Similarly with such market volatility in recent weeks, a few MarketRiders members have been asked to make some tough calls when, depending upon the portfolio, our rebalancing algorithms have alerted them to add to positions like, of all things, Europe. “Are you serious?” one member moaned. “Everyone knows Europe is blowing up. Why buy more now?”

Just like the man from the quote above, this member was having a tough time sticking with the plan. Sorry, but “buy low sell high” is tough to do. Successful investors must continually bet against the crowd, always with deep conviction, coupled with a tug of “unbelief.”

The MarketRiders system of buy, hold, rebalance is an investment approach, based upon solid research and unshakable facts. We can never remove all doubt, but we’ve harnessed the most scientifically verifiable investment approach known today. Rebalancing adds to returns and helps manage risk. You maintain your target allocations, and the risk level you set for yourself when you built your portfolio. Riding winners if fun, but what goes up, certainly comes down. Moving from religion to the casino: rebalancing forces you to “take money off the table” and add to losing bets that will be tomorrow’s winning ones.

It’s tough to maintain your allocations, and trimming a gold position or buying Europe while it is apparently swirling down the toilet is not easy. At moments like these, lean into the facts of the scientific research, push back your emotions and then rebalance your portfolio. You will be glad you did.

Investors who have decided to enter this tournament via day trading, market timing, technical analysis or even tactical asset allocation, need to pay close attention. You are playing a game that is very difficult to win, especially if you have fewer resources, knowledge and technology than your competition. Oh, sure, you might be lucky enough to win a few early hands but the long-term outcome is fairly predictable. Such investors live with a prevailing sense of unrest knowing that they have shown up to a shotgun duel carrying a pocketknife.

Wealthy families, endowments and elite institutions practice a different investment approach. These investors are wise enough to avoid, paying fees to managers trying to “beat” the averages in public stock markets. Sure, they may invest in private equity and venture capital where they enjoy an advantage via access to the best deals and terms. But when it comes to public markets, these investors commit a large portion of their portfolio to passive indexed strategies – the MarketRiders approach. The only bet such investors are making is that the world is in fact not coming to an end any time soon and that its markets, companies and their portfolio will continue to grow over long periods of time.

This approach provides amazing freedom from having to stare at your portfolio several times a day. Unconcerned about the daily gyrations of Jim Cramer and the rest of the bobble-headed finance media, long-term and disciplined MarketRiders can go about their daily lives with peace of mind. Sure, the market is down May and your portfolio probably dropped with it, but with a retirement time-horizon that is years away, your portfolio will not only recover, but grow quite nicely.  And by rebalancing you are taking advantage of these swings.  This knowledge frees you from staring at a computer monitor and gives you time to go about the real business of living your life.  In the end, isn’t that what the money is actually for?

And of course, a plethora of explanations quickly followed. We heard about the “fat thumb” scenario describing a trader who, keying in the wrong trade, sold billions of shares instead of millions, triggered the collapse. One of the more interesting explanations is a truly bizarre account involving Nassim Taleb, trader and author of “The Black Swan,” a book that discusses high-impact, impossible-to-predict, and rare events that are beyond the realm of normal expectations.  According to this grand irony, Taleb’s fund placed a sizable S&P short that got the ball rolling for Thursday’s violent selling — creating his own “black swan.”  In the end, however, the 1000-point drop remains a mystery, and in the absence of any truly credible and complete explanation, market fear has been resurrected.

More important than understanding the cause of this event is understanding how you responded to it.  Did you yawn, or did you freak? For those who live by the market’s vicissitudes, May 6th was an apoplectic ride on a terrifying roller coaster. With each swing of the market, such investors sit glued to the ticker, at one moment thrilled, the next gripped by dread. For those of us who are MarketRiders, such days produce a yawn.

With our investments sheltered by a distant time horizon, low fees and smart diversification, we are free to go about the more important business of our lives. Some investors prefer drama. We prefer peace-of-mind.

With rapacious accuracy, Rick rips back the covers on Wall Street to expose the true motives in selling this story. Wealth managers are having an increasingly difficult time selling clients on the value of high priced mutual funds that are less tax friendly and have tragically underperformed low cost ETFs.  In light of the giant swooshing sound of clients bailing out of the mutual fund merry-go-round for better constructed and performing ETFs, wealth manager came up with this core and explore pitch to sell manged products for small cap, foreign and emerging market investments. Unfortunately, Ferri points out that there actually is no such creature as an inefficient equity market. As he states:

“Core and Explore would be fine advice if it worked, but it doesn’t. The theory has several flaws. First, how does your adviser know which market is efficient and with is not, or if any market is efficient? The nation’s top academics cannot even agree. Second, why should your adviser suddenly become more skilled in selecting managers in inefficient markets simply because he or she is no longer selecting active managers in efficient markets? Third, there is no unbiased academic evidence to support the notion that active managers outperform in any market.

Two often presumed inefficient markets are U.S. small-cap stocks and emerging markets stocks. According to Core and Explore theory, these are two markets where active managers should have excelled. That has not happened. Data gathered from the S&P Indices Versus Active Funds (SPIVA) Scorecard for the first half of 2009 shows that over 67% of small-cap core funds under performed the S&P 600 index over the trailing five years and about 90% of actively managed emerging markets funds underperformed the S&P/IFCI Emerging Markets Composite index over the same time.

There are no inefficient asset classes where high cost actively managed funds consistently outperform their appropriate benchmarks. This means Core and Explore is about paying for something you do not need and likely will not benefit from. If your adviser has progressed to the point where he concurs with an all index fund portfolio, then you have a good adviser. If he insists that he can select superior funds on the explore side, then perhaps you should do some exploring on your own–for a new adviser.”

I am a big fan of Mr. Ferri’s and strongly agree with his poignant and entertaining expose. I would suggest an important caveat, however. Core and Explore does work, but only if you define the terms quite differently. I have used Core to reflect those assets which are directed at a long-term, reliable and scientifically sound retirement strategy. This Core portfolio should consist of indexes as recommended within the MarketRiders (www.marketriders.com) software. Explore, on the other hand, are the investments outside of my Core retirement portfolio that I am involved with that have a higher risk/return profile. I personally have ownership in a hydroelectric power  company in Chile, oil and gas in the US, a retail store as well as equity in early stage tech companies – for me all part of my Explore strategy that complements the overwhelming majority of my assets in a Core indexed portfolio with MarketRiders.  Even Ferri himself owns land in Texas and has investments outside his index portfolio. I personally like to direct between 10% to 20% of my investible liquid net worth in Explore style investments and see that percentage decreasing rapidly as I move into my 50s and towards retirement.

So, in conclusion, Core does fit with Explore, but when it comes to publicly traded equities, stay true to employing globally diversifed, low cost and tax efficient ETFs.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.

These are scary times for investors trying to shore up their retirement
portfolios. Stocks’ values are down, inflation is ticking up and home prices
are sliding. But as investors nervously eye all that, they may be overlooking
the biggest threat of all: themselves.

“How you react to negative news about the markets can do far more
damage to your retirement portfolio than temporary trends in the market,”
says Mark Cortazzo, an investment adviser at Macro Consulting Group in
Parsippany, N.J. “Investors can truly be their own worst enemies.”

While investors are prone to making mistakes no matter which direction the
market is headed, when stocks lose value — as they have for four consecutive
months — investor errors can have more exaggerated effects on wealth, Cortazzo
says.

So how much damage does the average investor inflict upon himself in real
numbers?

At the request of Barron’s, Christopher Cordaro, an investment
adviser in Chatham, N.J., with Regent Atlantic Capital, ran some
calculations to answer this question, and the answer isn’t pretty.

Bottom line: Simply by making three of the most common errors — failing to
diversify wisely, trying to time the market and overpaying on investment
expenses — you would have missed out on $375,000 of gains on a $1 million
portfolio invested for the 10 years through January 2008.

Cordaro found that a wisely constructed portfolio free of investor error
would have returned an average annual 6.86% during that period and grown to
about $1,942,000. But factor in the three errors, and the return shrinks to
4.59%, while the ending account balance drops to about $1,567,000. In general,
the smart portfolio was broadly diversified in terms of both asset class and country. It made no attempts to call tops and bottoms in the market, and it
steered clear of pointless but all-too-common fees.

The worst part, Cordaro says, is that investors often don’t even realize
they’re sabotaging their nest eggs — because the slippage in return isn’t
sudden or drastic. “It’s small enough that they don’t notice it, but it is
slowly eating away at their financial independence like a cancer,” he
says.

The good news? If you know what to look for, chances are you’ll be able to
avert disaster. Here is a rundown on the three most common and costliest
mistakes that investors make with their nest eggs.

Neglecting Asset Allocation

Practically all investors would agree that they want the best returns and
the lowest possible risk. But when it comes to setting up a portfolio to
deliver on that promise, many investors don’t go the distance — and they pay
dearly for it.

The best way for an average investor to achieve the highest risk-adjusted
rewards is to allocate investments broadly across different asset classes. Yet
few investors do so: According to a 2007 survey of 401(k) assets by the Profit
Sharing and 401(k) Council of America, the average investor holds
some 25% of 401(k) assets in his own company stock. Beyond that, at least a
third of assets are in domestic stocks. Less than 8% of retirement-plan assets
are in non-U.S. stocks, and fewer than 1% are in real estate.

In Cordaro’s example, you can see how an investor can buff up a return by
refining his asset allocation. A simple allocation of 60% in large U.S. growth and
value stocks and 40% in intermediate bonds would have delivered a 5.2% average
annual return in the 10-year period ending January 2008. Add a sprinkling of
small U.S.
growth and value stocks, and large foreign stocks, and you boost your return to
5.7%. Better yet, add some world bonds, emerging markets and real estate, and
the return plumps up to 6.4%.

That latter portfolio, Cordaro says, was invested 30% in large U.S. growth
and value stocks, 10% in small U.S. growth and value stocks, 10% in large
foreign growth and value stocks, 5% in emerging markets, 35% in intermediate
bonds, 5% in world bonds and 5% in real estate.

Juggling a number of asset classes isn’t always easy. Jay Berger, a partner
at Independent Wealth Management in Traverse City, Mich., said that in 2006,
clients panicked over the Pimco Commodity Real Return Fund’s 3% decline.
“We explained that we need a portfolio with assets moving in different
directions. The best analogy is: Look at it as a perennial garden. If
everything is in bloom at the same time, that probably means everything will
wilt at the same time.”

Timing the Market

Investors have such a dismal record of being able to time the market that
mutual-fund inflows and outflows appear to be contrary indicators of which way
the market is heading, says Meir Statman, a finance professor at Santa Clara University in California.

“It’s not the perfect-idiot forecast,” he says, but it’s close.
Ideally, of course, you would want to sell your holdings when prices are high
and poised to drop, and buy stocks on sale, right before a run-up in values.

But over the past decade, investors have done the exact opposite. The month
with the biggest-ever net inflows of assets into stock mutual funds occurred in
February of 2000, “which was the doorstep of one of the worst declines in
history,” says Ernie Ankrim, chief investment strategist at Russell Investments. The biggest outflows were also poorly timed: Some of
the biggest occurred in the months leading up to October 2002, when the market
hit bottom.

“This kind of behavior of getting excited after good news and scared
after bad news causes investors to give up between 2.5 and three percentage
points a year,” Ankrim says. “The whole reason investors put up with
the volatility of stocks is to gain about three or four percentage points over
bonds — if we give most of that back, that means we’re accepting all of the
volatility of the stock market for no good reason.”

In the 10-year period of Cordaro’s example, investors suffered more modestly
than Ankrim’s estimates, but losses were still significant. Using actual
mutual-fund flows over 10 years ending January 2008, Cordaro found that market
timing cost the average investor a half percentage point of
return each year. On his $1 million portfolio, that means missing out on
$93,000 in gains.

You don’t need to be near a long-term market top or bottom to do serious
damage. From 1980 through 2006, investors who missed out on just the five
best-performing days in the Standard & Poor’s 500
index would have ended up with 26% less than someone fully
invested in the index during that period, says Carolyn Clancy, executive vice
president of Personal Investments, a division of Fidelity Investments.
“Missing just 30 of the best-performing days would have reduced the value
by 73%,” she adds.

Another kind of market timing is more passive, yet still destructive: It is
simply to stop feeding more money into your investments in rockier times.

Consider this: According to a 2007 study by Dalbar’s, a mutual-fund research
firm, if you had invested $10,000 in the S&P 500 index over 20 years
through December 2006 in a sporadic pattern that matches actual behavior of mutual-fund
investors during that period, you would have ended up with a
total of $33,252.

If, however, you had systematically invested the $10,000 in equal increments
over 20 years — through good times and bad-you would have ended up with
$42,877. The study found that even if you chose a fund that captured only 75%
of the S&P 500’s return, by dollar-cost averaging you would still end up with more than if you had sporadically invested in the
S&P 500 fund.

Paying Too Much

Before you win cocktail-bragging rights for earning a robust return on an
investment, be sure to factor in how much you paid for your winnings through
expenses and fees.

While more investors than ever before are seeking out low-cost mutual funds,
there are still investors who believe that they need to pay higher expenses for
better performance, says Mercer Bullard, a securities-law professor at the University of Mississippi.
But, he adds, there is no evidence to support that. Higher fees simply do not
indicate better management.

Consider S&P 500 index funds. While the performance
of these funds is practically identical, given that they mirror the same index,
expenses are all over the map — some funds charge no load, some have no load
but do have a so-called 12b-1 fee, which is an operating expense, and
yet others have both a load and a 12b-1 fee.

A 2006 study by Zero Alpha Group, a network of advisory firms, and Fund
Democracy, a shareholder-advocacy group, looked at how much investors would pay
in fees if they invested $10,000 in these funds for 20 years and earned an
average annual 10% gain. It found that the average investor would have paid $2,582
in fees in the lowest-cost fund; $3,744 in the fund with only a 12b-1 fee, and
$7,600 in the load fund with the 12b-1 fee.

In Cordaro’s hypothetical $1 million portfolio invested 10 years ago, he
looked at the impact that half a percentage point in fees can make on a
portfolio. While his best-case portfolio earned an average annual return of
6.86%, he found that if higher fees knocked half a percentage point off of
returns, an investor would have ended up with $1,848,865 rather than
$1,941,837.

Taken altogether, Cordaro says, the impact of investor error — even
seemingly small ones — can be grievous over the long term. “We’re talking
about the difference in being able to retire in comfort or having to work many
more years to meet your goals.”

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