First, stock prices can be random, and it’s best to protect yourself. Don’t learn this the hard way: owning a portfolio of individual stocks that you think you “understand” is dangerous. BP has almost perfectly tracked the S&P 500 for years. Since April 26th, it has lost 50% of its value ($100 billion) due to a unpredictable event. Those who became comfortable with their stalwart, conservative bank and financial stocks (AIG, General Electric) learned about random events in 2008. Diversification means owning thousands of stocks and bonds in six or more asset classes using indexes and ETFs, not 20 stocks that you “like.”

Second, markets are mostly efficient. That’s because the smartest minds in the world are haggling over what companies are worth by trading shares all day. Buy a stock and 99% of the time, you are paying what it is worth. You aren’t getting a bargain, and you’re not going to “beat” the market.

Picture a gigantic computer, programmed with the best logic and infinite processing capacity, recalculating the value of all public companies every second of the day. On April 26 when the spill became front page news, BP dropped from $60 to $50 within days. The computer was busy digesting all the new data as daily shares traded spiked from 5 million to 156 million. By early June, as the spill worsened, the computer dropped BP below $30. Value investors estimated the spill’s damage against BP’s assets, cash flow, and litigation costs and bought from sellers who predicted bankruptcy. By June 10th, the computer was working overtime – 222 million shares were traded and BP closed near $31. But the computer was right: when a $20 billion settlement fund was announced a week later, BP’s price hardly budged.

Over a 10 – 30 year time horizon, you’re no match for the computer and neither is your financial adviser. It’ll out-think you. It’ll never get exhausted. Remember BP next time you are tempted to buy that stock you “like,” and then take that extra cash and rebalance your ETF portfolio.

One new MarketRiders member asked the other day, why we recommended VGK, an index made up of the largest 482 stocks in 16 European countries when “everyone knows” that Europe is in trouble. VGK is down 18% this year, while the S&P is down 2%.

First, think of the thousands of investors all around the world, who deeply understand the economic circumstances of every country in Europe, focused every second on figuring out what every one of those 482 stocks are worth.  Is your opinion on VGK’s price better than theirs?  Second, VGK belongs in a globally diversified portfolio, because we care about the long term.  Europe will recover.  In 10 years, VGK’s price today will likely look cheap because those 482 companies will be more valuable.

Last summer when gold was $900 an ounce, a member declined to include it in his recommended portfolio because in his opinion “it was over valued.” Today its hitting $1200.

It’s during times like these, that you can really appreciate the calming logic of the MarketRiders investment methodology.  Trying to time and guess the market’s direction is futile for most mortals and investment professionals.  MarketRiders is based upon the idea that since we never know how an asset class will perform — we own them all at a very low cost, in proportion to our risk tolerance and we rebalance them as the markets shift.

Sounds easy to “buy low and sell high” doesn’t it?  When you receive a rebalancing alert to buy VGK, are you willing to buy more Europe?  We certainly hope so.

Is your asset allocation right?  This market provides you with a litmus test.  If you are feeling panic, then perhaps your stomach lining isn’t strong enough for amount of equities in your portfolio.  It may be time to consider whether you should increase your exposure to bonds and TIPs.  Our software makes it easy to do this by clicking on “Change Targets % or ETFs” on the dashboard.

Markets like these test you.  Stay the course and take a gut check.  With MarketRiders, your fees are rock bottom.  Follow your rebalancing alerts to take advantage of the market’s volatility, and if your allocation is right, you’ll be able to keep your mind off the stock market.

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.

“The turbulent economy of the last two years has left accounts across the nation like beaches after a coastal storm — severely eroded. Clients in their mid- to late 60s are asking, ‘Can I still afford to retire?’ The answer depends on a person or couple’s assets, lifestyle and retirement goals. While retirement may still be feasible for the affluent, those less well-off or younger people whose modest portfolios have been battered need time to rebuild.”

So as you decide on your IRA investment strategy, consider an investment portfolio that provides diversification with an asset allocation fit to your financial goals and risk tolerance.  To protect your nest egg from further erosion, also be certain to entertain low cost investment vehicles such as exchange traded funds (ETFs) and index funds.  This coupled with a warm glass of milk should help you sleep more soundly at night!

Think of the conversations that occur behind closed doors at the White House, corporate boardrooms or U.S. Central Command. We all understand that there are elements of those conversations that are deemed, for whatever reason, unsuitable for public consumption. They are tucked into the classified file, sworn to secrecy and solemn oaths. But every now and again, some of the untold story leaks out – finds its way to the common person. Sometimes the information is so unbelievable, that it is marginalized as ridiculous. Other times it is corroborated with such credibility that all we are left with slack jaws and nodding heads.

Below are three brief but shocking behind-closed-doors accounts about Wall Street and investing that left me stunned.

CEO of a Top Publically Traded Tech Company: Having participated in the Silicon Valley for years and sat on the board of Baidu, I come into contact with a broad network of technology leaders and professionals. Recently, I became part of a stunning conversation with one of the top executives in The Valley.  This individual, while surprising humble, is also profoundly wealthy. For years he used the “top” wealth managers who have access to elite money managers who in turn “outperform” the market to justify their fees. After years of high cost and poor performance and tens of millions lost, this executive was seriously underwhelmed. He pulled his money out, embraced a simple indexing strategy and global diversifications. It takes him only a few hours a year to manage the money himself. He save hundreds of thousands if annual fees and achieves a much better result. Why don’t we ever see that ad during Wimbledon?

Former Banking Firm Top 500 Producer: Imagine being an investment advisor who has built a dream business – over $1B in assets under management (AUM) and a coveted Chairman’s Club member. Making just over 1% a year on AUM, this wealth manager was grossing over $10MM annually in fees. Unfortunately, he had a huge problem – he still had a conscious. The more he study active money management, the more he learned that it not only failed to add value to his customers, but was in fact deleterious.  When he approached management about this problem and sought an indexing approach, he was run out of town. After a legal battle and negotiations, the firm and the manager struck a settlement. He left his customers in the hands of the banking firm and he had to move on. I guess someone is now making money “the old fashion way – earning it.”

$750 An Hour Tax Attorney to the Uber-Wealthy: I was once invited into a private conversation with the uber-wealthy about tax management. The strategy was architected by top legal minds in the country. Profoundly expensive to set-up and maintain, this apparently legal and sophisticated offshore strategy would result in profound tax reduction. Imagine most of your wealth free to compound without tax consequence. These uber-wealthy could invest in the most sophisticated and elite products. When I asked the attorney what the majority of his clients were investing in, he just snickered. Over 60% of their dollars were dedicated to simple and diversified indexing strategies. There was no Wall Street, no active managers, or Jim Cramers – just hundreds of millions, even billions, going into a simple, proven approach used by those in the know.

I hope you are doing the same.

Well, of course it would. Fund companies, including PIMCO, Legg Mason, and Van Kampen, say they’ve got just the thing for you: They are called tactical asset allocation funds, and a new one seems to roll out daily. Don’t believe the pitch.  No manager can predict the future of one asset class let alone multiple ones. Yet terrible odds have not kept these new funds from becoming the trendy way to invest. So what is technical asset allocation and why is it dangerous?

How It Works

Tactical allocation requires managers to predict which asset classes will lead and which will lag, and then to own securities that will benefit. Needless to say, they don’t always get it right. But that doesn’t stop some of them from charging high expenses or keeping their investing strategies opaque or both.  This approach may sound like market timing, the discredited investment strategy of jumping in and out of a market to catch upswings and avoid downturns. But tactical fund managers prefer a more nuanced explanation of their approach. They typically hold a wide range of assets, overweighting classes they find most appealing and underweighting ones they consider overpriced or otherwise undesirable. Some choose allocations based on technical indicators, others on fundamentals. Sounds great, doesn’t it, but unfortunately it simply does not work over the long-haul. Portfolio diversification, however, is an investment strategy employed by leading institutions and endowments and is a great approach for retirement. Unlike tactical allocation, asset allocation focuses on using low-cost, tax-efficient index funds in specific target percentages that are rigorously maintained through rebalancing as markets shift.

Why It Is Dangerous

Research conclusively demonstrates that only a small percentage of managers will beat any one index in any given year. When you examine fund managers’ performance vs. the index out ten years, the winners drop into the low single digits. Now imagine asking a fund manager to not beat one, but four, five or six indexes all at the same time. Statistically, your likelihood of success drops into a fraction of one percent – probably not the best bet for your retirement.

The following paraphrases from David Swensen’s “Unconventional Success,”  There are core and non-core asset classes.  Core asset classes have 3 critical characteristics:

1) they give basic, valuable differentiable characteristics to an investment portfolio.  For example, while real estate protects against the effects of inflation, bonds protect against a financial crisis.

2) they rely fundamentally on market generated returns, not on active management of portfolios.  In most asset classes, active managers do not outperform the market and because satisfying investment objectives is critical, a core asset class won’t rely on luck or serendipity,

3) they are derived from broad, deep, investable markets.  As a core building block of a portfolio, we are focused on well-established marketplaces instead of trendy concoctions promoted by Wall Street financial engineers (ala all of the new ETFs currently coming out).

Non core asset classes fail to meet at least one of the three criteria above and usually depend upon active management.  There are many alternatives here, but unless you have the expertise and the resources to find high quality active managers, these are not generally recommended.

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.