MarketRiders Blog

Your Cash Ain’t Nothing But Trash

Thursday, November 10, 2011

Baby boomers who grew up listening to this Steve Miller song remember that it was about a guy who had cash, but couldn’t get a girlfriend, buy a Cadillac, or even get arrested.

In reality, cash isn’t trash, but cash generally doesn’t belong in long-term investment portfolios, unless you are an avid investor trying to beat the market. Here are several problems with having your retirement funds invested in cash.

Market timing doesn’t work. Many investors, when nervous about the market, “go to cash.” And they wait it out until they “feel better about things.” If you do this, you are timing the market, which means you believe that some little voice inside of you will tell you when to jump back in. Virtually all research proves that marketing timing doesn’t work. Most of the large market moves come within weeks after markets hit bottom. No one consistently can predict market bottoms—not even you.

It is shocking to look at long-term compounded returns when one tries to market time. In “Winning the Loser’s Game,” Charley Ellis points out that from 1980–2003, if you cut out the best 30 days (just half of 1 percent of the total days over those 23 years), you would have lost about 40 percent of the gains. Find the right balance of fixed income (bonds) and stocks that you can live with during dramatic market moves and stick it out, no matter what the market is doing.

Cash deteriorates over time. While you sit with cash, thinking that at least you aren’t losing money, realize that you are living with a false sense of security. Cash is eroded every day by inflation. Forget the government numbers; they are manipulated so the entitlements like Social Security don’t get out of control. We all know that steak dinners, vacations, gas, and cars are all more expensive than they were ten years ago. If real inflation is 3 percent, that cash you have sitting around for five years just lost about 15 percent of its value.

Is your cash safe? Where is the safest place for your cash? Hiding dollar bills in safety deposit boxes? If you leave cash in a bank account, the FDIC will guarantee your money for up to $250,000 per depositor per bank. Leave cash in a brokerage account and it is usually automatically invested in money market funds, which aren’t necessarily safe. Money market funds buy all kinds of bonds in order to generate a rate of return. Today, your money market fund probably has international bonds from Greece, Italy, and other countries that are in bad financial condition. The greatest fear from regulators is that a money market fund “breaks the buck,” which means that the value of each share falls below $1. At least 36 of the 100 largest money market funds had to be propped up in order to survive the financial crisis.

A safe way to hold cash is buying BIL, which is an exchange-traded fund (ETF). Owning BIL gives you a basket of U.S. treasuries that have a remaining maturity of one to three months and have $250 million or more of outstanding face value. The expense ratio of BIL is 0.15 percent, and since treasuries yield about as much, this fund runs at a breakeven. But you own treasuries, which are safer owning a money market fund. Holding BIL in a brokerage account like Schwab or Fidelity ensures that you can claim it as your property if the broker goes bust.

Cash for spending needs, and a rainy day fund is fine. But for your long-term investment portfolio that you are managing to fund your retirement, having cash is like driving with the brakes on. The “safe” part of your portfolio should be invested in bonds, not cash.

Filed in Asset Allocation, ETFs & Index Funds | Comments (0)

MF Global’s PIIGS Problem

Thursday, November 3, 2011

For some investors this Halloween, a trick instead of a treat was found in their proverbial retirement portfolio bag. Why? Because of the spooky gift supplied to clients via MF Global’s announcement of bankruptcy, the eighth largest in U.S. history.

Any while many investors had previously never heard of MF Global, the firm’s failure led to an approximately 10 percent single-day hit to financial stocks. A better understanding of the MF Global debacle may help you exorcise the goblins that may be lurking in your investments.

Indecent exposure

Apart from the alleged $700 million in missing money and illegal activity, MF Global’s core investment problem was its gun-slinging investment approach towards the sovereign debt of Portugal, Ireland, Italy, Greece, and Spain (better known as PIIGS).

Upon filing for Chapter 11 bankruptcy Monday, margin calls of some $6.3 billion in Eurozone debt was revealed. That’s five times the size of MF Global’s equity. MF Global placed a very large bet on PIIGS and in the end, it got stuck in the mud. Ironically, MF Global’s homepage mission statement reads: “Working relentlessly to bring our clients superior market access, hardworking insights and powerful trading and hedging solutions.” If accusations of wrongdoing prove true, they apparently left out: illegal use of funds, shortcuts, and daredevil investing. Powerful indeed!

Just when you begin to feel a bit of relief that your retirement dollars aren’t with that firm, a bit of research reveals that U.S. bank exposure to PIIGS and Eurozone debt is substantial. According to a recent report by the Congressional Research Service, nearly 5 percent of total U.S. banking assets are in PIIGS. That may mean your institution is silently at risk as well. Add to the sobering $641 billion in PIIGS exposure by U.S. banks $1.2 trillion in exposure to German and French banks and you are left with significant risks to U.S. banking infrastructure in the event that the Eurozone goes caput.

This brings us back to our investment primer—be a hawk at diversifying assets and managing risk. Warren Buffett’s famous maxim for investing is simple: “Rule One: Never Lose Money. Rule Two: Never Forget Rule One.” In the case of MF Global, rule number one was long forgotten in favor of leaning dangerously out to grab the brass ring. How does your investment portfolio look when it comes to risk management? Do you have global exposure to six or seven asset classes, or are your investments all stuffed into one asset class in a reach for high returns?

Will the big bad wolf blow your house down?

Worse yet, initial statements seem to indicate that MF Global had more than poor asset allocation to worry about. According to a board member at the Greenwich, Connecticut, firm Interactive Brokers, there appears to be at least $700 million missing from client accounts. Interactive Brokers was pursing a possible acquisition of MF Global when the alleged wrongdoing emerged.

Broker-dealers are charged with keeping client funds separate from company dollars, but according to testimony, MF Global used client money unbeknownst to clients for its own internal investing. How can an investor know if his broker is behaving similarly? The obvious answer is one can’t. Surely, however, placing funds under the care of one of the leading discount brokers that is less inclined to get involved in more esoteric investment banking activities is a start.

How safe is my money?

Moody’s downgraded MF Global last week. This downgrade was met by MF Global’s CEO publically minimizing the rating adjustment. In fact, while MF Global was swirling the toilet, its marketing arm was simultaneously sending out letters to clients reassuring them of the firm’s strength. Once calamity struck, clients who called MF Global on Monday were met with nothing more than a voice recording.

When a similar catastrophe strikes your broker, how do you know your money is protected? Investors may be aware of the Securities Investors Protection Corporation, a government-created entity which provides account insurance and oversees liquidation proceedings. Not all accounts have SIPC protection, so the matter of first importance is to confirm that your account is covered.

If your dollars are in fact covered by SIPC, you must understand the SIPC is not a guarantee that you will receive all lost funds. Unlike the secure promise of FDIC bank account insurance, SIPC coverage must be applied for within a designated deadline and may not cover all forms of fraud. It is the responsibility of the investor to provide the appropriate proof of assets and documentation with his application.

Kevin Bell from SIPC was asked about the process. “What customers ask is, ‘When am I getting my money?’” said Mr. Bell. “You tell them to sit tight, and start gathering their information so they can file claims.”

Some investors thought they had their money securely tucked away in a credible investment house. This week they awoke to their own nightmare to discover that their money was locked away in a house of horrors. Take some time to do a bit of research and vet your broker. Find out what their PIIGS exposure actually is. See if they in fact have high ratings from the ratings agencies. And keep a copy of your records close at hand.

Filed in How Wall Street Makes Money, Malfeasance And Fraud, Portfolio Diversification | Comments (0)

Why Your Investment Portfolio Is Not Diversified

Friday, October 28, 2011

Some people think investing is all about picking the right stocks to “beat the market.” Peter Lynch and Warren Buffett are fabled stock pickers. Wall Street would certainly have you believe this notion because “beating the market” rings their register. And then investors are told that they should be diversified. Does that mean owning 30 stocks? Which 30? And what’s the point?

Own stock markets, not stocks. Diversification means that you own enough stocks in a “market” so that no one stock can have any kind of major impact on your portfolio. Many brokers buy their clients 30 large companies and declare, “You’re diversified!” You know, all the usual big names. So how did that work out in 2008 when the largest U.S. companies, like General Motors, General Electric, Citibank and Bank of America, dominated a portfolio? Not so well. Do you subscribe to Netflix? Reed Hastings, its CEO, was often hailed as the next Steve Jobs until last July when Netflix began falling from $300 per share down to $75 this week¬—a loss of 75 percent. Big or small, individual companies blow up. And it happens suddenly. Want to minimize the risks that come from bad things happening to “good” companies? That means owning thousands of stocks.

Look inside most mutual funds and you’ll see 100 stocks, but for all the wrong reasons. To be a successful mutual fund manager, you must concentrate your bets on your favorite stocks. It’s the only way they have a shot at outperforming the market. But mutual funds with big Netflix positions are underperforming this year. So the typical mutual fund manager figures out over time that he can lose his job trying to be a hero and turns into a “closet indexer,” exchanging job security for any chance of beating his market (and justifying his fees).

That’s why we only recommend ETFs. They get you stock diversification and save you 80 percent in fees. Want to invest in small U.S. companies? Why pick a few good companies or hire a mutual fund manager? Just own one ETF and you’ll own literally hundreds of stocks. Netflix? Let it crash! You’ll never notice.

Spread it around. And consider this: There are other stock markets outside of the United States. Germans don’t obsess about our Dow. Half of all companies are outside of the United States. And world markets tend to move quite independently. Therein lies the second secret of diversification: What causes some to go up often causes others go down.

Yale professors studied money managers over 10 years to uncover the source of their portfolio performance. They found that 90 percent of the returns came from which markets they invested in. Less than 10 percent came from the individual stocks they bought and the timing of buying and selling investments. For example, if they owned small-cap stocks and that group of stocks did well that year, the performance of that market was the source of their success—not the specific small-cap stocks they had chosen.

Markets are the ingredients of successful diversification—and the more you have, the better. Diversifying into markets is kind of like creating a prized recipe. Garlic, lemon, oregano, and thyme are not too appetizing on their own. But when skillfully combined with a host of other ingredients, the results can be spectacular.

You want to own a host of diverse markets, and not just “safe” ones. Horseradish might be dangerous if consumed by itself, but as part of an overall recipe, it delivers positive results. The same goes for adding risky markets. Adding one or two to the mix can have a leavening effect that may actually reduce risk and volatility, while adding to overall performance.

U.S. stocks and stocks in Europe, Japan, and Australia tend to move independently from each other. So allocating money to all of these markets creates instant diversification. Emerging markets like China, Russia, India, Brazil also move to the beat of a different drummer. Bonds and real estate are even further afield from stocks, so adding these markets provides excellent diversification. Every year, some market wins and others lose, and no expert can predict the future. So the answer is simple: Own them all!

With the proper mix of markets—U.S. stocks of large and small companies, foreign developed countries, emerging markets, U.S. government bonds, real estate, and commodities (using ETFs for each of these markets)—you can consider yourself fully diversified. Now that’s a good salad!

Filed in Asset Allocation, ETFs & Index Funds, Index Funds Versus Mutual Funds, Portfolio Diversification | Comments (0)

Who’s Occupying Your Portfolio?

Thursday, October 20, 2011

The Occupy Wall Street movement has become a topic of national discussion.

Camped out in lower Manhattan for over a month, the protestors have spawned copycat events across the nation and abroad. While some identify with the frustration of youth trying to break into a job market that supplies a meager one job for every five seekers and a youth unemployment rate of 18 percent, others take issue with the movement’s anti-capitalist hysteria that seeks to penalize hard-working and productive Americans.

So what’s the fuss?

Behind all the brouhaha, however, there are some very real frustrations that all Americans, left and right, can identify with. How is it that politicians and bankers were in cahoots creating loose-money legislation and convoluted debt-backed securities that in turn were sold to the unsuspecting? How is it that trillions of dollars of government debt in the form of TARP, QE1, QE2, and beyond have been placed upon the shoulders of future generations to somehow resolve? How is it that some of the very bankers who were complicit in this disaster that destroyed the financial lives of millions of hard working citizens in turn made off like bandits? How is it that the Feds have embraced an inflationary exit strategy that threatens every hard-earned dollar you have saved and invested?

While protestors and non-protestors alike seek to place the blame for this travesty at the right doorsteps, these protests expose some deep assumptions about what is owed to us as citizens. These assumptions, once exposed, reveal some important lessons on investing as well.

Many of the protestors believe that they have a right to a well-paying job. And why should they not expect this basic opportunity? It has been the inalienable right of every American generation to date, spare the Great Depression, and therefore is deeply embedded in the warp and woof of the American mind. This assumption, however, is proving to be ill founded. While much of the third world can only dream of the minimum wage opportunities America affords, we have come to expect a middle-class life as a fait accompli for most, or at least the college educated.

The new reality is that the middle class is shrinking before our eyes as jobs flee to other nations whose middle classes are emerging. And gone the way of the shrinking middle class is the shrinking American Dream. Once assumed to be on tap for all hard-working citizens, this fount of prosperity and success seems to be running dry for many.

Who’s occupying your portfolio?

The new realities are just now beginning to sink in for many investors. You deserve nothing. Times have changed. You can’t just waltz your way into the American middle class anymore. You can’t rely on being a benefactor of past generations. The middle class is shrinking, and many who fail to work harder and invest smarter will be moved out while others in the world economy are invited in.

Additionally, you cannot look to Wall Street or the U.S. government to look after your retirement. It appears that Social Security will eventually fail. When it comes to The Street, we now know that many money managers will work to their own benefit, and if you happen to benefit along the way, you lucked out. If not, it’s your tough luck.

The critical question for today’s investor is, “Who is occupying my portfolio?” Is it an investment advisor? A fund manager? A small selection of equities and thus a small sample of fallible corporate directors and executives? When you look into the virtual room of your own portfolio, do you find yourself both present and vigilant? Sadly, many will find themselves strangely absent. Often it is because they are fearful of getting it wrong. Whether you are a do-it-yourself investor or an investor who delegates his funds to a professional, your presence in knowing what is in your portfolio, both in terms of fees and investment vehicles, and why is critical.

Additionally, at times such as these, the beauty of index investing is revealed. You can remove the advisor risk. You remove the money manager risk. You remove the individual corporate corruption risk.

You enjoy spreading your bets broadly across hundreds if not thousands of companies and are left to focus on what matters most in portfolio management—asset allocation. Now it is up to you to get globally allocated, remain disciplined with rebalancing, and behave like an adult managing something of great importance.

In the end, some may choose to set up camp in a tent, point a finger, and occupy Wall Street. I suggest you occupy your portfolio instead.

Filed in Asset Allocation, Index Funds, Index Funds Versus Mutual Funds, Investment Advisors and Wealth Managers, Portfolio Diversification, Underperformance of Managers | Comments (0)

Why Your Retirement Account Underperforms Most Pensions

Thursday, October 13, 2011

There’s a retirement crisis brewing in America. We all know it is coming, but it is unclear what to do about it. In 2008, employees were complaining, “My 401(k) is now a 201(k).” Many unemployed baby boomers over 50 are having a hard time finding work, and if they do, they aren’t paid what they had been paid. But what does a retirement crisis mean to the individual investor?

Let’s look at three big trends that have created the “perfect storm.” First, in 1975, the stock market was in the middle of a 10-year period slump—much like today. The S&P 500 began the ’70s around 90, ended at 100, and bounced around between 65 and 120 throughout the decade. In those days, 27 million workers had corporate pension plans, and they were guaranteed a fixed amount at retirement. The corporations had to manage the pension funds properly to meet these obligations. But with a flat stock market, these obligations became greater than what pension plans could support. New accounting laws mandated that these “unfunded liabilities” be shown in public financial statements. Corporations had dramatic decreases in their values because of these pension obligations.

During this time, Congress also approved new laws that created the 401(k) and the IRA. These plans made the worker responsible for his own investing. Corporations effectively said, “Hey, employee—we’re not going to guarantee you a fixed pension each year, but we’ll guarantee you an amount we will contribute. You then have to manage your own money, and whatever you end up with is your problem!” But there was another problem. While employees were given responsibility, the securities laws didn’t protect them from the financial services industry. The financial advisers were not held to a high standard.

In 1975, about 72 percent of retirement funds were professionally managed by corporations. Today that has dropped to 23 percent, while the rest are managed by employees in 401(k) plans and IRAs. With less protection from advisers and brokers and less expertise, employees started paying more in fees with subpar advice.

Returns have suffered. Corporate pensions between 1998 and 2007 generated average returns in excess of 7 percent, while 401(k)s returned 5.4 percent, and IRAs only 4.5 percent. Over a working life, these differences can mean that two workers making the same contributions will end up with very different nest eggs. That 2 or 3 percent can mean that the corporate worker can end up with twice as much as a worker managing his own 401(k).

Second, baby boomers will increase the over-65-years-old population in the next 20 years from 35 million to 70 million. But that is only half of the story because this creates a double whammy. The baby boomers between the ages of 45 and 65 who are working today are paying Social Security and Medicare into the system through payroll deductions. When they retire, there will be fewer individuals collecting a paycheck that the government can tax. And baby boomers are going to live longer, so there will be more years that the government will have to take care of the aging.

The third trend, of course, is that the U.S. government is going into increasing amounts of debt, and cutting that debt is hardest when your population is aging. This means that the government will be forced to manipulate inflation rates, add a year or two to the retirement age, and reduce Medicare benefits.

Retirement investors must understand that a harsh new world is in front of us. You are responsible for managing your retirement. The sooner you prepare for the new realities, the better. Here are three ways to positively impact your nest egg at retirement:

Overall asset allocation. Add up your retirement accounts, 401(k)s, IRAs, and pensions for you and your spouse and look at them as one portfolio. Are the allocations right for you? If not, make some changes.

Orphan IRAs. Do you have multiple IRAs that came from 401(k) rollovers from past employers? Consider combining them so that the dollar amount becomes more meaningful. It helps focus attention. Brokers like Schwab and Fidelity like having more assets and they make it easy to combine IRAs. See if you can continue making yearly contributions. Even if they aren’t tax deductible, they will grow tax deferred.

Fees. Blindly choosing the recommended funds in a 401(k) plan without looking at the fees is a big mistake. Look for an index fund (usually the one with the lowest fee) in each category and you’ll never go wrong.

Filed in Financial & Retirement Planning | Comments (0)

Does Stock Forecasting Work?

Thursday, October 6, 2011

Remember Yahoo, Gordo. It’s like Abracadabra.

In the time travel movie Frequency, this Yahoo stock tip was passed through time to the six-year-old Gordo via a mysterious interplay of a ham radio and the aurora borealis. This small bit of incomprehensible information was not only retained by Gordo, but later, when he grew up and became a stock trader, it resulted in him not only being fat, but quite happy as well.

The power of knowing the future is profound. Just imagine, for a moment, if you were given the privilege of seeing stock market results one year from today. A resourceful individual could easily parlay that knowledge into profound wealth. It is no wonder that economists, stock traders, fund managers, and financial advisers alike are desperately trying to find a way to peak around the corner of time to anticipate what the markets will do.

Forecasting markets is not for the feint of heart. Take, for instance, the recent housing bust and subsequent recession. Top economists and investors alike failed to see it coming. Ben Bernanke, the Federal Reserve chairman, testified at the Financial Crisis Inquiry Commission (FCIC) that, “We knew all those numbers, of course, but a lot of smart people, including people like Paul Volcker and others, . . . got it wrong. It is just another example of how difficult it is to predict.” Furthermore, Alan Greenspan commented, “We all misjudged the risks involved. Everybody missed it—academia, the Federal Reserve, all the regulators.”

It was not only the economists that failed to see the crisis coming, but leading investors as well. Take George Soros as an example. He became one of the world’s richest people by predicting the UK currency collapse and betting accordingly, and yet he took an ill-fated stake in Lehman Brothers just before the bank failed in 2008. Likewise, Warren Buffett, the Oracle of Omaha, lost billions in the downturn and testified before the FCIC that “no one saw the housing bubble.”

But just when you think that such foresight is outside the reach of common man, some prognosticator emerges with a specific contrarian view and then with eerie accuracy hits the nail on the head. It’s as though he found his own flux capacitor-equipped DeLorean and sailed from the future to the present with otherworldly insight.

Take for instance, the small group of esteemed economists and financial managers that called the housing crisis. There is Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, D.C., who in the August 4, 2004 issue of The Nation gave a detailed warning concerning the coming housing crisis in an article called Bush’s House of Cards. His predictions were five years early and largely ignored. Then there is Med Jones, the president of the International Institute of Management (IIM), a U.S.-based research and education organization. Although Jones is less known, he turned out to be the most accurate in predicting many of the downturn’s details.

Nouriel Roubini, an NYU economics professor known as Dr. Doom for his wild and dire predictions, became a media darling because of his accurate foretelling of the crisis. More bearish still is Peter Schiff, who now famously predicted the housing collapse in nationally televised debates. Although ridiculed by experts, he showed great courage, and his detailed analysis proved right in the end.

It is these types of expert forecasts that make investors seek the next accurate prediction. Think of how you might have managed your portfolio differently if you had only listened to these warnings before the housing crash. Furthermore, today, there are forecasters out there who are nailing their predictions right before our eyes. A year from now, many will lament the fact that their laser-sharp predictions were carelessly ignored.

So how does an investor know which forecasts to follow and which to ignore? The first thought that comes to mind is to follow the predictions of those that have gotten it right in the past. This method, however, proves to be ill fated. Take, for instance, the four gurus that called the housing crisis. Since that time, each of these prognosticators has supplied a long list of additional predictions. Sadly, the overwhelming majority of them have been tragically afield. In a famous prediction from 2002, Peter Schiff asserted that the Nasdaq would hit 500 and that the Dow would crash to 4,000. If you had followed his advice, you would have lost your shirt.

Nouriel Roubini has made over 30 economic predictions since 2006, with 22 coming up wrong and seven still awaiting fulfillment. Well, at least he got one right—the housing crisis. Whereas Med Jones seems to have a better batting average, Dean Baker’s predictions are about 50/50.

In the end, stock forecasting seems to be a bit more Abracadabra than most investors would prefer. As much as we would like the aurora borealis or at least something or someone to whisper an accurate stock tip that would leave us fat and happy, we are left with the harsh reality that forecasters often flop.

With no real way of seeing around the corner of time, smart investors are left with the proven methods of global asset allocation, low-cost indexing, and disciplined rebalancing. This proven approach may not provide the wonders of time travel, but it does provide a nice bounty to the principled and disciplined—over the long haul.

Filed in Investment Advisors and Wealth Managers, Stock Brokers, Underperformance of Managers | Comments (0)

What Makes You Trust Anyone’s Investment Advice?

Friday, September 30, 2011

It is well documented in surveys and studies by financial institutions that when we seek investment help, we make choices based upon one major criterion: trust. It all boils down to this one word. Who is giving me the advice? Can I trust them?

If you are a hard-core do-it-yourself investor who loves to day-trade, you may trust the Motley Fool or the Daily Options Trader based upon the success of their recommendations. If you delegate your investing, you may trust your friend’s son who works at Smith Barney. You know, the one who got his Wharton MBA and plays with your kids.

Conmen and Ponzi scheme operators know how to get our trust by playing with our fears and our greed. The SEC knows it can’t regulate trust, but it does regulate how advisors engender it. Thanks to laws from the 1930s, an investment advisor cannot advertise testimonials from other clients. That’s why you never see advertisements showing celebrities like Oprah crowing, “Joe Morningstar is my favorite money manager! He helped me buy this estate in Maui!” In fact, social networks are panicking many investment advisors today. We wonder: If a client “likes” you on Facebook, is he endorsing your service and leaving you open to an SEC investigation?

We may look at past performance from mutual funds for trust. But this has been proven fallacious at best; thus the fine print noting that “past performance is no indication of future results.” And as we’ve written many times, the game of performance reporting is rigged. A bad mutual fund can buy up a high-performing one and just assume the latter’s track record.

But when it gets down to it, we must trust someone or something before handing over our dough.

Unfortunately, most investors fly blindly without ever thinking through the question of, “Who should earn my trust and why?” We continually encounter investors who own a variety of mutual funds, pay enormous fees, and have no idea that they are engaged in “active” investing. They believe that if they are buying products from a large institution, then they’ll achieve their goals. We meet investors who have delegated managing their money to an individual because he was on the Barron’s “Top Financial Advisors” list. Others find status by being able to say, “I’m a Goldman client.”

Giving our trust is a complex emotional dynamic that we’ll leave to the shrinks to articulate. But what can we learn about trust from the smartest investors in the world? Do the trustees of Yale sit with prospective hedge fund managers, look them in the eye, and then have a discussion about who has better eye contact and a more confident handshake? No. They develop investment trust, not by emotions or instincts, but through a logical evaluation of three dimensions in the following order:

1. The process. First and foremost, smart investors invest with an investment methodology. They adhere to a philosophical approach that they believe to be true about investing. For instance, Warren Buffett fans believe in buying out-of-favor, inefficiently priced stocks and holding them until everyone else changes their opinion. At MarketRiders, we focus on finding the right asset allocation and then recommending low-cost ETFs and a consistent rebalancing protocol. Vanguard fund owners have generally bought into the idea that low fees will make them more money, so they like passive investing instead of active investing. Whether or not you know anything about investing, you need to spend some time learning about the various investing “religions” and developing your own point of view.

2. The institution. Institutions come and go, as we’ve seen with Lehman Brothers and Bear Stearns. A “Wall Street Legacy” is an oxymoron. The names come and go. But doing business with a firm with a culture and track record of delivering on your process is nonetheless vitally important. The firm needs to be solid and have checks and balances and high standards of compliance. Why does Vanguard have over a trillion dollars under management? Because Jack Bogle’s original vision to help working Americans by building a not-for-profit organization has remained intact. Vanguard continually lowers its fees as it adds assets, and it adheres to its process of passive investing.

3. The person. If you have a belief in an investment process and have found an institution that embraces that process, then trusting the individual with whom you work becomes the last piece of the equation. You can make sure the individual has not been sanctioned by regulators and ask for background information. But make this is the last piece, not the first, for establishing trust. Trusting people and institutions before you’ve first developed a core belief about investing gets the whole thing backwards. Spend the time to understand the various investment philosophies and then develop your own point of view. Then look for people and institutions to help you implement it.

Filed in Uncategorized | Comments (0)

Are You the Dumb Money?

Thursday, September 22, 2011

In the hit comedy, Dumb and Dumber, Jim Carrey and Jeff Daniels play two guys that are so utterly moronic, that their inanity actually becomes their best asset. Without knowing it, their stupidity guides them past unperceived dangers and smack dab into the middle of unsuspecting success.

If only life worked so charmingly. But in the cold world of Wall Street, the dumb are preyed upon, while the dumber quickly become extinct. Not only is this true, it is actually celebrated as fact by financial mavens and the media alike who have captured this ethos through their invention of the terms smart and dumb money.

In closed-door discussions from the venture capital industry, through the hedge fund industry, past leveraged buy outs and all the way to traders of simple stocks and bonds, those in the know whimsically discuss what the smart money is doing to get rich, and of course, how the dumb money is helping them get there.

And in the event that you are late to the conversation, in their mind at least, you may be the dumb money. More specifically, the dumb money is the individual investor who watches CNBC for stock tips. It is the investor that gets a hunch, or better yet, at stock tip from a friend and acts upon it. The dumb money is the lemming like masses that plunge off the bluff and into the sea when despair is on tap, and double down on their investment when a sector is running hot.

Like the ocean tides that move in and out with shocking continuity, the pros believe the dumb money to be so predictable, that these hawks consider it a contrary indicator of what the markets are about to do. When the dumb money is rushing madly into gold, the smart money starts writing shorts. When the dumb money is sure that the S&P 500 is dog meat and is running for the door, the smart money grins and starts moving in.

Fear, Greed and the Dumb Cycle

Dumb investors get caught in a dumb cycle—buying high and selling low. As ridiculous as this behavior sounds, a closer look reveals how the strong emotions of fear and greed can drive even the most determined investor towards this sadly dim-witted behavior.

In any intellectual exercise, like a crossword puzzle, knowledge wins. But in the real world, behavioral scientists have demonstrated that a primal need for rewards and security give tremendous platform to the emotions of both fear and greed.

To understand the dumb cycle, you simply need to understand the role of fear and greed in driving investment decisions. When an investment is returning nicely, the greed gland kicks into overdrive commanding us to buy more of what is working. The investor then sells his poorly performing asset classes and buys more of his winning investment. Likewise, when all hell breaks loose, the fear gland begins to repetitiously squawk like a malfunctioning fire alarm within the investor’s mind. Sell, sell, sell is it commanding instructions. Run for the door.

A simple analysis of inflows and outflows of capital to and from the mutual fund industry easily illustrates this point. In 2000, the dot-com hysteria had people so frothy that they were dipping into their home equity lines to double down on the new gold rush. The NASDAQ ran up to 5,000 and had a one-year return of a shocking 80%. The greed gland was pumping out its buy commands and the masses were moving in perfect harmony. Then, by the fall of 2002, the NASDAQ party came to a crashing halt, plummeting quickly to half it value. Fear was the order of the day and as money rushed out of tech, it moved quickly into bonds that predictably were at a record high. The dumb cycle was complete.

You Don’t Have to Be Dumb

Although Wall Street might look at you as the dumb money, you can in fact become the smartest money of all. To overthrow fear and greed’s reign of terror, the smart investor must develop principles and policies that will usurp the primal impulses that otherwise lead inevitably to the investment funny farm.

By rooting your portfolio management in highly researched and scientifically demonstrated principles of global asset allocation, disciplined rebalancing and especially staying the course when others are loosing their cool, you become a member of the smart money club.

In seasons of wild market swings, investing takes faith—faith that stocks will do better than bonds, and that bonds will do better than cash, just like they always have. It requires faith that via diversified participation in the global free market, you will benefit from the rigors of millions of workers and thousands of companies striving daily to do well.

While Dumb and Dumber provides a great laugh on the sliver screen, being the smart money provides the best laugh of all.

Filed in How Wall Street Makes Money | Comments (0)

How Politics Affect Your Portfolio

Friday, September 9, 2011

The markets shuddered last week when the Bureau of Labor Statistics announced unemployment remained stalled at a dismal 9.1 percent. While this news launched a wave of rhetoric from politicians on potential solutions, for the layman the meaning and impact of such numbers can be deceiving. A deeper dive into the unemployment report, as well as other statistics, such as the inflation rate and mutual fund performance, reveals some shocking facts.

Unemployment. The U.S. government uses dishonest statistical skullduggery to calculate the “official unemployment rate.” Lying with statistics is easy. It is not how you count, it’s how you define what to count, and over the years both political parties have used this trickery.

When the government reports unemployment, it understandably excludes people that are under 16, institutionalized (in jail, hospital), are in the military, or retired. What many do not know, however, is that the government also excludes discouraged workers—people who want to work but have not been able to find a job and have given up looking after four weeks or longer. In this economic climate, there are many citizens who want to work but have taken an understandable hiatus from pounding their head against the wall of employment rejection. But by excluding all unemployed people who have not applied for a job in four short weeks, the unemployment rate is dramatically skewed downward.

A simpler way of looking at the unemployment story is through the often-overlooked employment-to-population ratio, or how many able-bodied adult Americans actually work compared to those that don’t. You may be shocked to learn that this number stands at just over 58 percent. There are many stay-at-home parents and others who are not interested in employment who should not be considered as unemployed, but to think that more than 4 out of 10 able-bodied Americans simply don’t have work is eye opening.

Inflation. What about inflation? Could it be that the governmentskews inflation number downward, too? The Consumer Price Index (CPI) is calculated monthly based on a basket of 84,000 goods. This sounds straight forward enough, but there is a twist. New methodology was introduced in the calculation of the CPI in which goods and services in the defined basket could be substituted. Some argued that if beef, for instance, goes up in price, consumers may switch to something cheaper like chicken. Therefore, items that are actually moving dramatically higher in price are switched out for “similar” items that are not inflating at the same dramatic rate.

Although there is a debate among economists on this new methodology, the renowned economist John Williams described this change as manipulative and suggested a return to the more honest and accurate fixed-basket methodology.

Why might the government prefer reporting a lower inflation rate? Could the fact that the government must make inflation adjustments to pension benefits, government entitlements such as Social Security, and even the returns on Treasury Inflation Protected Securities (TIPS) based on the CPI number? A higher number means much higher government expenditures.

Because the CPI is artificially skewed downward, it makes sense for investors to respond by adding to their TIPS allocation and other commodities such as gold and energy that help protect a portfolio from the actual rate of inflation.

Mutual fund returns. It is not just the government that may be trying to play you by the numbers. Take a closer look at your investment adviser and the mutual funds he may have sold you. When you receive your annual performance report from your adviser, note that most do not report the 1 to 1.5 percent fee taken from your portfolio annually.

Unfortunately, the story gets worse. Although mutual funds report performance after mutual fund fees, such reports do not take into consideration taxes—a kind of invisible fee. Although churning is against SEC rulings, according to Vanguard founder John Bogle, the average turnover for actively managed funds increased from 65 percent in 1975 to 90 percent in 2000. This buying and selling may help the fund report a higher return, but for the unassuming investor, the result is much lower performance.

Many of these churned stocks will create tax liabilities, some at short-term interest rates, reducing the performance of the fund significantly. When you add the invisible fee of taxes to adviser fees, it’s no wonder index funds and ETFs with low fee structures and tax efficiency are rapidly becoming the preferred investment choice for so many.

When it comes to investing, it pays to know the real numbers both in your portfolio and the economy. By having honest reporting, you can make informed decisions that protect and guide your retirement future.

Filed in Index Funds Versus Mutual Funds | Comments (0)

Are You Gambling or Investing?

Thursday, September 1, 2011

Are you saving money to travel, buy things you want, help the charities and people you love, send kids to college, stop working, or just plain relax?

If so, consult your favorite Wall Street broker, mutual fund, or become a stock picker yourself. Either way, within 20 years, say goodbye to 33 percent of your money and many of those dreams.

How could this be true? Most people confuse investing with gambling. Gamblers try to “beat the house.” Investors want to be “the house.” Imagine a casino in Las Vegas called World Markets Casino. World Markets offers all kinds of gaming options—blackjack, poker, roulette, craps, slots—along with great food, entertainment, and well-appointed rooms.

Guests have a lot of fun at World Markets—the excitement of gambling, the thrill of winning and losing. Some come in with various “systems” like statistical models and card counting systems to beat World Markets. Others talk to God. Poker players have their favorite seat.

There was a Grandma who dropped a quarter in a slot machine and won $250,000. Another person who had never played blackjack hit 21 in his first hand, made $50,000, and proposed and married his girlfriend all in one great evening.

It’s fun being at World Markets—just look at the posters and marketing brochures.

But most guests don’t just play, win, and leave. They continue playing and that’s what World Markets counts on. Like all casinos, it has special “house” odds. Sooner or later World Markets will win more money than it will lose due to human nature and statistics. Depending on the game and how wagers are placed, the casino earns up to a 35 percent commission from the winnings. It is impossible to do consistently, but guests come year after year to try to beat the house.

Suppose you buy stock and invest in the imaginary World Markets, Inc. (WMKTS). Investors care about one thing only: making money. They’re not concerned with having fun or discussing the night they had the “hot dice” at the craps table. They could care less if they ever hear the noise of a winning pull at a slot machine. They just want to know that they’ll make money year after year after year.

World Markets investors never know from night to night where they’ll make money. Some nights there’s a guest with a streak of luck on the craps table and the casino loses money there. But that same night, perhaps World Markets is making money on blackjack. On nights where guests are beating the house on all tables, the casino is still picking up antes from the poker tables, and making money on food, hotel rooms, and entertainment.

World Markets investors are “the house,” and ultimately those investors always make more money investing in the house than its guests who are trying to beat the house. It’s just a statistical fact.

But how is it that most people invest their own money as if they were gamblers at World Markets, instead of investors?

Most investors attempt to “beat the house” of world asset markets—U.S stocks, bonds, real estate, foreign stocks, emerging market stocks—by picking stocks on their own, giving their money to a broker who they believe is a good “stock picker,” or investing in a mutual fund that has a great track record.

But reams of studies from experts have confirmed that investors do worse than the house by the money they spend trying to beat it. Investors leave an average of 2 percent of their money every year at World Markets and pay more taxes because buying and selling stocks creates taxable income. Over time, due to mathematical laws such as compound returns, investors can lose 33 percent of their money over 20 years—just like a guest at World Markets Casino.

So how do you become an investor in World Markets instead of a gambler? Buy and hold a collection of exchange-traded funds (ETFs).

For every $100,000 invested, you’ll pay $200 in yearly fees, instead of $2,000 in fees to money managers, financial advisers, and broker commissions. You can invest like smart investors and endowments at Yale, Harvard, Princeton, and Stanford. You’ll never have to pick a stock or mutual fund again. And you can dial the risk levels of your portfolio up or down to whatever level you feel comfortable.

Be the house, not the guest.

Filed in Active Versus Passive Investing, ETFs & Index Funds, How Wall Street Makes Money | Comments (0)

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