Get Me Into the Market

Source: Capital Pixel

One of the questions I have potential clients answer is why they are seeking the services of RW investment Strategies.  This, of course, points me, as an advisor, in a particular direction and tells me a lot about whether I can help them.  A frequent answer is that they need help getting into the market.

This, in fact, is one of the best reasons to seek the help of an advisor. Often, I'll find that potential clients have poorly timed the market by buying in after the market has gone up.  They then wring their hands and stress out as they watch their portfolio drop, only to sell out at the wrong time.  After selling out, they have to watch from the sidelines as  the market rises.  This, of course, is the emotional roller coaster investors ( I use the term loosely) needlessly ride.  And - it is costly!

2011 has been a case in point.  I find investors have pulled their hair out as they've witnessed and reacted to 400-point swings in the market by capitulating at the wrong time and seeing now that market indices are  positive for the year.

This is the point where they show up on my doorstep.

Some appreciate the advice I give them by acting on it in timely fashion.  Others, despite my best attempt, don't.  They will walk away and, if the market moves 15% higher, jump in.  Basically they will continue the behavior that has been harmful in the past.  This, of course, is a phenomema that is not confined just to the financial arena.

Get Into The Market

I'm a proponent of indexing.  This makes getting into the market easy.  If you have a brokerage account and we meet at 9:30 a.m., I'll have you in the market by 10:30 a.m. at the latest.  We won't try to pick stocks or sectors.  We won't discuss macroeconomic developments.  We won't even try to guess what China and Europe have up their sleeves.  What we will do is buy the whole market.  If you are with Schwab, we'll buy SCHB.  If you are with Vanguard, we'll buy VTI.  With others, we may buy IWV. These are all low-cost, broad market exchange traded funds.

The bond portion is just as straight forward.  We use low-cost exchange traded funds that are indexed to broad portions of the fixed income market.

How much will we buy?  How much in stocks and bonds?  This takes a bit of time and collaboration.  It is why we might need until 10:30 to get you invested.  We'll talk about your goals and take into account answers to other questions on the questionnaire.  We'll determine an appropriate asset allocation model that targets a given percentage in stocks and fixed income.

If the appropriate model is 70% stocks but you are very leery of the market, we might start with 60% stocks.

A number of factors come into play, but the bottom line is you'll be in the market.

12-Months Experience

Some people are wondering what the big deal is.  Over the past 12 months ended 12/23, the "Moderately Conservative Benchmark" specified by Schwab returned 3.13%.  This benchmark is comprised of 60% bonds and cash and 40% stocks.

In comparison, your money fund probably returned on the order of 0.1%.  Even if you had money in a certificate of deposit, you likely earned only slightly above 1%.  Thus, the opportunity cost of not being in the market and riding out the craziness that has taken place over the past 12 months has been meaningful.  In fact, although the benchmark return at 3.13% is below the rate of consumer inflation over the past 12 months ,it is at least close to tracking it.  Money fund performance, in contrast, has been hammered by inflation.  This is a risk many fail to appreciate.

As a point of reference, markets over the past 12 months have bordered on the insane with a government that was totally inept, a Europe that has struggled all year with the possibility of a breakdown, China slowing, and a stubbornly high rate of unemployment in the U.S.  All of these scary factors and excuses have kept investors on the sidelines and have been costly.

2012 will very likely be just as wild.  Should you be in the market?

Disclosure:  This post is for educational purposes only.  Market returns are unpredictable.  Individuals should do their own research or consult a professional before making investment decisions.

How to Index

Yesterday, DIY Investor argued that one of the keys to figuring out how to invest is to look at how the experts invest. DIY Investor looked at and presented some evidence on the extent to which some of the nation's largest pension funds index the assets they manage. He noted that, although they are well positioned to find superior performers with their well paid, highly educated advisors and staffs, they invest the bulk of their assets by indexing. In other words, they seek to achieve close to the return on the market. They aren't out there trying to find the  market beaters with the bulk of their assets. This sends a powerful message in favor of the indexing approach - to DIY Investor as well as to many others.


So, how can the average investor index? How hard is it? Do you need to hire an advisor? DIY Investor is a bit battle weary because he has been battling on other sites those who claim indexing is complicated. Here, DIY Investor will show that it is fairly easy and support his thesis that many people, although admittedly not all, can do their own index investing.

Many people confuse investing with  financial planning. Let's be clear, from the start, on the difference between the two. Financial planning is complicated. Financial planning is a road map to guide you over a number of years on your financial journey.  Figuring out the amount to save to reach a target, along with assumptions about life expectancy, inflation, and market returns, is complicated. Understanding the tax implications of various transactions, how to finance a college education, how to title inherited IRAs, and so forth is all very complicated. Getting started on the road to estate planning, as a good financial planner will do for you, is complicated. All of this  is financial planning. Depending on where you are in life, it may very well pay for you to get a financial plan done. And, financial plans are fairly expensive - on average a good plan costs about $2,700.

One of the outcomes of a well done financial plan is an asset allocation. This is where the investing part starts. To be clear, you don't need a financial plan to get an asset allocation; but a good financial plan will produce an asset allocation. To get an asset allocation by itself is not overly difficult and will be discussed in a future post.

For our purposes here, DIY Investor will assume that we have in hand an asset allocation. Again, note that this is the point where we separate with the financial planning firm. At the end of the presentation, they make the pitch to manage the money by arguing that it is complicated and that they only charge 1% of the market value of the assets. DIY Investor politely declines. If they start whipping out charts and talking about how they are great stock pickers and/or market timers, DIY Investor puts his hand on his wallet and runs for the door.

Now we are on the street, breathless, with asset allocation in hand:

Adapted From Schwab

It looks something like this. This is basically an 80% Equity/20% Fixed Income allocation. The percentages represent the target percentage for each asset class. Thus, 20%, for example, is targeted to the international equity class. This allocation wraps up a lot of what the planner found out about you. It takes into account your retirement goals, the number of years until you retire, how you are expected to respond to the ups and downs of the market, and both your need and capacity to take risk. It is one of those areas in which you should feel free to ask a lot of questions.

Investing

The next step is to get actual investments to implement the allocation. To begin, visit the iShares site .  Next put your cursor on the "iShares ETFs" tab, and from the drop down list, click "Core Solutions."  Scroll down and find:

CLICK TO ENLARGE For the "Newbies," the capital letters are ticker symbols. IVV is a "Large Cap Equity" offering, and it fits the bill for the first asset class. Note also that the expense ratio is only .09%. The average actively managed fund charges approximately 1.4%!

So go to Yahoo! Finance and put in the ticker symbol IVV, and find the price of $133.62/share. Assume your portfolio is $1.0 million. The asset allocation specifies 45% in large cap equity, i.e. $450,000. Divide $450,000 by the price of $133.62/share, and you find that you need to buy approximately 3,300 shares of IVV.

If at this point you know how to find prices of ETFs, have a discount brokerage account, know how to execute a trade, and followed the simple arithmetic above, you are good to go. If, in fact, you have a million dollar account, you've probably saved yourself at least $10,000/year in investment management fees.

An unabashed plug: for those who find this approach worth pursuing and yet don't feel quite up to getting it off the ground, I offer, at a reasonable fee (.4% of assets), to get it going by managing it for several months. This gets the initial set-up done, makes sure investments are located properly, and  goes through the rebalancing process. Once they feel comfortable, they can take over the controls on their own.  For those with a bit more experience, I  offer hourly consulting to talk them through the process on the phone or sit down with them as they execute their trades.

An additional point:  some brokers sell commission-free ETFs. These are very convenient for rebalancing - a subject DIY Investor will discuss in the future.

DISCLOSURE:  DIY Investor may own some of the ETFS mentioned here. This information is for educational purposes only. Individuals should do their own research and consult an advisor before investing.

Should You Index?

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

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

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

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

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

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

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

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

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

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

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

I Almost Became Famous

Many years ago, in a different universe, I had a streak of luck with a small fund. As I recall, it was a few million. It was a Treasury bond fund. I saw myself as a superb market timer; and when I took over the fund, I judged yields as being excessively high. I invested aggressively in 20-year and 30-year Treasuries. Treasury yields at the time were double digit.

As soon as the the investments were made, yields dropped like a rock. The push up in bond prices yielded a nice capital gain and, to capture my good luck, I realized the capital gain and put the proceeds in 1- and 2-year maturities. As soon as these buys settled, yields shot back up and I re-entered the market. This went on a few times during the quarter, and after a while I was feeling like King Midas.

When the quarter ended and the smoke cleared, I found my fund was the third best-performing fund in the country. Pensions & Investment Age produced the rankings and, in their quarterly performance issue, interviewed me along with other "top" managers/bond market rock stars.

I gave my burgeoning rock star status considerable thought, and it dawned on me that I could lock in this superior performance for a long time by "closet indexing." In the bond market, this would mean structuring the bond portfolio similar to the Aggregate Index - its benchmark. The portfolio would have the same average coupon, duration etc.

All of this is more complicated to explain than to carry out. By "closet indexing" I would retain the superior performance for some time while not taking a risky market timing posture. The superior performance would attract money, thereby increasing the size of the fund. Bringing money in, of course, is the purpose of institutional money management.

The reason I relate this story is twofold. First, you need to be careful in evaluating performance. A fund's performance may look good but really be the result of one period's luck. By coming into the fund and paying high fees to attain superior performance, you may be buying into a conservative approach - one which could be attained at much lower costs. Or worse, the manager comes to believe he or she is King Midas and it takes time to realize that the prior results were luck. Secondly, it is easier to produce exceptional results with a smaller fund. The history of Wall Street has many instances of funds which started out on fire and gradually turned mediocre as asset size grew.

As it turned out, I was recruited to go to another investment management company that offered me more opportunities. Still I wondered over the years how much money would have come in with the "closet indexing" approach for that fund.

Required Reading

Larry Swedroe in "How Not to Create A Fortune" does something rarely done. He examines stock recommendations made in the past. In particular, he looks at the 8/14/2000 issue of Fortune magazine that touted "10 Stocks to Last the Decade."

The results are not pretty. Two companies, Enron and Nortel, are bankrupt; and 7 out of 8 of the remaining companies underperformed market averages! IMHO every such magazine cover should have on the front in bold letters : Following the Stock Pick Advice Given in This Magazine May Be Hazardous to Your Financial Health."

The folly of following such advice is not the only takeaway. It is also important to understand that, if we asked 1,000 self-proclaimed market gurus in 2000 to produce a list of 10 stocks, some would have done exceedingly well by pure luck. Some surely would have picked the dot.com companies that made it thru the bust and avoided the mine field of financial companies in 2008.

Surely some of the gurus would have done well because of skill. The issue is that no one has yet shown how to identify them ahead of time.

The bottom line, once again, is to follow the advice of long-time market investors Warren Buffett, John Bogle, William Bernstein, Burton Malkiel, Charles Ellis, Dan Solin and many others to invest in low-fee, low-cost, low-turnover index funds .

Follow Up

Read:
-"The Elements of Investing", by Ellis and Malkiel
-"The Investor's Manifesto", by William Bernstein
-"The Smartest Investment Book You'll Ever Read", by Daniel Solin

Why Active Management is Eating Up Your Nest Egg

People hand over their nest egg to active managers who claim they can pick stocks, time the market, and make tactical asset allocations. Many times the managers do OK for a period, and historical results seem to indicate superior performance. But careful analysis of long-term results show that very few active managers outperform the market after all fees are taken into account. Furthermore, it has been shown that outstanding performance doesn't persist; and it is not possible to pick the managers who will outperform the market.

Why is this? After all, these are the brightest of the brightest. They consume considerable resources in their endeavors. One important reason is as follows. Investing is a zero sum game. When a stock transaction takes place, there will be a winner and a loser. In the aggregate, professionals make up about 90% of the market. In other words, they are the market. The key to understanding long-term under performance is to understand fees. Here is a table taken from "The Intelligent Asset Allocator" by William Bernstein, page 92. Click to enlarge. Understanding this table can save your retirement dreams.



Look at Large Cap. If you get buy an actively managed fund that seeks to outperform the S&P 500 there is an expense ratio,on average, right off the top, of 1.30%. Also,these funds typically have high turnover - in other words they trade a lot. This takes another 0.3%. This is a fee you don't see. There is a bid-ask spread that takes another 0.3%. Note this is considerably larger for less liquid parts of the market like small cap etc.

The bottom line is that professional managers on average make close to market returns but fees subtract so much that the bottom line is greatly impacted.

The good news is that today (this hasn't always been true-it's a fairly recent developement) it is easy to achieve close to market returns after all fees by buying low-cost, indexed, ETFs. For example, the SPY, which tracks the S&P 500, has an expense ratio of .09%. By buying this the individual investor saves 2.1% of assets right off the top EVERY SINGLE YEAR.

Disclosure: This material is for educational purposes and is not intended as specific investment recommendation. Individual should consuly an advisor and do their own research before investing. The writer holds SPY.

Think you or your advisor can beat the market?

Mike Travaglini is the executive director of the Massachusetts employee retirement system-one of the largest pension funds in the country. Pension funds of this size have huge staffs of very smart analysts searching the world for the most talented investment managers. They had hired Bill Miller of Legg Mason, manager of the Value Trust Fund which had beat the S&P 500 for 15 consecutive years. They fired him in 2006 after his luck ran out and "...decided to get out of actively managed U.S. stock funds and stick with passively managed funds..." Mike Travaglini went on to say "The extra cost to hire a money manager didn't seem worth it." "If Bill Miller can't do it on a consistent basis, then nobody can".
If you think you or your investment advisor are smarter than Bill Miller and have as much information as Bill Miller and can actively manage assets to beat the market, then go for it. It goes without saying that Bill Miller at one time could pick up the phone and talk to the CEO of any major company in the U.S. Do you or your advisor have that kind of access?
The end result is that, according to an article on the front page of the Baltimore Sun today, Legg Mason is making major cuts in its work force.
This is just another piece of evidence supporting the thesis that individual investors should go with low cost index funds and stop paying self proclaimed "gurus" excessive fees to try to beat the market.