Try to Avoid "Tilt"

Poker players know about "tilt". Taken from pinball terminology it refers to losing good poker technique following a "bad beat". Every poker player has been bluffed by a pair of tens when they held a pair of kings. This can play havoc with one's emotions and can lead to stupid (this is the appropriate word) bets. The cure is to get up, walk around, take some deep breaths and know that emotionally your brain wants to fight back.

Well, the same thing happens in the investment world. To be clear I'm not a fan of most investors buying individual stocks but if you want to do it that's ok. I suggest that individuals mostly use low cost index funds and with 10% at most invest in individual stocks.

Still, if you invest in individual stocks so be it.

So, suppose you bought Boeing on 2/22/19 at $424.05. By  2/28 it is at $439.95 and you are high fiving yourself and (big mistake) bragging to your friends. After all you've got a layup with a reasonable p/e, a wide moat (worldwide duopoly with Airbus), and a nice dividend. Your brain is congratulating you on being a genius.

Then the 737 mess. By 3/12 the stock is at $375.41.  Your brain now has all kinds of scenarios including you living under a bridge. You might look at your other stocks and imagine worst case scenarios. This is TILT !!!!!!!!!!!!!!!!!

Knowing that this happens is in itself valuable and can help you calm down. Think back to 2008 and know that many investors blew out their entire portfolios and never got back in. You've read the horror stories.

The other thing that I suggest is to limit yourself to 5% of total assets in any particular stock and 10% to any industry. This is where the value of diversification really comes into play.

Updated BlackRock "Asset Class Returns"

Source: Capital Pixel

The
updated "BlackRock Asset Class Returns"

two-page chart is out.  This is my favorite investment chart.  It shows 20 years of investment returns for 7 different, color-coded, asset classes including fixed income, international stocks, cash, and various stock sectors.  Most importantly, it shows a diversified portfolio comprised essentially of 65% stock and 36% fixed income and cash.  The actual composition is given in the very last footnote of page 1.

It cuts through all the nonsense and shows vividly that diversification reduces volatility.  It also shows that chasing the hottest sector can be damaging.  Consider, for example, 1998 and 1999 where Large Cap Growth was at the top of the column.  If you would have run into someone claiming that they were hitting the ball in the upper deck with their Large Cap Growth Fund, you would probably have been sorely disappointed in 2000, 2001, 2002 as this sector was near, or at, the very bottom.

Page 2 shows line graphs of each sector over the 20 years.  As you look at this roller coaster experience, recall 9/11, the dot.com bust, and last (but not least) the 2008 housing crisis.  While you are at it, you can recall the ongoing geopolitical problems as well as the periods where it looked like even the U.S. government was on the verge of breaking down.  As you recall all the reasons for grabbing your wallet and seeking a fast exit, grab your smart phone, your laptop, and even your iPad.  You didn't have these 20 years ago.  For that matter, you couldn't get a genome sequencing.

The bottom line is that the constant preaching of stalwarts like Warren Buffett, John Bogle, and Burton Malkiel to ignore the noise and get an asset allocation paid off.  As shown on page 2, the diversified portfolio turned $100,000 into $531,326.  The average investor over this period did considerably worse - especially those trying to pick stocks and/or time the market.  This includes the parade of pontificators on CNBC, mutual fund managers and even the largest college endowments in the country.

I like to track the BlackRock diversified portfolio and

estimated the 2014 return

on New Year's Day at 7.96%.  As shown on the chart, it was 8.1%--so I was off by only.14%.

Portfolio Performance - 2013

Source: Capital Pixel

HAPPY NEW YEAR!

Regular readers know my favorite investment chart is the BlackRock 20-year sector performance.  It details the relative ranking of asset classes on an annual basis as well as the performance of an easily replicated low-cost diversified portfolio comprised of 65% stocks, 35% bonds.  The diversified portfolio returned 12.2% over the 12 months ended 12/31/2012 and 7.9% on an average annualized basis over the past 20 years.

The diversified portfolio allocation is an appropriate benchmark for individuals in their 40s and even early 50s, depending on risk tolerance.  The table contains sufficient data, however, to construct a benchmark and analyze performance for any specific allocation; and, in fact, the allocation can be changed over time--as it should be as the individual ages.

Voluminous data from unbiased academic studies have been presented over the years showing that a diversified portfolio of low-cost funds outperforms upwards of 70% of active managers over the longer term after all costs are taken into account.  These studies cover various time periods, countries, asset classes, and investment methodologies.  In line with this data, the low-cost diversified approach warrants consideration as a benchmark for investors.  It shouldn't go unnoticed that the approach economizes on the investor's time.

Here is an update showing the approximate performance of the diversified portfolio for  2013:

Weight	Fund	Return (%) 12 months ended 12/31/2013	Expense Ratio
35	AGG  (Barclay’s Aggregate Bond Index)	-2.15	.08
10	EFA (EAFE Index)	22.62	.34
10	IWM (Russell 2000)	38.85	.24
22.5	IWF (Russell 1000 Growth)	33.19	.20
22.5	IWD (Russell 3000)	32.18	.21

 
The overall return of the diversified portfolio was approximately +20.09% for the year.

Disclosure:  This post is intended for educational purposes only.  Past performance is not indicative of future performance.  Individuals should consult a professional or do their own research before making investment decisions.

My Favorite Investment Chart

Regular readers of D-I-Y Investor know that the BlackRock "Asset Class Returns" chart is my favorite investment chart.  In fact, one of the first things I do with new clients is go over its main points.  IMHO, time spent with this chart can be more valuable than spending days reading investment books or even blogs.  It gets you past all the salesy mumbo jumbo of the investment world and looks at what actually happened.  It is a great place, IMHO, to start to think about what can happen and how to prepare.

Source: BlackRock

 CLICK IMAGE TO ENLARGE

If I was teaching a course (actually I will be doing an online book discussion of Millionaire Teacher - click "Seminars" tab, above) on investing, an assignment would be to write out a description of the table, explain 3 really important points you get from the table, etc.

The table shows 20 years of color-coded sector returns, ranked with the top performer at the top (with actual returns in each box) and the worst performer at the bottom.  So, for example, if you are interested in how Large Cap Growth stocks performed, just eyeball the purple box.  You'll note that Large Cap Growth was the top performer in 5 of the 20 years.  Notice, as well, that it was the worst performer among the 7 sectors shown for 3 of the 20 years.

The 3-year period 2000-2002 is instructive.  You'll notice that Large Cap Growth ended up at or near to the bottom.  This follows 2 years at the top.  This was a period where many investors got hammered as they piled into Large Cap Growth!

Diversified Portfolio

The real strength of the chart goes beyond the annual relative ranking of sectors.  It shows also a diversified portfolio - the white box.  The diversified portfolio - spelled out in the footnote - is basically 65% stocks and 35% fixed income (bonds).  Important point:  the diversified portfolio is never the top performer but also is only in the bottom three 2 times over the 20-year period!  This is an excellent visual depiction of how diversification reduces volatility!

Next, look at the "Fixed Income" box.  This is the bond market ( not CDs or cash or money markets - but the bond market as represented by the Barclay's Aggregate Index).  As you look at it, notice the "Large Cap Core" box.  This is essentially the S&P 500, the most widely used benchmark in the stock market.  You'll see that "Fixed Income" tends to do well when "Large Cap Core" does poorly. The most stark example is 2008, with "Large Cap Core" down -37% and "Fixed Income" up +5.2%!

Notice other years where "Large Cap Core" had  negative returns.  Eventually the light bulb will go off, and you'll see that "Fixed Income" has been an excellent hedge against drops in the stock market. Understanding the role of "Fixed Income" is very important in portfolio management. 

Another use is to approximate returns for different asset allocations.  For example, if you're wondering how an aggressive allocation of 90% "Sm Cap" and 10% "Fixed Income" did over the period, just calculate the annual returns and multiply.  For 1983, for example, the return was .9*18.9 + .1*9.8 =  17.99.  Multiply the annual returns (use 1.1799) and take the 1/20th root and you've got the average annualized return.

A final use of the chart is to start off with a sum of money, $500,000, say, and draw down 4% at the beginning of the year, using, for example, the diversified portfolio.  In this way, you can get a feel for how a retiree in the decumulation stage would have fared over this period.

The bottom line is that the chart can be used for many purposes, only limited by your imagination.  As a caveat, keep in mind that it is one 20-year period.  The next 20 years will be different.  Still, in some ways, it very likely will be similar.

The next post will look at the second page of the chart.

Teach Your Kids About Stocks - Dividend Yields

In honor of Financial Literacy Month, we continue today with an exercise parents can do with their kids to learn about stocks.

Bonds pay interest and stocks pay dividends. Bond interest is usually a fixed percentage of the principal amount and has to be paid as scheduled - otherwise a company may be forced into bankruptcy. Dividends on the other hand may or may not be paid and they can be increased or reduced.

If we put on the hat of the CFO (Chief Financial Officer) of a company we realize that he or she has a choice on what to do with profits earned by the company. They can be reinvested in the company  or they can be paid out in dividends to the owners, that is the stockholders.

As investors we are interested in the dividend yield of stocks for a few different reasons. Dividends act as a cushion when the stock market drops and are therefore stocks that pay dividends are generally considered less risky than non-dividend paying stocks. Dividends provide an income stream to investors who are in retirement and living off of their investments. Many dividend stocks today actually yield more than bonds and have the likelihood of increasing their dividend over time. Simply stated, investors would rather have a stock like Johnson & Johnson (ticker = JNJ) that pays a dividend of $2.28/share to yield 3.50% than the 10 year U.S. Treasury note that yields 2%.

Not only does JNJ have the higher yield but it also has the potential to raise the dividend payout significantly over the next 10 years, Keep in mind, however, that JNJ is riskier than the U.S. Treasury note - what we are describing here is the basic risk/return trade-off.

After reading the posts of the last 2 days it should be easy for you to find the dividend and yield of any stock. Just go to the Yahoo Finance site described in those posts and you'll find, for example, the yield discussed here:

Source: Yahoo

CLICK IMAGE TO ENLARGE  Take the dividend (2.28) and divide by price(64.20) to check the yield calculation. If you follow the procedure to get historical prices that we looked at on Monday you can actually see the quarterly dividend payouts. It would be a good exercise for a young person to write-up the process of getting the actual dividend payouts for a stock (Coca Cola say) for the last 2 years.

Investors, as you might imagine, keep track of which stocks have increased their dividend over a long period of time. These are called "dividend aristocrats".

Today dividend investors are fortunate because there are a number of good blogs devoted to dividend investing. They do excellent research and give the dividend investor good ideas. Here are a couple I follow:

• Dividend Ninja
• The Dividend Pig
• Dividend Growth Investor

To me one of the best ways for the DIY investor to participate is with dividend exchange traded funds. They provide you with immediate diversification. Some I use are DVY, SDY, and SCH . Using the method described yesterday  find the 5 top holdings in these funds and compare their yields.

Disclosure: I own some of the stocks and exchange traded funds mentioned in this post. It is intended for educational purposes only. Individuals should do their own research or consult a professional before making investment transactions.

Diversify and Start Young

If it hasn't been written yet, I'm sure someday someone will write the book on the fundamental principles of life.  Granted, we have a lot to argue about and to debate, but there are principles that I believe most people would agree are beyond dispute.  The investment section of the book would undoubtedly include the principles of diversification and the value of time in the investment process.

To illustrate, I once again go to the BlackRock "Asset Returns Table" - this time to page 2.   Here is shown the 20-year results of investing $100,000 in various asset classes and in a diversified portfolio.  Before looking at the results, reflect on the thought that most workers will spend 40 years in the work force.

Diversification and Time

Source: BlackRock

CLICK IMAGE TO ENLARGE   The diversified portfolio is "composed of 35% of the Barclays Capital US Aggregate Bond Index, 10% of the MSCI EAFE Index, 10% of the Russell 2000 Index, 22.5% of the Russell 1000 Growth Index and 22.5% of the Russell 1000 Value Index."  This  portfolio is easily replicated with low-cost, index funds.  The results are straightforward.  At the realized return of 7.7%, money quadruples in 20 years (rule of 72).  Over 40 years, it increases by 16 times!  You can run all kinds of savings scenarios; but the bottom line is that workers who have a regular contribution to their 401k, starting at least by their mid-20s, will have a good-sized nest egg when they reach their 60s, by investing in a diversified portfolio.

Hopefully it goes without saying that they need to ask about company matches and take a look at the choices available in the company 401k plan.  ALL 401K PLANS ARE NOT CREATED EQUAL!

Understanding these basic principles and applying them will result in a person typically being fairly wealthy by the time they reach their 60s.  These are fundamental principles.

But what will keep emotions in check?  Look closely at the chart, and you can easily identify the 2008 period where portfolios fell off a cliff.  Look closely at the black line which traces the diversified portfolio and observe the important fact that it is a lot less volatile than the asset classes it is compared against.  This, of course, is the second half of the investment equation:  risk.  By being less volatile, the diversified portfolio is one where most investors can sleep at night.

Those of a mathematical bent will note that the table shows standard deviation, the basic risk measure for investments.  The take-away is that the diversified portfolio return is reasonably close to the annualized return on the best-performing asset classes over the period at a significantly lower standard deviation - i.e. volatility.

So the fundamental principles are as straightforward as they possibly could be: s ave young, save often, and diversify.  You don't need to pick stocks; you don't need to do a lot of analysis; you don't even need to take a course in investments.

BlackRock 2010 Periodic Table of Returns

Source: Cedar Advisors/BlackRock

The 2010 BlackRock Table of Returns through the end of 2010 covers 9 asset classes/indices on an annual basis from 1991 through the end of 2010. It covers the S&P 500, growth stocks, value stocks, foreign stocks, and bonds. For the first time, it puts in a commodity index and includes the 3-month Treasury bill.

For each year, the categories are ranked with the top-performing sector at the top and the remaining sectors in descending order, all on a color-coded basis.

As in the past, a diversified portfolio--basically 65% stocks/35% fixed income--is also shown. It is notable that the diversified portfolio is never among the poorest 3 performers and only in the top 3 once. Thus, it illustrates the dampening quality of diversification. Over the 20-year period, the diversified portfolio achieved an average annualized return of 8.89%/year (4th place on the list), slightly below the S&P 500 annualized return of 9.14%.

Callan Periodic Table revisited

Source: Callan Associates

DIY Investor recently took another look at Callan's Periodic Table of Investment Returns (CLICK TO ENLARGE) which ranks investment performance on a yearly basis, going back 20 years, for 9 different asset classes.

This data offers many insights for investors on longer term relationships, the interaction between asset classes, the value of diversification and so forth.

To begin with, DIY Investor wondered how a 70% S&P 500/30% Barclay's Aggregate Bond Index (BC AGG) portfolio performed over the period. Putting the data points in Excel and doing the appropriate weightings produced an average annualized return of 8.46%. This is an interesting result, but few people would have this weighting over a 20-year period, although given the Dalbar results for individual investors maybe they should have.

Anyways, DIY Investor considered a 40-year-old investor in 1991 with an allocation of 80% S&P 500 and 20% Barclay's Bond Index. DIY Investor further assumed that every 5 years the allocation was changed such that the equity portion was reduced by 5% and the bond portion was raised by 5%. Thus, in 1996, for example, the portfolio was weighted 75% stocks/25% bonds. By the time 2011 was reached, the 40-year-old was 60 years old and the allocation was a reasonable 60% stocks/40% bonds. The calculation under this assumption achieved a return of 9.25%, somewhat greater than the return reported above for the constant 70%/30% allocation.

 Next, DIY Investor became interested in how this very basic sector diversification stacked up relative to the 9 asset classes shown in Callan's Table. The table on the left shows the results on a yearly basis over the 20-year period.
 It provided some diversification but still was highly volatile. On one occasion (when both the S&P 500 and the bond index were at the bottom of the performance list), the portfolio (which actually was 70% stocks and 30% bonds) ranked 9th overall out of 10 asset classes. It is also notable that the portfolio ranked 2nd in 2008 - actually a good year to rank 2nd as most investors would agree!

For the most part, the simple diversification did its job in keeping the portfolio away from the extremes and dampening overall volatility.

It did leave DIY Investor wondering how a further simplified diversification might affect the results. For example, how would adding international stocks to the mix via MSCI EAFE.

If DIY Investor had a bit more energy, he would do an analysis showing a formal rebalancing each year and maybe attempt an analysis whereby the 40-year-old starts with $200,000, say, and adds $15,000/year. As we know, sequence of returns plays an important role.

A fundamental rule of diversification

The very first investment principle a DIY Investor should learn - one that is learned by some at great cost (monetarily and psychologically)- is don't put all your eggs in one basket.

Many of the employees at Enron didn't understand it, but I bet you today they get it.

Every advisor who has been in the business long enough flinches whenever they see a major stock run into difficulty because they know someone who holds the stock who wouldn't reduce their exposure. For example, I pleaded with an elderly lady in 2006 to reduce her 28% holding of a major bank stock she had inherited from her mother. She liked the dividend she said, but I knew the real issue was emotional attachment because I showed her a number of stocks in different industries that paid close to the same dividend. Needless to say, I didn't get that account because she didn't want to hear the advice I gave.

Today I think back to a lady who had inherited BP stock and couldn't part with it. The shares had been given to her by her dad to finance her retirement. I can only imagine the sleepless nights she must be experiencing now.

Here's the rule: limit exposure to 5% of total investable assets in any one name (stocks and bonds combined). When the price rises to put exposure at more than 5%, reduce the position. If there are tax consequences, then manage these.

This comes from someone who has been stunned by developements in recent years by the companies that have run into difficulties: Bear Stearns, Lehman, Citi, Bank of America, AIG etc.

Remember: Fortune magazine was praising Enron right up until it imploded despite having no clue on how it achieved its earnings.