preferred Index. It is presently priced to yield 7.19% and pays a dividend at the beginning of each month. The dividend record is available at the iShares site:

(Source: iShares) CLICK TO ENLARGE.

It is also worth keeping an eye on individual holdings. These are available as well at the iShares site:
(Source: iShares) CLICK TO ENLARGE
The holdings list is a good place to start for those interested in investing in individual issues. To analyze specific issues, investors may want to go to .

How Trust Preferreds Trade
First off, those that are issued by banks will trade in line with the perceived strength or weakness of the banking sector. You can see this by going back and examining their price history during the 2008 debacle. Keep in mind that issuance of trust preferreds is a low cost source of bank capital and to the extent that policy makers are interested in keeping the banking sector viable they will tend to bend over backwards to see that dividends are paid etc.

The suspension of dividends is a big issue and, although not something to obsess over, should be watched. The risk of dividend suspension is why the yield is so attractive just as the possible default of a corporate bond issuer is why corporate bond yields exceed Treasury yields (although admittedly this is getting a bit convoluted to say the least.:)

The financial improvement of the banking sector is a positive and generally has helped this sector. With a positive yield curve (1 year T-bill 0.15% and 10 year Treasury note yield 2.94%) banks have excellent opportunities to borrow at low rates and lend at considerably higher rates to earn an attractive spread.

In the event that rates fall, as they have recently, Trust Preferreds can be expected to underperform a bit because of their callability feature. For this reason DIY Investor only buys below par. For the PFF etf mentioned above, $40 is par value. Before the recent drop in rates it had been above par but now is a bit below and thus, more attractive.

At the other end of the spectrum, if rates climb sharply, trust preferreds will extend in maturity and thus likely underperform.

In this regard they are a bit like mortgages that are refinanced when rates drop but tend to last considerably longer when rates rise. For these types of securities the investor does best when yields stay within a range.

DISCLOSURE: This post is intended for educational purposes only and is not a recommendation. I hold PFF in my personal account as well as client accounts. Individuals should do their own research or consult with a professional before investing.

Saturday, June 18, 2011

How Would You Do in the Financial Hot Seat?

Tiger 21 is an elite investment club comprised of members with a net worth of at least $10 million, described by Paul Sullivan in "Financial Advice Gleaned From a Day in the Hot Seat", New York Times. They engage in a process referred to as "the portfolio defense," which in actuality is a wide-ranging frank appraisal of life style, finances, etc. Michael Sonnenfeldt, the founder, refers to the "hot seat" process as "carefrontation."

New York Times
columnist Paul Sullivan sat in the hot seat and was told his family needed to rethink the spending issue and that they fell short of life insurance and disability insurance needs. The advice also pointed out the need for more liquidity that should be achieved by selling a Florida condominium.

A couple of thoughts occurred to me as I read the article. First off, it is difficult, many times, to be frank with potential clients. If only they could see their financial advisor pore over the account statements and initially get a picture of their financial positioning. Sometimes, the advisor just wants to scream. All of this typically gets watered down when we meet with the client. The brutal frankness of the Tiger 21 group was refreshing in this regard.

Secondly, it has always occurred to me that financial planners have different points of interest, expertise, and emphasis. Some are tax experts, some are great at budgeting, and others are expert at investments. The fact of the matter is that if you go to 3 different planners/investment managers, you'll many times come away with 3 very different approaches. The idea of bringing different consultants to the table at the same time to provide thoughts and advice seemed to me to be very valuable, in that they can play off of each other's thoughts and advice.

It would be valuable, I would think, if a similar group was available for average Americans to go in front of to receive financial advice - a group where not one firm's philosophy or approach was presented but, in fact, the viewpoints of several professionals. Too often, advice is tailored to products the advisor is selling either directly or indirectly.

Friday, June 17, 2011

Greek Default?

Pundits argue that a Greek default is inevitable. Even former Fed Chairman Alan Greenspan chipped in with his two cents last night, and he is one who should know fairly well what it takes to bring an economy to its knees.

Imagine taking a car loan out for $35,000 and and then losing your job. Your car is worth $25,000, the loan is outstanding, and you have no savings. Your peers tell you to cut back on job search expenses and are tired of lending you money. In fact, you owe your friends so much that they are vulnerable if you don't pay them back. This is the situation that Greece and the European Union is in.

Some say that loans would be a waste of time and money - instead just give Greece the money to solve its problems. But, then again, Greece isn't the only country in difficulty and the question is: where does it end. Unfortunately, these situations seem to have an underlying commonality - those who play by the rules and live within their means are expected to bail out and sacrifice to pay for those who live beyond their means.

Plenty of advice has been offered by the U.S. which, ironically, is traveling down the same road. Its municipalities (not to even mention the Federal Government) have over promised and many find themselves in dire straits.

Excellent background on all of this is offered by an interactive site at the New York Times which provides a neat picture of the European Union and the status of each country. The second slide at the site shows that both Italy and Greece have debt-to-GDP ratios exceeding 100%, but 7 of the other 27 members of the Union have debt loads exceeding 75%.

For investors, risk gets measured by interest rate spreads. In the European Union there are 6 countries, as shown on the 7th slide, whose debt pays more than 2% compared to Germany, the benchmark country. Greece's debt has a spread of 15%. The next riskiest is Ireland at 8.6%!

The big concern in all of this is, of course, the much-feared contagion effect. As Greece move closer to default, a major repricing of risk is taking place. The end result is anybody's guess, but chances are it won't be pretty.

Thursday, June 16, 2011

An Important Question for Investors


Greek default, contagion effects, imploding euro, fragile European Union, rioting in the streets, weakening economies, and "flight to quality." The unending tsunami of negative market news has investors on edge, and fear has grabbed the baton from greed. Still on investors' minds is the 2008/early 2009 market debacle. Some are expressing a "here we go again" attitude.

With this backdrop, Chuck Jaffe of MarketWatch has 5 questions investors should ask.

To me, the most important is his third question about asset allocation and age and thinking long term. As he points out, there are many younger investors with low stock allocations who could be looking at the present situation where stocks have moved lower as an opportunity to buy great companies at bargain prices. He points out that they may be putting too much emphasis on recent market movements in their decision to stay away from equities. The guiding principle is that, in the accumulation stage, you want low prices.

At the other end of the spectrum are those in retirement who still have portfolios that are more appropriate for their working years. Those in the nest egg paydown stage should keep in mind that, when markets fall, it takes time for them to recover - sort of like when they engage in too vigorous physical activity.

Thinking through Jaffe's questions can help investors position themselves correctly, weather the down turn, and avoid potentially costly mistakes.

Tuesday, June 14, 2011

1 Out of 10 Passed This Quiz

In this post you'll learn two things. The myth of the "Little Dutch Boy" who plugged the dyke on his way to school isn't a real Dutch myth, and the American public is financially illiterate.

The story of the Little Dutch Boy was made up by American writer Mary Mapes Dodge. It is very popular around the world but is not, as widely believed, well-known in the Netherlands.

Speaking of plugging the dike brings to mind the effort to raise financial literacy in the U.S. According to financial literacy expert Anna Maria Lusardi, only 10% of people who took the following quiz got all 5 questions right:

1) Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
a. More than $102
b. Exactly $102
c. Less than $102
d. Do not know
e. Refuse to answer

2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
a. More than today
b. Exactly the same
c. Less than today

d. Do not know
e. Refuse to answer

3) If interest rates rise, what will typically happen to bond prices?
a. They will rise
b. They will fall
c. They will stay the same
d. There is no relationship between bond prices and the interest rates
e. Do not know
f. Refuse to answer

4) Please tell me whether this statement is true or false. A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less.
a. True

b. False
c. Do not know
d. Refuse to answer

5) Please tell me whether this statement is true or false. Buying a single company’s stock usually provides a safer return than a stock mutual fund.
a. True
b. False
c. Do not know
d. Refuse to answer

(Answers: a, c, b, a, b)

Monday, June 13, 2011

Why Am I Not Surprised?

(Source: Disney)

One of my favorite characters in animated films is Iago, the parrot in Disney's Aladdin. His sarcastic response of "Why am I not surprised?" to various revelations always got a chuckle out of me.

This was brought to mind by Jason Zweig's "Here's One Way to Beat the Market." In it, he points out the practice of some money managers of comparing their performance, including dividends, with the S&P 500, excluding dividends.

Stephen Horan of the CFA Institute points out, "There are two main ways to earn returns: price appreciation and income. If you systematically exclude one of them from your benchmark, while knowing that your strategy includes them, you're making a fundamentally unfair comparison."

One of the culprits named is Jim Cramer. His trading tip service from, Action Alerts PLUS, proclaimed it was "CRUSHING the S&P 500." Actually it was - without dividends included for the S&P 500. With an apples-to-apples comparison, the story was much different. The advantage was less than 1%/year and that was before trading costs, the annual subscription cost, and tax consequences.

One can only wonder how widespread the practice is.

So the plot is a bit different, but the ending is the same.

Why am I not surprised?

Saturday, June 11, 2011

How to Tie Your Shoes

The small advantages in life (found at Canadian Personal Finance Blog):

Friday, June 10, 2011

401k Fees

Many Americans have been ripped off by the outrageous hidden fees embedded in many 401k plans:

This is about to change in 2012, as 401k fees will be required to be disclosed. Notice the names of the 401k providers in the video. Why wouldn't they return the calls of Bloomberg News?

Hopefully, Americans will get proactive on this important issue and understand the impact of fees on their retirement.

Thursday, June 9, 2011

How to Measure Investment Risk?

Considerable mathematical analysis of investments and portfolio construction rests on the acceptance of standard deviation as a measure of investment risk. Once accepted, mean-variance analysis takes center stage to generate optimal portfolios and eventually arrive at an elegant presentation of the "Efficient Frontier" and a focus on the asset allocation issue.

But for many, the acceptance of standard deviation as a proxy for risk is not straight forward. They argue that risk is about losing money, about downturns in the market, and about running out of money - not about returns that are significantly higher and lower than average.

William Bernstein emphasizes the different ways of looking at risk in The Intelligent Asset Allocator.
Incidently, this is one of the first books (along with Random Walk Down Wall Street by Malkiel) that I recommend to people who indicate a serious interest in the subject of investing.

The very foundations of investment theory, of course, rests on the crucial trade-off between risk and return. In this light, consider the following table (1964 study by Paul Miller) presented on page 116 of The Intelligent Asset Allocator:
CLICK TO ENLARGE The Table shows interesting results comparing value stocks versus growth stocks. It finds that value stocks significantly outperform (at +12.18% versus +1.50%) over the almost 3-decades period examined. This result is typically attributed to the additional risk inherent in the low p/e stocks, and this higher risk in evidenced by the much higher standard deviation of the low p/e stocks (21.1% versus 15.7%).

The interesting point of the table, however, is that it also shows additional measures of risk; and these measures are not as cooperative to the theory. The number of losing years and the number of years where the loss exceeds 10% are both less for the "riskier" low p/e stocks! With these measures, a higher return was achieved with less risk.

This points to one of the values of utilizing a total market index, in that it automatically gets an investor to hold stocks that are deemed unattractive, i.e. have low p/e ratios.

Wednesday, June 8, 2011

Technology Helps Kids Save

You and I learned to save with a "piggy bank." That's old school. Technology is on the scene. If it helps kids learn the value of deferring gratification, I say let's raise our glasses and give a toast. Notice the new look compartmentalized piggy bank:

Tuesday, June 7, 2011

Are You an Investor or are you a Gambler?

(Source: American Songwriter)

This is a 10-question quiz produced by John Mowen, a social psychologist and emeritus regents professor in the Spears School of Business at Oklahoma State University.

IMHO, some of the questions are excellent - some not so much so. For example, an emotional, superstitious, thrill seeker should stay away from stocks and hire a professional to manage their money.

On the other hand, puts and calls can be used to "gamble" in the market; but they also can be used to hedge a portfolio.

Also, I would rephrase the question on whether a stock has been held "...for less than a day." A few years ago, I read the morning Washington Post and noticed a company I had never heard of was testifying in front of Congress on bomb detection devices which it produced for airports. This was a subject that the country was hyped up about and I figured this would, in effect, be free publicity for the company. I looked it up, thought the company had good financials, and was reasonably priced. I bought 1,000 shares and went off to my morning dentist appointment. On my return I saw the stock had moved from around $4, where I picked it up, to around $7. I sold. This is rare for me but, hey, if the market gives a gift I will take it. Even investors don't look a gift horse in the mouth (what a great expression!).

All-in-all the quiz is valuable in that it will get investors thinking about an important question. I answered the quiz as if I was a gambler to see the resulting advice/commentary. It said that gambling with a small portion of assets wouldn't be overly harmful. I would be careful here - gambling can be like smoking. Some people can smoke a couple of cigarettes a month - others can't. Smoke a couple and the next thing you know you're at a pack a day!

Monday, June 6, 2011

Annuity Puzzle

Bemoaning the demise of the defined benefit plan is a popular past-time. People used to have it easy when it came to retirement planning. Get a gold watch, and live off of Social Security and the company pension. Live within your means as you had your whole life.

Today we have to figure out the income we need, how to structure an investment portfolio, and whether we can sleep at night with the inevitable ups and downs of the market. We have to do involved, careful calculations to determine the safe withdrawal rate.

But there is a simple way to effectively convert at least a portion of a portfolio into a guaranteed income stream: buy a single premium immediate pay annuity (SPIA). That is, give an insurance company a lump sum and they will pay you for as long as you live. The amount you are promised is greater than you can generate yourself by buying bonds because you are paid on the basis of group mortality rates. Essentially you win if you live longer than average, and the insurance company wins if you don't. This is a bit of a simplification. Actually you gain from the peace of mind a guaranteed income can provide.

The question is why retirees don't take greater advantage of these types of annuities. Why don't they convert the uncertainty of an investment portfolio into a guaranteed income stream upon retirement? In fact, this is called "The Annuity Puzzle" as explained by Richard H. Thaler. One reason, Thaler points out, is that those retirees who die younger lose out. But on the other hand, live too long and draw down assets too aggressively and retirees will become a burden to their children.

There are a couple of other reasons why SPIAs aren't used as often as one would think. First, fee-only financial planner/investment managers (even though they are fiduciaries) won't recommend them because they reduce the bread and butter of their operations - assets under management. Secondly, interest rates are at historically low levels and a primary determinant of the payout is the level of interest rates.

Any retired person who met with a financial planner 5 years ago, when 10-year Treasury yields were above 5%, has a legitimate question if they weren't asked to consider SPIAs for a portion of their assets.

SPIAs also are somewhat complicated in that you need to diversify among insurance companies, buy inflation protection, and carefully read the fine print. You have to know what you want going in because insurance companies are notorious for selling products consumers don't need.

As always, it could pay to get a planner to look over any offerings to provide objective advice before purchasing.

Sunday, June 5, 2011

401k Fees

(Source: Bloomberg)

Ron Lieber of the New York Times has an excellent piece on 401k fees and the upcoming requirement that costs be revealed to plan participants. For those who require a bit of titillation on this subject, Mr. Lieber's article has a murder in it. Not exactly a Robert B. Parker novel but still...

He points out an example of the impact of fees on retirement balances (i.e., the "nest egg") put out by the Labor Department.

The Labor Department looks at a person who will retire in 35 years with a balance today of $25,000. Assume a 7% average annualized return and that plan expenses amount to 0.5%/year. At the end of 35 years, the plan participant will have a nest egg of $227,000. If, instead, fees are 1.5%, the nest egg will end up at $163,000--a 28% reduction!

BrightScope has been compiling 401k plan data enabling participants to assess how their plans compare to similar plans. At the BrightScope website, participants can easily get this information at no cost by just typing in their company name.

BrightScope finds that larger plans pay considerably less and that plans with less than $10 million take an average 1.90% out of the bottom line. As an aside - smaller plans, with less than 100 employees, can significantly reduce these fees by offering a SIMPLE IRA to their employees.

In 2012, fund providers will be required to reveal the detail on these fees - a huge step in the right direction.

Friday, June 3, 2011

Why Macroeconomic Policy Doesn't Work

This morning we got an anemic employment report, as expected, with a slight pickup in the unemployment rate. This comes after, in effect, throwing the kitchen sink (in terms of fiscal and monetary policy) at the economy.

On the fiscal policy front, the Bush tax cuts have been extended and a payroll tax cut has been enacted along with a massive stimulus program. On the monetary policy front, short-term rates have been driven to zero and two massive programs of monetizing the debt, known as QE1 and QE2, have been carried out. The end result of these policies have been a record deficit of $1.4 trillion, a national debt equal to the GDP production of a year, a bloated Federal Reserve balance sheet, a sinking dollar, and a protracted fight over increasing the debt limit.

And still, the economy limps along. How can this be? Why isn't macroeconomic policy working?

The answer, IMHO, goes deep into misinterpreting British economist Keynes, the inevitable arrogance that power brings, and a basic misunderstanding of economics.

Let's start with the basic misunderstanding of economics. Controlling prices distorts resource allocation. This is Econ 101. Instructors put up the well-known minimum wage graph and show the unemployment that results. Instructors put up the graph of rent control and explain that, over time, rent control destroys cities.

Then they go teach their macroeconomic class and somehow fail to grasp the long run consequences of the Federal Reserve controlling arguably the most important price in the economy - the price of short-term money.

Take a quick look at the past decade during which, in 2003, the federal funds target rate under former Fed Chairman Greenspan was driven to 1%, during a strong housing market. This poured gasoline on a fire. The housing market took off on a moonshot. The labor force poured into the home building market, the mortgage creation industry, and, yes, the financial services industry of securitizing exotic mortgages. In other words, controlling prices and jerking them around have real consequences.

The Fed then turned around a year later and systematically, as shown on the graph ( CLICK TO ENLARGE), pushed short-term rates sharply higher. This caused the housing market, which was speeding ahead at 110 miles an hour, to slam head-first into a wall. In real terms. all of sudden the home builders, real estate agents, etc., were superfluous.

These are people, many of whom would have finished college with a degree in another area, satisfying a legitimate economic need - not one artificially created by a Fed controlling the price of short-term money. And today people need to be retrained in a world that has become considerably more complicated. Putting people back to work takes a long time in today's technologically driven world.

The story for fiscal policy is just as depressing. John Maynard Keynes, in The General Theory of Employment Interest and Money (arguably the most influential book of the 20th century), outlined a specific strategy for countering a severe economic downturn. It justified deficit spending during such periods. Unfortunately, politicians have used the justification to spend irresponsibly during all phases of the business cycle. This brought us into the present situation already with a massive debt and a large deficit. In other words, there were holes in the roof before it started to rain.

Even the man in the street knows that fiscal policy programs have to be paid for. Politicians have ignored this basic principle and now are willing to bring the U.S. to the brink of default, surely causing Alexander Hamilton to spin in his grave.

The programs lead to spending, but they don't retrain people for the types of jobs that are now available.

Where does the arrogance come in? It clearly is a power trip for those who have taken it upon themselves to set the price of short-term money. Former Chairman Greenspan was at the point of changing the rate practically every time he forecasted a change in the overall economy. It is reminiscent of former Soviet Union economic planners.

And many have argued that the Fed Chairman is the second most powerful person in the world. In fact, this is probably true - unfortunately, this power is hurting millions of American families.

Thursday, June 2, 2011

What is the Efficient Frontier?

Source: FolioTechnologies


As a graduate student in economics, one of my fields was econometrics, which basically merges statistics and economics. Most econometricians spend considerable time doing regression analyses and mathematical economics. In fact, one great joke in graduate school was wearing a t-shirt that said "we are regressing - we are econometricians."

Understanding econometrics was important to me later when confronted by large-scale models of the economy. It provided the background to understand that most large-scale models of the macroeconomy - to put it politely - were pure bogus. Put in the data and solve the equations and the results were nonsense. Adjustments had to be made (called "fudge factors") and the output considerably massaged until anything resembling reasonable results emerged.

And this type of outcome, to a degree, is fairly common in a lot of areas. For example, not understanding the concept of the "efficient frontier" can lead to people being overly impressed with the concept. In the hands of a fast talker, with an expensive suit, it can be a great selling device to extract what I, and many others, view as excessive management fees.

After all, the efficient frontier indicates that considerable knowledge is necessary to structure a portfolio appropriately. You need to know expected returns and correlations to obtain the highest return portfolio. You need to carry out a (gasp!) mean - variance optimization.

Most people sitting through 20 minutes of this, with all the charts and correlation matrices etc., will gladly hand over their life savings and pay 1 to 2% to have it managed.

The problem is this: aside from being a broad conceptual guideline, the efficient frontier has not produced exceptional portfolios. William Bernstein, author of the widely regarded The Intelligent Asset Allocator, puts it like this:

"In other words, next year's efficient frontier will be nowhere near last year's." Anybody who tells you that their portfolio recommendations are "on the efficient frontier" also talks to Elvis and frolics with the Easter Bunny. (p.57)

In Bernstein's assessment, if someone tries to sell a portfolio based on the efficient frontier, run in the opposite direction. I agree.

So what is the problem? How is the efficient frontier generated?

How the Efficient Frontier is Generated

The efficient frontier shows the portfolios that have had the highest returns for a given amount of risk. Risk is measured by standard deviation. Returns are measured by averaging returns over a specified past period.

So, for example, we take 5 asset classes and calculate their respective average annualized returns over the past 10 years, say. Then we calculate the standard deviation of each asset classes returns over the same period.

We then combine the asset classes randomly and calculate portfolio returns and portfolio standard deviations. For example, one portfolio might be 20% of each asset class (small cap U.S. stocks, large cap U.S. stocks, 5-year U.S. Treasury note, small cap international stocks...). Do this randomization for 1,000 portfolios and plot the resulting outcomes on a graph with standard deviation on the horizontal axis and average annualized return on the vertical axis.

As you study the graph, you come to see that, for every given standard deviation, i.e. set risk, there is a portfolio that produced the highest return. In fact, the exercise produces a border, as shown above, that specifies the portfolio with the highest return for any given level of risk.

The Problem

What's the problem? The market doesn't cooperate. Past performance is not indicative of future performance. Asset classes become more risky and less risky over time. Top performing sectors, for example, Japanese stocks in the 1980s, later go through decades of subpar performance.

One really important result does emerge from the analysis. That is that even the most risk averse investor should have a small portion of assets in riskier assets. As shown on the diagram, expected return can be increased and risk reduced at the left hand side of the curve.

Wednesday, June 1, 2011

Are Stocks Really Less Risky in the Long Run?

Here is a WealthTrack interview with Lubos Pastor, University of Chicago Professor. This interview was sent to me by a client, and I saw it again this morning at "The Calculating Investor" blog.

Pastor's work challenges the accepted wisdom that stocks are less risky over the long-term. In the interview, he also offers many other interesting viewpoints. At the end of the interview, he touts index funds and low expenses. Well worth watching for the serious investor.