Plan Your Bond Allocation

The key (IMHO) to successful investing is to have a well-thought-out plan.  Sometimes the bull will be on the rampage; other times the bear will amble in.  There will be trying times.  On occasion they will be so trying they trigger a "flight or fight" response.  This is when investors without a plan ( I have to say that the Dennis Hopper commercial will forever pop into my head when I talk about investment plans) tend to do exactly the wrong thing.  They throw overboard their investment program just when they should stay the course.  If you have ever participated in a bubble or seriously liquidated after a sharp drop in the market, you know exactly what I'm talking about.

With these considerations in mind, it is worth thinking about your plan for fixed income assets.  I find it ironic that this portion of assets, which is usually considered the "safest," tends to cause the most angst for a lot of investors.  Simply, most investors don't feel comfortable with bonds.  They struggle with the question of whether they should buy individual bonds or funds.  They worry about the impact of rates going higher, and they just feel outright cheated when they contemplate the thought that they could have a negative return when they in effect are lending money to corporations or the government, etc.

The bottom line is that many investors are stymied with this part of their portfolio and, as a result, hold an excess in cash (at practically zero interest) or buy CDs which lock them in at low rates.  Or they take up the laborious task of constructing a laddered portfolio of individual bonds.

I'm not in a position in this post to alleviate all of these concerns with fixed income assets, but I do think it adds perspective to look at a basic ETF bond allocation for the past few years to see one possibility in terms of allocating bond assets.

Returns from iShares

 CLICK TO ENLARGE  The table shows returns for 50% of the assets in the overall market represented by the low-cost Barclay's Aggregate Index (AGG) and the remaining 50% allocated among 5 other sectors.  The other sectors include a short corporate ETF (CSJ), a mortgage ETF (MBB), a high-yield ETF (HYG), an inflation-indexed ETF (TIP), and an emerging countries ETF (EMB).

The right hand column shows the return on the portfolio with the weightings.  In other words, with 50% allocated to the overall market in 2011 and 10% to the other sectors, the return would have been approximately 7.1%.

In normal times (with the 10-year Treasury yield at 5% -6% ), it would be sufficient to just hold the whole position, or at least most of it, in the AGG.  But these aren't normal times - short-term yields are at historically low levels, and most observers see the possibility of a sharp rise in rates sometime in the next 5 years.

In any event, the results show that this simple construction provided exceptional returns - well in excess of what was available in cash and in CDs.  In fact, retirees who achieved similar returns surely were well satisfied.

As always, the allocation for a specific individual will be somewhat different.  The purpose here is just to bring out the actual performance results of a particular allocation that can easily be implemented.  You can play with the returns in the table and add those of other sectors to calculate performance of allocations you would be comfortable with.

Disclosure:  This information is for educational purposes only.  I hold, and my clients hold, some of the ETFs mentioned.  Individuals should do their own research or consult a professional to make investment decisions.

Howard County Maryland Financial Literacy Event

http://jamaryland.org/

This Saturday, January 28, from 10 am - 2 pm, Junior Achievement

http://www.makingchangecenter.org/about_us.html

and makingCHANGE will put on a financial literacy event at Howard Community College.  It is free and targets youth between the ages of 12 and 18.  Young people and their parents go through various stations where they make financial decisions such as buying a car, buying groceries, paying rent, etc.  I have participated in this event the past 2 years and have enjoyed watching young people and their parents talk over financial decisions.  At the end of the day, the young people have a much better appreciation of what their parents and guardians are engaged in when they are holding a job and running a household.  Most importantly, they are exposed to the kinds of financial decisions they will be making as they become older.

The attendance is always high, and a big crowd is expected this year!

What Cancer and Investing Have in Common - from Andrew Hallam

Some really good advice from someone who has "been there and done that."  Andrew Hallam tells you all you need to know to beat the pros at their own game in the investing world.  His ability to get at the essence of the best approach to investing is why I continually recommend Millionaire Teacher:  The Nine Rules of Wealth You Should Have Learned in School.  Get it for your kids, get it for yourself.  Read it!

Reversing the Bond ETF Trade (Follow-Up)

Source: Capital Pixel

On December 12, I wrote a piece to show how professional bond managers approach the fixed income market.  I find, when I talk to potential clients, that the fixed income portion of their portfolio tends to confuse them - especially in today's environment of low interest rates.  Potential clients have an asset allocation which tells them that 40% or 50% should go to fixed income, but they don't know what to do next.  Many of them are making big interest rate call bets - whether they know it or not - and it is costing them.  Instead, this follow-up looks at how portfolio shifts can be made on the basis of yields in different sectors.  If you get the idea, you can use it also to make profitable adjustments on the basis of the yield curve.

The December 12 piece adapts to ETFs how I approached the fixed income markets as a managing director of ASB Capital in the 1990s. This is just trading on the basis of spreads among different sectors.  The objective was to outperform the Barclay's Aggregate Index (actually at the time it was the Lehman Aggregate Index).  The Barclay's Aggregate Index is the bond market equivalent to the S&P 500 Index in the stock market.  Just as most active managers fail to beat the S&P 500 in the stock market, bond mangers tend to underperform their index.

Why is this?  Basically because interest rates look like they are easy to predict when, in fact, they are notoriously difficult.  The bond market, like the stock market, is pretty efficient.  Yields reflect all available information.  Where they go from here depends on news, which, by definition, is unknown until it happens.

The present situation is a case in point.  Most professional bond managers last year this time were convinced that rates were headed higher.  In fact, rates dropped.  Big time bond managers, like Bill Gross of PIMCO, took it on the chin by positioning their portfolios in low-duration fixed income assets.

So, instead of trying to predict the level of rates, many bond managers seek to add value by identifying opportunities where yield spreads basically are "out-of-whack" in various sectors.  The underlying principle is that investors, over time, view risk differently.  Sometimes investors are fearful and will avoid more risky assets (you can read "junk bonds" here) and, at other times, they embrace risky assets.  Their views drive the yield spreads.  Over time, the relationship has an average spread; and this whole idea rests on the notion of what is called "reversion to the mean."  A good way to think of this is in terms of a car veering to the right and then to the left.  Eventually (hopefully) it gets back to the road.

Like many concepts in finance, this idea can be a bit fuzzy in the absence of an example.  So here is the example with a revisit to the December 12 starting point.

On December 12, we looked at HYG, a high-yield bond ETF, priced at $87.26, and IEF, a  7-10 year Treasury ETF, priced at $104.26.  The yield on HYG was 7.97% and the yield on IEF was 2.69%. Selling IEF and buying HYG picked up +5.28% in yield (7.97% - 2.69%).  If you tracked this relationship over time, you would find that this is considerably greater than the average pickup in yield, reflecting investor fear of risk at the time.  Traders would say that risk is cheap in the bond market.

So where does it stand today?  Suppose we had done the trade.  Suppose we had sold some of our IEF position and bought HYG.  Today HYG is priced at $89.58 for a yield of 7.69% and IEF is priced at $104.45 for a yield of 2.56%.  Thus, HYG is up in price by more than 2 points, whereas IEF is up only marginally.  Thus, this was a great trade!  Note that the yields have fallen.  This, of course, is the basic bond relationship.  Prices rise when yields fall and vice versa!

Hopefully this isn't too confusing.  Fundamentally you want to start by trading 2 apples for 3 oranges and then get to the point where you can trade 2 oranges back for 2 apples--at which point you've made a profit of 1 orange!

Today the bond manager approach would contemplate reversing the trade - i.e., selling the HYG position and buying back the IEF.  The overriding factor would be the relationship over a sufficiently long-term period.  This, in turn, is easily accomplished by going to a site such as Yahoo! Finance and analyzing past data.

Disclosure:  The information here is for educational purposes.  I hold HYG and IEF in client accounts.

The Highest-Yielding Stocks in the Dow Jones Industrial Average

Source: Capital Pixel

The Dow Jones Industrial Average (DJIA) is the most quoted stock average among followers of the markets.  "Where's the Dow?" is the question people ask when they want to know how the market is doing.  The average is comprised of 30 stocks and has been used since 1896 to track the market.

Most market participants are somewhat familiar with the DJIA, but how many can name the highest-yielding stocks in the average?  And what is the yield on the highest yielders?  This is especially interesting today because, for the first time in decades, the dividend yield on market indices is above the yield on Treasury bonds--which has led many to rethink the whole bond allocation question.

In any event, these questions are readily with a neat table I found on The Dynamic Dividend blog listed in the "Weekly Reading" list on the Dividend Pig's blog.

Here's the first part of the table:

Source: The Dynamic Dividend

CLICK TABLE TO ENLARGE,/b> As you look at the yields, recall that the yield on the 10-year Treasury note is slightly below 2%! Furthermore, the payout on the Treasury is fixed for the next 10 years; whereas many dividend payers increase their payout.  In fact, one of the really good reasons to follow the dividend bloggers (as I call them) is that they do great analysis to identify those companies likely to increase dividends.

Be sure to visit Dynamic Dividend to see the compete list and follow its updating, especially if you are looking for ideas among dividend payers.

Former Major League All-Star Sues Advisor (Follow-Up)

Yesterday's post on Denny Neagle's financial woes generated some interesting comments on the need for personal responsibility in the personal finance world.  One point personal finance bloggers understand well is that nobody knows your financial situation better than you do.  Up to a certain point, everybody should know basic investment and financial planning concepts - they need to take some responsibility for financial decisions.  This definitely includes the cost of different approaches to managing assets.

Having said this, I believe I am probably not as hard-nosed as some of the commentators.  I understand exactly what they are saying when they argue that it was Neagle's fault in being taken advantage of; but, still, I try to put myself in some of these athlete's shoes.  At the time they sign professional contracts, they are young and naive.  Supposedly they have agents working on their behalf = there may be a whole back story here that hasn't come out.  Where was the agent who undoubtedly received big bucks as his representative?  I believe that major league baseball (maybe the union) has a list of approved agents and possibly approved asset/wealth managers.

Somewhere along the line, I believe, these young people signing these massive contracts should be exposed to the various views on how to invest.  At the table should be a rep explaining that many very astute market participants (including Warren Buffett, John Bogle, and Burton Malkiel) believe a large portion of assets would be best invested in low-cost, well-diversified, index funds structured with an allocation that reflects risk tolerance.  In the case of athletes, the asset allocation would take into account that there is no need to take an inordinate amount of risk given the size of the contracts.

Then, if the athlete, on the advice of his agent, goes the limited partnership/alternative investments/ high priced hedge fund route,  I join others, wish him/her the best, and have no sympathy if he/she ends up like Neagle.

To me, all of this points to the need for strong financial literacy programs in high school.  The athletes who blow enormous wealth get the publicity.  The average person ripped off by the financial services industry goes unnoticed.

Former Major League All-Star Sues Advisor

Denny Neagle, 2-time all star pitcher, and his ex - wife are suing their financial advisor who put them in hedge funds, private equity funds, and alternative investments where they have experienced large losses and today cannot access their funds.  As Larry Swedroe points out in  "Invest Smarter Than an MLB Star" posted at Arianna Capital's site, "Working with an advisor you can trust is important but shouldn't replace your own education on financial matters."

Neagle signed for $51 million in 2000.  Swedroe lists a number of other big time athletes who blew their fortunes because they were financially illiterate.  Here's the rub, at least to me - it is not difficult to gain financial knowledge.  It's a hell of a lot easier than walking to the mound in Yankee Stadium in front of 57,000 screaming maniacs with the bases loaded in the bottom of the ninth.

For example, these athletes could have saved millions by spending a weekend reading Millionaire Teacher (available at $11.49 used on Amazon) or a similar book.  The advisor  wouldn't tell them this. Quite the opposite - he would emphasize how difficult investment management is and, in the process, build up his importance and rationale for a huge fee.

Most people reading these books are learning how to build their wealth.  These books are also valuable, however, for those trying to understand how to manage risk and preserve wealth--which is a big part of the game.  It's a mistake to automatically assume that, because you are well off and have a high-priced adviser, you don't need this information.

My question, though, has to be on what the advisor's motives were.  Advisors know that accounts of this size don't come along often and are literally a gold mine.  There never is a need to try to hit the ball in the upper deck (to use a baseball pun), but especially with an account of this size.  Was the advisor that greedy?  I'm not naive - I know about Madoff et al. - but it does puzzle me!

Swedroe also points out that financial illiteracy is not just a problem for high-priced athletes.  A large percentage of adults admit to pretty much being clueless when it comes to their investments.

The sad part, IMHO, is that it isn't difficult to remedy a large part of the problem.  But until steps are taken, stories like the Neagles' will, unfortunately, be all too common.

Stock Picks Guaranteed to Beat the Market

Zacks, the well known stock research company, is offering 10 stock picks that "...promises market-beating gains no matter the direction the market heads."

Not only that, but with a $299 subscription, you get a number of free reports!

Some of you might question what happens if (alas!) the picks don't outperform.  No problem:  "...if the service doesn't BEAT the market, we'll credit the cost of your annual subscription to another Zacks product."

Maybe I'm being a bit nit picky here, but isn't this a bit like a used car dealer offering another lemon at a discount after the first one broke down?

The Fed Transcripts - The Emperor Has No Clothes

"How could I have been so mistaken as to have trusted the experts?"- John F. Kennedy (after the Bay of Pigs fiasco)

More people today are learning what many have known for some time:  the Federal Reserve policymakers are a collection of arrogant clueless elitists.  If it weren't for the fact that their actions cause widespread misery, I would label them as a joke. The latest transcripts will be eye-opening for many.  After all, to the mainstream press, Federal Reserve Governors are viewed as rock stars. And Bernanke is lead singer.
 
Well, the 2006 transcripts have seen the light of day and they are, to put it mildly, embarrassing and highly revealing.  How will people keep from laughing when Congress next asks Bernanke for his view of the economy?  And what about Geithner?  Here's what he had to say before the housing debacle:

"We believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest,"

Our present Treasury Secretary obviously had no clue on the relationship between the financial markets and the mortgage market!  Recall that the Fed meets daily, with so-called primary dealers, to discuss markets and that the mandate of the Fed is to ensure a well functioning banking system.

Bernanke got a laugh when he responded,

"Anything to report on co-op prices in Manhattan?"

To keep the joke running, Geithner responded,

"If you see hiring at the New York Fed go up substantially in the market, that will be a good leading indicator of housing prices reverting somewhat," 

Yellen, president of the San Francisco Fed, chipped in on Greenspan handing the Chairmanship to Bernanke with,

"And if I might torture a simile, I would say, Mr. Chairman, that the situation you're handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot,"

The evidence is clear that the Fed had no clue how housing affected the economy, how Wall Street and the housing market were interconnected, and the appropriate policy to enact given the storm about to unfold.  This will be difficult for many to accept because, for many, it is hard to see that the emperor has no clothes.

But it goes beyond this and has more important implications.  The problem is that the Fed caused the crisis, and this is what the foxes inspecting the henhouse are missing in their rock star idolation.  The evidence clearly shows that, if the Fed had not lowered short-term interest rates to 1% in 2003, thereby throwing gasoline on the fire, the ensuing runup in housing prices and subsequent crash would have never occurred.  Forget rating agencies, the slime bags at Countrywide, Fannie Mae, and Freddie Mac, and even the government mandate to issue mortgages to the lower income sector.  They are all scapegoats.  Greed would never have had the chance to go hog wild if the Fed hadn't set the stage by pushing rates to historically unprecedented levels.

To fully grasp this, think about what would happen if the government set the price of gasoline at $1/gallon.  Clearly car dealers would go bonkers.  They would set financing terms at ridiculously low levels, offer car loans extended to 10 years, push gas guzzlers, etc.  The next thing we would see is that grid lock has worsened, pollution has worsened, accident rates have gone up ,etc.  Who would be the culprit here?

What should be done going forward? S hould we let the arrogant blind continue to steer the ship?  There is one more point that is worth making that bears crucially on how the Fed operates.  Almost from day 1 in an introductory economics course, students are taught that controlling prices distorts resources allocation.  Typically this is presented in terms of the minimum wage and rent control.  In both instances, there are well-documented impacts via unemployment and public housing that is boarded up and abandoned in the inner city.  Guess what?  The Fed controls the most important price in the economy by setting the federal funds rate.  This is the price of short-term money.  This determines the rate on adjustable rate mortgages.  This affects the rate on 30-year mortgages and other long term rates.  It even affects the price of goods in international markets via the impact on the value of the dollar.

To put this differently - the Fed snubs its nose at what is taught in introductory economics and, in its arrogance, believes it knows more than the marketplace on what these important prices should be.  The transcripts that have been released (and those that will be forth coming) are clear evidence the emperor has no clothes.

What should it do?  IMHO, the Fed would be better off controlling M1 (up 18% over the 12 months ended in December!) and letting the market determine the appropriate rate of interest, i.e. the price of money.  This, of course, is what former Fed Chairman Volcker did to defeat inflation and put the economy on a long-term growth path in the early 1980s.

An ETF for the Long-Term Contrarian Investor

A number of years ago I attended a presentation at the Touchdown Club in Washington, D.C. given by a successful contrarian money manager.  In fact, his investment record was so outstanding the audience hung on every word.  After all, he was giving the secrets to beating the market using a sort of "Dogs of the Dow" on steroids approach.  As I scanned the audience, I noticed slight nods as he described his methodology.  You could almost feel the "hey, I can do this too" idea forming in the audience's brain - the same sort of thing you see when Buffett or Munger speak.

Then came the point where the golden goose pulled out a small piece of paper from his suit jacket and announced he wanted to go over some of his recent buys.  The audience edged further on its seat and pens came out of pockets, poised over napkins - ready to scarf up the golden eggs.

His first choice was General Public Utilities (GPU).  The color drained from the audience's face and pens stopped mid air.  Should they write it down or what?  As the money manager listed the metrics, including a price in the single digits that was down sharply, a low P/E ratio and all the rest, the audience reflected on the fact that GPU owned Three Mile Island - a utility in Pennsylvania that had just experienced a nuclear meltdown.

The point here is simple. Contrarian investing can be very successful, but it is not easy.  Everybody can't do it.  In fact, few have the stomach for it.  The evolution of the human brain learned quickly that walking out of the cave with a mastodon out front wasn't a good idea.

I have to admit that I walked away from the presentation chuckling.  In case you're wondering, the money manager ended up hitting a huge homerun (actually into the upper deck) with GPU.

These thoughts came to mind recently as I read a recent recommendation to buy ETFs that track European stocks by Mitch Tuchman of MarketRiders.  An example is VGK from Vanguard.  It returned -11.63 in 2011 as U.S. stocks were marginally positive.

Most investors are well aware of Europe's problems and the economic uncertainty surrounding the region.  Those who follow events closely are treated to what amounts to a daily 3-ring circus as leaders play a cat-and-mouse game, constantly meeting and presenting vague baby steps towards solving their problems.  Investors nervously eye bond auction yields as an indicator to the market's assessment of events.

In contrast, the contrarian thinks about the market years ahead.  The contrarian sees beaten down prices and a market several years in the future when today's problems will be long past.  The contrarian sees today's problems as an investment opportunity.

I agree that investors with a contrarian bent will likely profit from taking a long-term position in a well-diversified, low-cost ETF comprised of European companies.  In terms of the portfolio's overall positioning in global markets, I would limit exposure to 20%; but this would depend on individual risk preference.  As a point of reference for future tracking, VGK closed at $41.96 yesterday and SPY (S&P 500 ETF) at $129.51.

Disclosure:  The above is for educational purposes.  Individuals should do their own research or consult a professional before making investment decisions.

Target Date Fund Performance

Target date funds are, IMHO, a pretty good product for people who need to invest but don't want to invest the time to learn the basics of investing or get professional investment advice.  This article, "Target Funds Miss Their Marks - Again," by Sarah Morgan in the Wall Street Journal may cause people some pause in this regard.  Ms. Morgan reports that funds within 4 years of target date returned -0.4% for 2011, which was not good.  Most conservative funds that I have looked at returned between 2% and 4%. In her article, Ms. Morgan points out that the S&P 500 returned roughly 2% and the Barclay's Aggregate Index (the bond market) returned approximately 8%.  Thus, a 50/50 weighting would have achieved in the neighborhood of 5%.

The culprits in 2011 were basically international and small cap.  See Biz of Life for a comprehensive listing of ETF sector returns.

Also, if you were accumulating, as you probably were since you were 4 years from target, i.e. retirement, you took advantage of the strong 4th quarter in your dollar cost averaging.  In other words, systematically contributing to your 401(k) or 403(b) during the down phase in 2011 really paid off. Bottom line:  your return probably exceeded the -0.4% return on the target date fund.

Screening for Dividend Payers

Source: Capital Pixel

I'm an indexer.  I agree with Warren Buffet that most investors and individuals will do best by indexing the broad stock market.

Still, I belong to the "there is more than one way to skin a cat club" and, if an individual is willing to take the risk, has the time, expertise, emotional fortitude, and resources, he or she may outperform the market with a well-thought out/disciplined approach. Again, I would index at least 80% of the portfolio using it as an anchor for retirement assets and seek to outperform with the rest.

With this caveat in place, let's examine a popular theme and one way to approach it for investors.  The theme centers on the idea that a tsunami wave of retirees is just now beginning, and these retirees will move their assets to produce greater income, i.e. into the dividend sector.

McVey's Approach

Henry H. McVey heads up the asset allocation process at Kohlberg Kravis Roberts and incorporates this idea in what he calls his "Brave New World" thesis as described by Shirley Lazo in "Dynamic Duo."  He screens stocks according to the following criteria:  dividend yield between 2% and 5%, earnings growth between 5% and 15%, 12-month trailing return on equity rising, P/E below sector average, increasing payout ratio or a increasing dividends paid.  Thus, McVey is seeking dividend payers that should be able to increase dividends and offer value on a price basis.

Backtesting this approach achieved an average annualized  return of 11.2% versus 4.9% on the S&P 500 over the period 1/2004 - 11/2011.

The following table shows 10 of the stocks that made the screen (see the above article link for a more complete list):

Source 1/2/2012 Barron's

Click to Enlarge

I believe the approach has possibilities.  I would emphasize, however, that the results reported above were "backtested"!  Backtesting, as we know, can find the best coin flipper out of 30 people by running trials.  It doesn't help us, though, moving into the future.

A second caveat is that I am sensitive to the fact that I've seen companies implode over the past several years that I could never imagine having the problems they brought upon themselves.  These include GE, Ford, Fannie Mae, Merrill Lynch, and many others.  Some would, undoubtedly, have made this list in the past!  As a result, the backtested results suffer as well from what is called selection bias.

The bottom line is - proceed with caution.  This is an approach that has possibilities but has to be watched closely, IMHO!

Disclosure:  Post is for educational purposes only.  Investors need to do their own research before investing.  I hold some of the stocks mentioned above.

Bela Fleck in Africa

Source: Argot Pictures

Here is a belated Xmas gift to my readers- "Throw Down Your Heart" on Hulu.  Bela Fleck takes the banjo back to its origins.

If you like music, play it loud and enjoy.  Worth watching all the way through.  Hulu even throws in some commercials to give you time to replenish your wine.

Thanks to David, my music guru and son,  for giving me the link!

Dividend ETFs

Source: Capital Pixel

Anyone casually following investment markets knows that dividend stocks are the investment du jour.  After all, with the yield on the 10-year U.S. Treasury bouncing around 2%, big cap, well-known names yielding greater than 2% with a history of increasing dividends look very attractive.  Furthermore, the blogosphere has numerous bloggers who provide excellent dividend stock analyses - check out The Dividend Ninja (also see list at the end of his current post).  Thus, today investors don't have to do a lot of work digging up interesting investment candidates.


Another way to go is with dividend ETFs.  As always, they provide excellent diversification, are low fee (compared to mutual funds) and, in some instances, are commission free.

To get a take on what's available, I looked at the Schwab comparison chart shown here:

Source: Schwab

CLICK IMAGE TO ENLARGE As shown, there are 6 dividend ETFs listed including the new Schwab dividend ETF.  The following table shows the recent performance of 4 of these ETFs and their expense ratios:

CLICK TO ENLARGE  The table shows that the 12-month returns were quite attractive compared to the S&P 500 and that they varied fairly widely.  The thing to know is that there is wide variation in risk among dividend-paying stocks (and ETFs) - this is a really good reason to read dividend bloggers on an ongoing basis because they analyze this risk differential.  In particular, DVY is riskier than the other funds - its screening process will allow issues that have a higher payout ratio, lower capitalization, etc. and thus accounts for its higher performance.

I purchased some of DVY for clients who require an income stream.  Here is a history of a purchase:

Source: Schwab

CLICK TO ENLARGE  Note that it pays quarterly and that, given the dividend payments and today's price of $53.82, it is easy to calculate total return.

Disclosure:  Although the data in this post was obtained from reliable sources, it cannot be guaranteed.  I and my clients hold ETFs mentioned in this post.  This post is for educational purposes only.  Readers should consult the disclosures of the data sources as well.

How Did the Stock Pickers Do in 2011?

Source: Capital Pixel

My last post presented results on the BlackRock standard portfolio which is basically 65% stocks/35% bonds and cash equivalents.  It returned approximately 1.6% for the year.  To me, it's a good benchmark against which to measure investment performance.  After all, it is simple and very easy to exectute.  It takes very little time, is well diversified and low cost, and it is an approach recommended by many very knowledgeable long-time students of the market, including Malkiel, Ellis, Bogle, Hallam, and Bernstein.  Even Warren Buffett says that most investors, individuals as well as professionals, should use index funds.

As it happens, I am conversing with a potential client whose inherited IRA dropped 11% last year.  His broker (not a registered investment advisor) invested the IRA in funds that have a front load of 5% and expense ratios averaging 1.22%.

I gave him a cursory overview of why that was horrendous performance and why he should be in low-cost index funds.  He ran it past his broker who responded that he was in funds that had a superior 10-year record versus the S&P 500.

This brings us to a point of where there is a bit of odor in the room ,but we can't tell where it is coming from.  Down 11% but in great funds!  The potential client is a professional fireman and, unfortunately, not a professional odor spotter.  A long-term track record would seem to be obviously important, especially when presented with multi-colored graphs on glossy paper.  What isn't intuitive is that, if one has 30 funds ,it is rather easy to pick out the best 5 which probably outperformed the market. It  is sort of like having 30 people flip a coin 10 times and finding the 4 or 5 that got the most "heads."

The question most people would not know to ask is "what does the evidence show on consistency of performance."  And the evidence is clear - there is no consistency.  The best coin flippers tend not to outperform in the next round, as is the case with active fund managers.  In fact, the lack of consistency is also revealed as top investors fall to the bottom.  In recent years, we've seen Miller, Paulson, Berkowitz, and even Bill Gross humbled by Mr. Market.  Unfortunately, what people don't see are the investors whose retirement assets are put in jeopardy because they over invested with the "best and the brightest."

A related question arises as to the stock-picking ability of analysts.  Sometimes I run into people who claim " Yeah but I've got a guy...".  Here is an interesting piece written by Brett Arends, "Should you buy Wall Street's top stocks for 2012?", where he examined the top picks by analysts (paid the big bucks) out of the S&P 500.  They were - 3.5% in 2011.  The S&P 500 index was flat for the year and earned the dividend.

Imagine paying 5% up front and then 1.2% management fee to these analysts.  Sure, some will come out on top but, over the long run, the odds decreased.  You'd be better off putting your money with the top coin flippers in my opinion.

Disclosure:  Investors should do their own research and consult a professional before making investment decisions.  The information here is for educational purposes only.

2011 Performance - BlackRock Standard Diversified Portfolio

HAPPY NEW YEAR EVERYONE!!!  I had a wonderful New Year's in Ocean City, Maryland with my wife.  The weather was absolutely great.  We stayed at a fun place where the rocking chairs are comfortable and the house wine is perfect.

The view of the surfers from the deck was excellent.  I could appreciate them because I spent a day surfing in Galveston, Texas in the Gulf of Mexico years ago.  I only made it on the board once or twice, but it was fun!

Our stay in Ocean City was great place to welcome the New Year.  I hope everyone's New Year was as enjoyable.

Now, back to the real world.

A useful research piece on market performance  is the "Asset Class Returns: A 20-Year Snapshot" table produced by BlackRock and discussed at Cedar Financial Advisors.  It shows annual asset class returns, color-coded, ranked so that investors can easily see the best-performing and worst-performing sectors for each year over the 20-year period.

Similar so-called periodic tables of investment returns are produced by others, but the BlackRock table is unique in its inclusion of a diversified portfolio.  The diversified portfolio is an excellent benchmark for many DIY investors to consider, in my opinion.  It is comprised of low-cost, index exchange traded funds.  The 20-year annualized return of the portfolio was 8.89% for the 20-year period ended 12/31/2010.

2011
 
2011 was undoubtedly a challenging year for many investors.  Those swayed by their emotions had plenty of opportunities to make portfolio-busting shifts.  Most of those who had a plan and stuck with it probably came out OK.  The table shows performance achieved by various sectors as represented by low-cost ETFs and the weights of the various sectors.  Europe was the obvious drag on the portfolio as evidenced by the -12.17% return on EFA.  Once again, the overall bond market was the knight in shining armor, with AGG returning +7.58%.  Overall the portfolio returned +1.61% for the year. Although below the rate of inflation, many investors would have been satisfied with this return.  For those with the funds parked in money funds or even short-term certificates of deposit, this performance would have been acceptable.

Source:  Data from Morningstar/BlackRock Diversified Portfolio

CLICK IMAGE TO ENLARGE  As a point of reference, the S&P 500 returned 2.11% for the year.




Accumulators vs. Decumulators

My clients include both accumulators and decumulators.  Accumulators seek to take advantage of dollar-cost averaging.  They are contributing a fixed amount to their 401ks, etc.  Down markets benefit them as they buy at lower prices.  Decumulators, on the other hand, can unambiguously get hurt in a down market if they don't have a plan to draw down their nest egg.  Dollar-cost averaging can seriously harm the retiree drawing funds from their nest egg.

2011 was fairly neutral for both as long as no rash portfolio shifts were made.  The following shows the S&P 500 as represented by the SPY ETF:

Source: Yahoo/Finance

 CLICK TO ENLARGE As shown in the chart, U.S. stocks tried to trend upwards over the first half of the year and then hit a serious air pocket from which it again trended upwards.  The second half of the year was extremely volatile, as headlines out of Europe dominated even economic data showing the U.S. economy was showing some life.  In this market, dollar-cost averaging resulted in paying more for shares early in the year compared to where the market ended up.  Still, if investors held in and no shifts were made, shares were accumulated over the later half at attractive prices as the market rebounded strongly in the 3rd quarter.  In other words, dollar-cost averaging paid off over the later 6 months.

By the same token, the decumulator, drawing what is essentially a paycheck off of the nest egg, who had sufficient funds to ride out the downturn participated in the upturn.  In contrast, the decumulator who sold equities to fund cash needs during the first half of the year partially missed out on the rebound.  To stave off this negative impact, those living off their nest egg should have, at a minimum, 9 months in cash and a portfolio yield  dividends and interest) of at least 2.4% to replenish required payments.

Disclosure:  This information is intended for educational purposes.  Individuals should do their own research or consult a professional before making investment decisions.