Michael Jordan's House

OK. So Michael Jordan bought a house and, all in, it's going to come to around $20 million. This has gotten a lot of commenters' knickers all in a snit. And the economics of it all is coming out. How could someone who played a game afford that kind of house when average Americans who worked "real" jobs all their lives blah! blah! blah!... The same arguments that come out over and over and that are dealt with in econ 101 - at least they should have been dealt with.

First off, I will admit that I find it hard to understand how someone wants a house with 11 bedrooms, a two story guard house etc. My house has 4 bedrooms and I'm trying to figure out how to downsize. But all of this is besides the point. If he wanted a $20 million purple dog house - hey, it's his money.

Secondly, just for the record, I've never heard of any of the commenters. The world has heard of Michael Jordan. He has entertained millions. That has something, obviously, a bit to do with the economics. When you have a skill that will fill an arena with people willing to pay top dollar, it is rare. Michael Jordans or Lady Gagas don't come along every day. And this gets us into the economics.

Economists worried about this fairness issue early on. They framed it in terms of what they called the diamond-water paradox. How could something like water, which is necessary for life, have a price of zero when a luxury item - total unnecessary- such as a diamond carries a high price. Through this paradox, they came to understand that value in use is not necessarily the same as value in exchange. School teachers, fire fighters, police officers, the military, hospital workers - the most valuable members of society - don't command as much in the work place as entertainers, money managers, etc. Value in exchange is determined by what economists call marginal utility and marginal cost (works out to demand and supply). A flawless diamond is very rare and is very difficult for mother nature to produce and, hence, carries great value in exchange. A glass of water has zero marginal utility (unless you are in the desert) because you've already had a lot of water.

This is important because many people, like the commenters, go a step further and proclaim that the free market system is unfair, etc. They haven't thought it through, but the implication is that they have a better way to set prices - they know what is "fair."

Let's hope it never gets to that point. Better: I would suggest the commenters work on taking off from the foul line and dunking the basketball. Then I'll pay the big bucks to see them. I have to admit, I don't understand the Lady Gaga thing - I just threw that in for effect.

Unconventional Investing

Do you see yourself as the next George Soros, Jim Rogers, or some other well-known hedge fund manager? If so, then hopefully you know that you have to think differently from the crowd. If you are loading up on gold and patting yourself on the back about how smart you are, hold the high fives - you are probably headed for the proverbial crash.

An interesting post is presented along these lines by Kevin at Invest It Wisely where he looks at unconventional investment moves for 2011. Here he considers some areas that have not done well and at the moment are a bit unloved by the investment community. But these are exactly the types of situations that produce the outsized returns when they come into favor. To appreciate this, reconsider the mood of the country when BusinessWeek published its infamous "Death of Equities" cover in 1979. With a stock certificate folded into a crashed paper airplane and crumpled up stock certificates on the table, it captured the negative mood in the equity markets. Guess what? That was the time to sell the house, cars, kids - whatever - and put it all in the stock market!

Kevin's ideas are worth pondering.

Contrarian thinking - not easy but if you get it right, it goes a long way.

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.

How to Become a DIY Investor

Yesterday I presented reasons for becoming a DIY Investor. The bottom line, IMHO, is that becoming a DIY Investor is the best chance for most people to reach their retirement goals. It saves a lot of money over time, and it gives them the best chance of getting and even exceeding market returns.

But...how does one become a DIY Investor? It's easy... get an MBA from Wharton! Ha! Ha! That's a joke.

Seriously, it is fairly easy and it doesn't take much time to carry out once implemented. You do need, however, the interest and the willingness to make a commitment. This is what I recommend :

1. Pay attention in the human resources meeting at work where the 401k provider talks investments. I know-some of the presentations can cause the eyes to glaze over. Try to stay awake and understand the fees of the funds and the choices offered. Don't rely on co-workers for getting ideas on how to allocate your balances and contributions. There is a lot to learn in these meetings and in meeting with the reps. Typically, 401k providers (think Schwab, Fidelity, Vanguard) have online technology available to participants that can provide in-depth info on asset allocation etc. Learn and use this to come up with an allocation you can be comfortable with in stormy seas because that's where you are headed.

2. Get an investment philosophy. Too many people approach investing as a seat-of-the pants operation. It is almost a given tha,t if you do, you will end up buying high and selling low. Don't take my word for it - google "Dalbar Study." My philosophy is based primarily on using low-cost, low-turnover, index funds within the framework of an acceptable asset allocation model based on my risk tolerance. I refer to this as "evidence based investing" simply because there are innumerable studies supporting this approach. This leads to point 3 - the best way to develop a philosophy is to read the masters.

3. Read "The Four Pillars of Investing" by William Bernstein, "The Elements of Investing" by Charles Ellis and Burton Malkiel. Watch the Google authors presentation by Dan Solin on YouTube.

4. Find an experienced fee-only registered investment advisor who charges by the hour. Go over with him or her the differences between taxable investments and qualified accounts such as 401ks. Talk about opening up an account at a discount broker and the mechanics of making trades, if necessary. If you are planning on rolling over 401k funds etc., go over how to do that. There are actually nuances (sometimes it pays to rollover company stock to a taxable account) that can avoid adverse tax events.

In carrying out point 3 above, you will find that the approach outlined here has, over long periods in the past, outperformed 8 to 9 investment professionals who claim they can "pick stocks" and/or "time the market." The reward for making the effort to becoming a DIY Investor could well put you on the road to retiring a couple of years early.

Picture: Burton Malkiel, author "A Random Walk Down Wall Street."

Why Become a DIY Investor?

One way in which the world has become meaningfully different in recent decades is that people are now in charge of their own investments and retirement. It used to be that workers received a defined benefit at retirement and had a known monthly check coming in. Now we have IRAs and 401ks or other qualified accounts. Some of us are quick to throw our hands up and seek professional management. Here are some reasons to think about taking a different route - about learning how to manage your own money.

1. Save investment management fees. Pick up the local phone book and call 10 investment advisors out of the yellow pages. They will quote you a fee of between 1% and 2% of the market value of assets to be managed. For $1.0 million, that amounts to between $10,000 and $20,000/year. There are other costs as well. If they use mutual funds, the average expense ratio is 1.4%. If they trade actively, there are trading costs. Here's an idea: at the very least, take $5,000 of the $10,000 you save and take a great vacation. Take the other $5,000 and give it to Children's Hospital. Now you feel good, you've done good, you get a great tax break, and you understand what is happening with your money. Think of it like this: you can either drive your own car or you can have a chauffeur drive you around. For most people, the chauffeur is a big waste of money.

2. You have control of your money. If it is managed by others, you gradually lose an understanding of how it is invested. I know because I ask people questions that they find awkward. I ask them the most important question in investing: what percentage of your assets are in stocks and what percentage in bonds? Many people will hem and haw and sheepishly admit they really have no idea. I ask them how they performed last year. Some say they did OK and give me a dollar amount of how much their account went up. "My guy made me $22,000 last year." This of course, is meaningless. What was the percentage return? If the market went up 12% and "your guy" got you a return of 10%, he actually cost you 2%. I hate to rain on the parade, but this is quite common. People walk around thinking their advisor is doing a good job managing their money when, actually, the performance is horrible and very costly. I know many people will want to put this in the "ignorance is bliss" bin and move on. I'm obviously not in that camp. I've seen how the "ignorance is bliss" crowd handles markets like 2008.

3. It is not difficult to manage your own money. Think about this: you have probably managed or are managing a part of your own money already. If you have a 401k or a similar type of qualified account, you have probably read some investment related material, listened to a fund sponsor rep, and decided on how to invest your assets using the choices provided. Guess what? You are half way there. One thing that is generally missing is how to bring it all together by looking at all your assets holistically. But this is something most people can easily handle. Another thing you have to learn is how to pick appropriate funds and how to get the correct mix of stocks and bonds. Listen to the rep, but take what he or she says with a grain of salt. Many times they are insurance company sales people or brokers getting paid commissions for selling products.

4. It doesn't take a lot of time to manage your own money. Let me put it like this: that advisor I mentioned above who will get between $10,000 and $20,000/year to manage $1.0 million for you is getting one of the highest per-hour compensation rates on the face of the planet. I know. I've been there and done that. I know how many hours ( I probably should say minutes) typical advisors spend thinking about your account. I was in a meeting one time and the stock picker was asked by an advisor when the last time the stock had been reviewed. It turned out the stock was on the "buy list" and hadn't been reviewed in over a year and a half! The upshot is that, with today's technology, it is very easy to track and manage your investments using approaches recommended by highly-respected long time students of the markets.

Tomorrow we'll look at how to become a DIY investor.
Picture by LMW

Thoughts For The DIY Investor On Building a Bond Portfolio

Suppose we are a fly on the wall (actually in Maryland a stink bug is more appropriate - we've been inundated with them!) and looking in on a DIYer who has completed his asset allocation work and has come up with a percentage of assets to put into the fixed income. Just focusing on these fixed assets, how should they be specifically allocated?

Every situation is a bit different, but here is one approach.

First off, unless he has been living under a rock, the DIY Investor has heard a lot about the so-called "bond bubble." If he hasn't, he should use an advisor.

Should he buy individual bonds or buy funds? If he has the time, resources, and know-how, he can be my guest and buy individual bonds; but I generally recommend against it because individual bonds are illiquid, very difficult to price, and it is almost impossible to determine if you are getting good execution. To do it right, you almost have to use multiple brokers. All of these disadvantages can easily be overcome by using funds.

So, the DIYer makes the smart move, IMHO, and heads down the fund path. Let's assume he will use exchange traded funds. Warning: if he will make a lot of transactions, he should be aware of commissions! There are some commission-free ETFs, but most still have a commission.

Choices
Exchange traded bond funds provide a bewildering array of choices. From behavioral finance, we know this can be both good and bad. Some DIY Investors will exploit the available choices; others may freeze up and not be able to choose. Among the choices are corporate bond funds, Treasury bond funds, international bond funds, municipals, and agency bond funds.

Secondly, he will need to think about maturity. Other things equal, the longer the maturity of a bond, the more volatile the price. In his investigation, the DIYer finds that the typical grouping is in terms of short-term, intermediate-term, and longer-term bond funds.

From previous posts, the DIY Investor has learned about the yield curve and about a source of comprehensive information for Exchange Traded Funds. Thinking about the yield curve and the bond bubble, he develops a game plan for his fixed income assets positioning. He realizes that, first off, it is impossible to predict interest rates. If he could predict interest rates, he would be at Salomon Brothers making a zillion $s/year as a bond trader.

With these thoughts in his head, and respecting the bond bubble idea, he puts half of his fixed income allocation into the overall bond market by using AGG. AGG tracks the Barclay's Aggregate Bond Index - it captures the overall U.S. bond market. Under more normal circumstances, the DIY Investor would have considered investing up to 75% of his bond position in AGG.

Next, he would look at CSJ, a shorter-maturity ETF comprised of non-U.S. government names. CSJ presently has a yield of 2.79%. Holdings can be found on Yahoo Finance. He decides to put 25% of his fixed income assets into CSJ.

The remaining 25% he might spread around to high-yield bonds (HYG), emerging markets bonds (EMB), and mortgage-backed securities (VMBS).

There are, of course, many other choices for the DIY bond investor, but this at least has him started on a well-diversified, low-cost, low- turnover approach to the bond market that takes advantage of bond exchange traded funds.

This post is intended for informational purposes only. Specific investments should be undertaken only after completing research and consulting a professional advisor. I hold some of the ETFs mentioned.

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