You, CFA

August 1, 2012

If you don’t handle your retirement, he might do it for you. IS THAT WHAT YOU WANT?

You can do this.

Fund managers have to be conservative, by definition. Even the smallest fund has tens of millions of OPM (Other people’s money. What are you, 80?) under its control. A fund manager has far less margin for error than does a private investor, at least professionally. If you maintain your own portfolio, and it loses 40% of its value in a given year, that’ll affect you and a handful of others. Do so as a fund manager, and your career will be dead on impact. (Actually, that’s not true. You’d be fired way before you lost 40%.) Imagine the looks of horror and sotto voce comments at the Wharton class of ’07 reunion. (And yes, plenty of fund managers are indeed that young.) You wouldn’t dare show your face. “Is that Spencer? Wasn’t he on the fast track at Vanguard? I heard he’s working in the suburbs now. Had to cut his cocaine use back to weekends only. Poor bastard.”

Fund management, for the most part, is regression to the mean. The same funds hold the same damn stocks, over and over again. Some funds are required to hold the stocks of companies that have reached a certain size. Make the Wilshire 5000, and that automatically qualifies you to be in somebody’s fund. Join the Dow (and someone soon will, to replace recently departed Kraft), and the same thing happens.

This is perverse. The tail is wagging the dog, for lack of a more original phrase. A fund doesn’t take on a new component because the fund manager sees something he likes and discreetly buys a position before someone else can. Funds take on new components because they have to. Or because everyone else is doing it.

Furthermore, fund managers aren’t just sheep. By and large, they’re hypocrites and liars. (Yes, we know. Welcome to the human species.)

Joe Light recently wrote in The Wall Street Journal that Facebook didn’t just seduce ordinary investors suffering from Streisand Syndrome. The professionals got sucked in, too. Big names. Fidelity. JPMorgan. The most successful website since Google (by number of users, anyway) went public, and did so in at least a couple of senses of the phrase. Everyone was talking about it and familiar with the story of its origin (thanks to a timely and critically acclaimed big-budget movie), and few institutional investors had the fortitude to say “no”. Or even say, “Can we take a look at the company’s financials?”

160 mutual funds bought Facebook. These included Fidelity’s Dividend Growth Fund.

Read that last sentence again. Facebook doesn’t pay a dividend.

The JPMorgan Intrepid Value Fund presumably invests in value stocks. An unproven IPO (that ended up losing 1/3 of its market cap out of the gate) doesn’t fit anyone’s definition of a “value” stock.

The managers of these funds didn’t answer the allegations of impropriety. Neither did any company spokespeople. And for the sake of consistency, we’ll end this paragraph in italics, too.

So why the hell were these funds, with their objectives included in their titles, buying a stock that had nothing to do with those objectives?

Again, defense. Say Facebook did what its devotees wanted, and exploded out of the gate. The punishment, professional and otherwise, for being the manager who could’ve bought Facebook but didn’t is overwhelming.

You can complain about how the financiers are screwing the little guy, Wall Street over Main Street, etc. if it makes you feel good. Or you can go David and aim for their heads.

Being small and nimble, i.e. an individual investor, gives you advantages that no fund manager can ever enjoy. Why?

  • You don’t have to answer to anyone.
  • You can take calculated, intelligent risks. Ones where you’ve weighed the potential downside and have decided you can live with it. Professional fund managers can do that too, to some extent, but when they do it it’s no bold move. It’s a piddling activity whose downside is mitigated by there being so many components to their funds. Hundreds of funds owned General Motors stock when it got delisted and the company eventually went bankrupt. No manager who bought GM lost his job, at least not for buying GM.
  • Your objectives are clearer. You’re there to make money. To maximize return by finding value and exploiting it.
    Is a fund manager there to make money? Yes, but not as unambiguously as you are. A fund manager makes a cut, yes, and also makes a salary. Thanks to that salary, the fund manager is operating under the same directive that most people do – I must preserve my job at all costs. The higher the salary, the more tightly someone will hold onto that job and the less they’ll to do risk getting fired. Playing not to lose isn’t just acceptable, from a fund manager’s perspective, it’s good business sense. At least as far as longevity is concerned.

Yes, selecting investments (it’s not “picking stocks”, thank you very much) is hard. It’s not an intellectual exercise along the lines of solving one of Hilbert’s Problems, but it’s hard in that it requires discipline. The same intestinal fortitude that gets your heart in shape or your lungs tobacco-free, can get you rich. Here’s how to start.

Filed Under: Estate Planning, Finance, Healthy Living, Investments, Making Smart Choices Tagged With: , , , ,

GUEST POST: The Art of Investing For Profits – AKA The Uncommon Sense

February 10, 2012

Remember when the Carnival of Wealth was hosted by Arohan of Personal Dividends? He was the Jack Paar to our Johnny Carson. The Al Atkins to our Rob Halford. The Blue Ribbon Sports to our Nike.

After handing off control of the CoW to us, Arohan took off the superhero mask and identified himself as Shailesh Kumar. He now runs Value Stock Guide, where he admits to a long history of antisocial behavior (at least when it comes to investing in stocks.) And he wrote today’s post. Subscribe to Shailesh’s newsletter, if you can handle no-frills stock advice. Or not. It’s your money after all, we don’t really care.

Investors are a fickle bunch. They move in and out of stocks for reasons that have not much to do with the business fundamentals. The general perception of the economy and the expectations of the future stock market returns define how most investors behave. Unfortunately, they generally do the very thing they should not be doing and don’t do the thing they should be, exacerbating the boom-and-bust cycles the stock market continues to go through.

This may sound strange, coming from a value investor who mostly relies on company fundamentals to find value stock picks. (Value investors tend to have their heads in the sand and ignore the behavioralists as quacks.) But the general economic sentiment changes investor behavior in a way that has a detrimental effect on their portfolio performance.

The Feel Good Bubble

“Irrational Exuberance” is how Alan Greenspan described it. This period is characterized by a climbing stock market, strong real estate sector, low unemployment rate, high consumer spending and a general feeling of financial security that leads people to believe that the good times are here to stay and they can continue to binge on their credit. This is also the time when most investors are brainwashed into thinking “this time it is different” by the media and the pundits (who generally have a vested interest in seeing that the bubble continues as long as it can). So rising stocks rise faster as investors throw caution (and investing common sense) to the wind, and pile on.

Unfortunately, more and new investors are also drawn into the market with the lure of quick profits, when they see the Joneses buying new toys that no longer fit in their garages and vacationing in far-away dreamy lands.

The result is that when the bubble bursts, most people end up with assets bought at high prices, overextended credit, dysfunctional marriages and gloomy job prospects.

The Economic and Investment Recession

The inverse of irrational exuberance is, of course, rational pessimism that changes the hitherto rose-colored lenses to dark gray. It is perverse that at the times when opportunities abound, humans have the uncanny ability to turn inward and refuse to answer the knocks on the door. Making matters worse, the scars of investments gone sour so affect the psyche that these investors continue to pull out of their investments at the most inopportune times.

It is as if the herd has unanimously decided to fall off the cliff. Investors lose the ability to look around and make a rational decision about the environment they find themselves in. Their complete focus is on getting out before it’s too late.

It’s already too late.

When the cycle bottoms out, most people end up with assets in cash and under the mattress, with their investments sold at low prices. If they have exercised better sense in other areas of their lives, perhaps their marital bonds are stronger and they have made the effort to pay down their credit debt.

Break Out from the Herd If You Want to Profit

The basic premise of successful investing is “buy low and sell high”. Common sense, right? In reality, it is really, really hard to do. As soon as you let your emotions, hopes, and fears rule your investment decisions, you lose. If you give in to your inbuilt urge to be seen doing the same things that you see others doing, you lose. You need to detach yourself from these blocks and social niceties and start making investment decisions on their merit.

Unlike other financial bloggers who will list 101 tips to investment success, I will only give you 2:

  • Sell on the high – When the markets are high, or your stocks have gone up beyond your judgment of their value, sell. Ignore all the voices on the TV, around the water cooler, and in your head that keep telling you that the stock will go higher. So what if you lose out on a few more percentage points of appreciation? Real money is not made on your sale price. Real money is made at the price you buy the stock. When the asset tops out, you want to be in the cash, not invested in the asset.
  • Buy on the low – If you believe that things can’t get any worse, and that the world is coming to an end, then know that you are not the only one who believes this. The weak hands have already sold or will do so soon. Investors who are still holding are doing so for more fundamental reasons. If you have been practicing the “Sell on the high” concept, you have cash to invest. This is the time to choose which stocks you would like to buy. Choose wisely – this will determine your returns.

There is no precedence of the world ending in the history of mankind, as far as I know.

Breaking out from the herd is hard to do at first. But once you do it and see the results, you will be able to give that “knowing smile” to the poor saps who dole out stock tips from the bar stool. Not that you will hang out with them any more.

Filed Under: Investments, Making Smart Choices Tagged With: , , , , , ,

Index Funds Don’t Work in Bear Markets

May 27, 2011

This is a guest post from Rob Bennett. In the Carnival of Personal Finance we recently hosted, we included a submission from Mike Piper at The Oblivious Investor that Rob disagreed with. He asked if he could rebut it, and because he largely met the Control Your Cash guest post criteria, we said yes. We then gave Mike the opportunity to rebut the rebuttal. He politely declined, so we’ll consider today’s post to be the terminus of this issue. (So if you want to leave a comment today, you’d better make it count.)

As for Rob, his claim to fame is developing “the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins.” His bio is here.

Some people LOVE a bear market


Mike Piper at The Oblivious Investor blog argues in a recent article that Index Funds Work in Bull and Bear Markets. The argument is that index funds earn the market return and that, if you try to pick good stocks, you might pick wrong and end up earning less than the market return. So index funds are your best choice.

 

I don’t buy it.
If stock investing were not so intensely emotional an endeavor, we would all be able to spot the flaw in this logic chain in 10 seconds.

 

Stocks do not do well in bear markets! Index funds are stocks! You do not want to be invested in index funds in bear markets! D’oh!

 

I have a stock valuation calculator (“The Stock-Return Predictor”) at my web site that performs a regression analysis on the historical stock-return data to reveal the most likely 10-year return for stocks starting from any of the possible starting-point valuation levels. It shows that the most likely annualized 10-year return in 2000 was -1%. Treasury Inflation-Protection Securities (TIPS) were at the time paying a government-guaranteed return of 4% real.

 

That’s a differential of 5 full percentage points of return per year for 10 years running. The investor who chose stocks over TIPS in 2000 was setting himself up to over the course of 10 years lose 50 percent of his accumulated savings of a lifetime. The investor with a $100,000 portfolio was likely to end up $50,000 poorer at the end of 10 years. The investor with a $500,000 portfolio was likely to end up $250,000 poorer at the end of 10 years. The investor with a $1 million portfolio was likely to end up $500,000 poorer at the end of 10 years.

 

Those who appreciate the power of the compounding returns phenomenon will understand why those numbers are only the beginning of the story, not the end of it. Investors who won for themselves a $50,000 differential or a $250,000 differential or a $500,000 differential will be seeing the size of those differentials grow and grow over the course of however many years they will be continuing their walk through the valley of tears.

 

It’s not just crazy Rob Bennett who says that valuations affect long-term returns. Yale Economics Professor Robert Shiller showed this in research published in 1981 and explained why it works this way in his widely praised and best-selling book Irrational Exuberance. There is now 30 years of academic research backing up Shiller’s findings. The latest study making the point is a study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo. You’ll find that one here.

 

Pfau’s study states: “On a risk-adjusted basis, market-timing strategies provide comparable returns as a 100% stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns…. Valuation-based market timing with P/E10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

 

So we do not need to be invested in stocks via index funds or through any other means during bear markets!

 

Long bear markets are not random events. They only show up following runaway bull markets. And they always show up following runaway bull markets.

 

Pay attention to the price of the stocks you buy, going with a lower stock allocation when stocks are insanely overpriced than you’d go with when stocks are fairly priced or low-priced, and most of the risk associated with buying stocks no longer applies for you. Yet you obtain higher returns! Investor heaven!

 

This approach (Valuation-Informed Indexing) sounds so easy and so rewarding and so rooted in common sense. Why doesn’t Mike Piper follow it? Why doesn’t everybody follow it?
Stock investing is an intensely emotional endeavor. When stocks were priced at three times fair value in 2000, the numbers on the bottom line of the last page of our portfolio statements overstated by a factor of three the amount of lasting wealth we had accumulated up to that time. We all wanted to believe that it was the portfolio statements that had it right and the last 30 years of academic research that had it wrong.

 

We tell ourselves that index funds always work even though there is a voice of common sense within each of us that tells us that it cannot possibly be so. How could there ever be an asset class that is worth buying at any price?

 

Mike uses numbers in his arguments. But it is emotion that drives his analysis of the numbers and it is emotion that makes Mike’s analyses popular with his readers.  Mike and his readers very, very, very much want to believe that index funds work during bear markets. But it is not so, at least not according to the 140 years of historical data available to us today.
Filed Under: Economics, Education, Estate Planning, Personal Finance Tagged With: , , , ,