MarketRiders Blog

How to Manage Your Investment Anxiety

Friday, August 26, 2011

As uncouth as it may be, worrying about one’s investments seems to be the order of the day. And it’s no wonder. As the markets careen to and fro, publications are replete with stories of advisors and Wall Street pros dumping their stocks in favor or bonds and cash as they scurry to the sidelines.

And, as usual, the average retirement investor feels caught off balance and a few steps behind the curve. What is the ordinary investor to do? It does feel a bit like 2008 again, doesn’t it? Is it too late to take a cue from the pros, pull up stakes on a long-term investment mentality and find a nearby bunker to hunker down in with a bag of bonds now returning less than the rate of inflation?

At times like these, simple positive thinking doesn’t seem to extract the thorn of worry from the back of the investor’s mind. As much as he conjures up Bobby McFerrin’s “Don’t Worry Be Happy” chorus or hums a bar of “Hakuna Matata,” the worry seem to still creep in at unexpected moments like a terrible and relentless rot.

Investment anxiety, however, can be tamed. They key is having a clear understanding of those things that should and should not be on your list of worries. Let’s begin with what not to worry about – the direction of the markets.

I Don’t Know and I Don’t Care

The famous financial columnist, Jason Zwieg, once wrote powerfully about how index investing liberates the investor from the anxieties of trying to predict market movements. His words from 2001 are as relevant today as they were then:

Indexing enables you to say seven magic words: “I don’t know, and I don’t care.”

Will value stocks do better than growth stocks? I don’t know, and I don’t care – my index fund owns both. Will health care stocks be the best bet for the next 20 years? I don’t know, and I don’t care – my index fund owns them. What’s the next Microsoft? I don’t know, and I don’t care – as soon as it’s big enough to own, my index fund will have it, and I’ll go along for the ride.

Indexing enables me to say, “I don’t know, and I don’t care,” liberating me from the feeling that I need to forecast what the market is about to do. That gives me more time and mental energy for the important things in life, like playing with my kids and working in my garden.

When it comes to worrying, one should only worry about what he or she can control. Although countless have tried to control the public markets through worry filled hours of mental consternation and sleepless nights, markets rarely, if ever, obey. Therefore, the current vagaries of the market need to be ignored in exchange for the science of long-range planning based on hard, cold investment facts. It may seem like the world is falling into a hole, but investment science indicates otherwise.

Those who have the courage to ride the markets through the ups and downs, holding their course over decades, will be handsomely rewarded.

I Do Know and I Do, In Fact, Care

There are some aspects of investing that, in fact, are worthy of serious retirement investor’s attention. Two elements within the intelligent investor’s control are asset allocation and investment costs.

While millions of Americans tune into Jim Cramer’s Mad Money to watch him race about with his shrieks, squeaks and squeals, proclaiming what stock to buy or sell, the intelligent investor understands that the research is conclusive – 90% of investment returns are rooted in asset allocation, not stock picking. Therefore, the intelligent investor focuses his energy on identifying six or seven asset classes, with as little correlation as possible – U.S. equities, foreign developed stocks, emerging markets, commodities like gold and energy, real estate investment trusts, inflation-protected Treasuries, bonds and possibly more.

The investor then works carefully to identify, based on his risk tolerance, time horizon and other factors, the appropriate mix of theses assets classes for his portfolio. Once the portfolio is constructed, the investor rigorously maintains his allocations over the years, making adjustments only when his needs dictate a need for investment policy changes – not because Cramer bonked his bonker or because of any other market madness.

Finally, the intelligent investor overcomes investment anxiety by driving all unnecessary investment costs far from his portfolio. While market movements cannot be controlled, costs can be. Therefore, the investor makes sure to use low cost index funds and ETFs as essential building blocks for a diversified portfolio. Instead of paying one to one-and-a-half points for mutual funds the intelligent investor is able to achieve global diversification for around one fifth of one percent annually.

Additionally, by removing all unnecessary intermediaries that stand between the investor and his money, agency risk is dramatically reduced. The investor no longer needs to fret that some money manager is going to go AWOL with his retirement dollars or that he is going to become an unwilling participant in the next episode of the ongoing Wall Street saga of investor meets crook.

Like Wilkie Collins, the famous English novelist, once said, “Peace rules the day when reason rules the mind.” By accepting your inability to control or predict the markets, and embracing your ability to drive down fees and construct wise allocations, you too can shirk Wall Street madness and say goodbye to investment anxiety.

Remember the Law of Compound Returns

Friday, August 19, 2011

When the markets get turbulent as they are today, investors get emotional. We want to react. Today is a fear day, but last month there were greed days. On fear days, we react. We wonder, “How much more money can I lose? Should I be getting out?” On greed days, we get excited and after looking at what we “shoulda, woulda, coulda” done, we get anxious and may buy into a rising tide.

But what is the purpose of investing? It sounds like a stupid question, but ask 10 investors, and you’ll get a surprising variety of answers. Is there an answer that allows us to conduct ourselves in a rational way that is not influenced by fear and greed?

Try this out. A recent biography on the world’s most famous investor is titled “The Snowball—Warren Buffett and the Business of Life.” The term “snowball” is a metaphor for a core investment concept: the law of compound returns. Understanding it is critical to your success as an investor and should be at the center of all your investment decisions.

Think of the law of compound returns as a force of nature that describes how wealth grows. A small snowball rolling down a hill will gather weight, which increases its speed, which keeps increasing its size. Wet snow and a long hill are the conditions that turn a snowball into a very large boulder. Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.

Trading, taxes, and fees. Management fees and taxes dry out your snow. A small difference can mean the difference between having a boulder when you retire, or a snowball. Have you checked the taxes you’re paying on your mutual funds? It’s probably taking 1 to 2 percent off your returns because managers change all the stocks out an average of once every 18 months. Mutual fund charges, broker, or advisors fees on portfolios average 2 percent. But index funds and ETFs run about 0.25 percent. You might not think that’s a big difference.

But here’s how it is. Take a $100,000 portfolio. Using the market’s long-term average growth of 10.4 percent a year, compounding your gains over 20 years, and deducting the 3 percent in fees and taxes, you’d have $287,928 after taxes. But if your fees and taxes were 0.25 percent instead of 3 percent, you would have $607,465. That’s over a 100 percent difference! That’s double your money. All based upon a tiny difference in fees and taxes of 2.75 percent.

How quickly will your money double? Einstein’s “Rule of 72″ says if you take your yearly percent return and divide into 72, you get the number of years it takes to double your money. Let’s start with $100,000. If you have a 9 percent return (divided into 72), your money will double in eight years ($200,000). In another eight years, you would have $400,000, and so on. But if you get a 6 percent return (divided into 72), your money will double every 12 years ($200,000). Within 24 years, someone getting 9 percent will have twice as much as someone getting 6 percent.

Here’s an answer to the initial question. Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming. Then you must help the law of compound returns work its magic. It is not to compete against the stock pickers and market timers on Wall Street—or even hire one to manage your money.

No one can give you a longer hill—your age and personal working situation define your time horizon. But you can keep your snow wet. Taxes, trying to time the market, paying large investment fees, and making investment mistakes interrupt the law of compound returns and lower your returns. They dry out your snow.

So when the market has ups and downs, remember that if positioned correctly, your portfolio will grow over time—capitalism demands a return. Your job is not to react to your fear and your greed, but rather to stay out of the way, remove the obstacles to the law of compound returns, and let this force work its magic on your money.

Filed in Law of Compound Returns | Comments (0)

How to Invest for the Long Run

Thursday, August 11, 2011

Well, we’re scared, but we ain’t shakin’
Kinda bent, but we ain’t breakin’ in the long run
Ooh, I want to tell you, it’s a long run in the long run

The Eagles, The Long Run

The Eagles understood something about relationships that many investors have yet to learn about portfolio management. Success is measured in the long run.

In both romance and investing, bright beginnings inevitably turn to tougher times that test our metal. What we do in such moments as investors will significantly impact our retirement outcome and reveal if we are the type that runs for the door or hangs tough to see a better outcome.

The principled investor buys equities based in policy driven portfolio management, not inspiration. With cold-hearted accuracy, these investors know that as soon as they make their purchase, their investment is as likely to go down as up. They don’t care. They are thinking about a five, ten, twenty, even thirty-year time horizon.

The inspired investor, however, is in a sense looking for a touch of magic in their purchase. It may be the investments PE ratio, technical characteristics or even an insightful analysis from a trusted expert that makes this investment irresistible. There are countless reasons the inspired investor falls in love, but in every case, the same expectation is shared – that this new object of affection will break free of the market’s gravitational pull and float skyward towards unfettered wealth.

When such an investor finds his special equity, he can’t help but feel a smidge of infatuation with his new purchase. In this early phase of the investment cycle, the investor is dancing with Cinderella under the stars in all her glory. But even for Cinderella midnight must eventually come.

When that inevitable moment strikes and sends his darling plummeting, the inspired investor is gripped with horror as he watches his Cinderella like vision of beauty and grace turn into a soot covered house cleaner tumbling down the boulevard like a tattered pumpkin towards what appears to be an ignominious demise. At such a moment, we learn if the investor is merely a one-night stand specialist or a truly inspired prince who is in it for the long run.

Are U.S. Companies Really Worth 15% Less Than One Week Ago?

Infatuated investors are also those that suffer the greatest whipsaw effect. As the fret mongers and deep-dive analyzers abounded this week decrying the demise of American ingenuity and business, their dour chorus crushed many an investor’s inspiration, turning it to disillusionment. As quickly as these inspired souls rushed in, they now in turn rush out with similar enthusiasm.

This whipsaw effect was sadly illustrated once again in this week’s market crash. And strangely, this crash was accompanied by the pundit’s singular focus on the bad news leaving the story about corporate earnings mostly unnoticed.

It is early in the second quarter earning season with just 143 of the S&P 500 firms reporting. And the reports are promising. 75% of firms have reported earning above expectations. 13% have met expectation and a mere 13% have missed targets. Historically, only 62% beat expectations.

Furthermore, the earnings details are also quite encouraging. Average earnings for those reporting is 9.2% over last year – good but not shockingly good. Take into consideration, however, that Bank of America had to settle a lawsuit that represents a one-time, non-recurring expense, remove that singular expense from the calculations, and earnings skyrocket to a very encouraging 15.2% over last year.

More firms must still report and surely it will not all be good news. But apart from the dour media makers, reality tells us that U.S. companies are essentially earning 15% more while the public markets just decided that they are worth 15% less.

Buy, Hold and Rebalance

Buy low and sell high. It is a simple principle to understand, but much more difficult to follow, especially in times like these. We can all look back at ’08 and recall the many testimonies of those that ran for the door when the DOW was at 7,000, just to in turn stand on the sidelines, paralyzed, as the markets moved back up to 12,000. Don’t be that investor. It is easy to get out but very difficult to know when to get back in. If you miss a few critical days of market movement, you miss most of your portfolio growth. As others run for the door in fear, follow Buffett’s famous adage and be bold to buy. For the flint-jawed long term investors, now may be the perfect time to trim winners and buy losers in principle driven rebalancing act.

When all hell broke loose for Prince Charming, he knew that the slipper in his hand belonged to a woman he was not going to let go of. As an investor, do you know that your investments are worth holding onto? If in fact you own a globally diversified portfolio of low-cost index funds or ETFs, you can rest assured that today’s pumpkin will in fact transform into tomorrow’s carriage, yet once again.

Filed in Active Versus Passive Investing, Modern Portfolio Theory | Comments (0)

Phyllis Borzi Wants to Save Your IRA

Thursday, August 4, 2011

Just when you think that our government is full of incompetent career politicians who can’t get anything right, a real hero rides in.

You’ve probably never heard of Phyllis Borzi. She is an assistant secretary at the Department of Labor and she’s helping you and our country in ways few will ever appreciate.

We’ve written extensively about the inherent conflicts of interest when you trust someone with your money. In finance circles, it is called “agency risk.” Yes, your broker, or mutual fund manager may not fully put your interests ahead of their own. These conflicts almost define how the investment management business operates and is regulated.

Borzi runs the Employee Benefits Security Administration (EBSA), which “pursues policies that encourage retirement savings and that promote retirement security for all working Americans.” Our retirement security depends in large measure on the sound investment of more than $11.2 trillion in pensions, 401(k) accounts, and IRAs. To guide our decisions, we get advice from trusted experts.

But a flawed 35-year-old rule gives brokers a loophole that allows them to skirt these fiduciary standards. Under her stewardship, the Department of Labor has been pushing through regulations that would force service providers to disclose fees and limit conflicts of interest.

“The law on its face is simple enough: advisers should put their clients’ interests first. But as always the devil is in the details – in this case, in the question of what constitutes paid investment advice,” Borzi said last week before a House committee. “(We) will amend a flawed 35- year-old rule under which advice about investments is not considered to be “investment advice” merely because, for example, the advice was only given once, or because the adviser disavows any understanding that the advice would serve as a primary basis for the investment decision.”

When it comes to your retirement savings, fiduciaries who advise you have a duty of “undivided loyalty” to your interests, to act prudently when giving advice. You can sue a fiduciary personally for any losses arising from breaches of such duties.

But the 1975 laws were made before 401(k)s and at the inception of IRAs. The loopholes and technicalities let brokers easily dodge fiduciary status. Borzi has reams of evidence showing that because of this, IRAs are dramatically underperforming 401(k)s.

“For additional evidence, consider the underperformance of IRAs relative to plans, the size of the gap is troubling,” Borzi said. “IRA holders do not have the benefit of an employer to represent their interests in dealing with advisers. From 1998 to 2007, the average annual returns for IRAs were 4.5 percent, compared with 5.4 percent for 401(k)s. IRA holders often pay fees that can be two to three times higher than the fees paid by employee benefit plan participants.”

Borzi believes that Americans with 401(k)s and IRAs are entitled to receive impartial investment advice and wants to ensure that you can see the fees you are paying. Her new proposals would protect us and our IRAs from conflicts of interest and self-dealing by correcting outdated 1975 rules.

The brokerage investment community is having a fit because many IRAs today are held by brokers, not advisers. Brokers do not have to live up to a fiduciary standard and can get paid for advice by commissions for trades and by getting a piece of the fees you pay to mutual funds. Brokers claim they are not fiduciaries because they “disclaim any understanding that their advice might constitute a primary basis for the IRA holders’ investment decisions.”

If brokers become fiduciaries, they could not accept commissions or revenue sharing payments. To do so would constitute “fiduciary self-dealing,” which is prohibited. They would have to be transparent and show you what you are paying.

They have submitted hundreds of comments, even going so far as to claim that Borzi’s proposals would increase costs to the investor.

Borzi is on a mission to change the system so anyone getting advice on IRAs could receive an extra 1 to 2 percent return by eliminating the conflicts. Fees would go down and investors would retire with more. There are 75 million IRA accounts with $4.7 Trillion invested. If she impacts half of that and help investors keep another 1 percent, that’s almost $24 billion each year that will stay in our pockets.

Filed in Financial & Retirement Planning, How Wall Street Makes Money | Comments (0)

Americans are More Indebted Than the U.S. Government

Thursday, July 28, 2011

You may remember J. Wellington Wimpy, more commonly known simply as Wimpy, Popeye’s beloved friend from the iconic comic strip. Wimpy was soft-spoken and intelligent, but also cowardly, lazy, stingy, and gluttonous. A true scam artist, Wimpy usually finagled his favorite meal, a hamburger, from some unsuspecting patron at the local diner. Wimpy’s parsimonious ways included his famous con line, “I’ll gladly pay you Tuesday for a hamburger today.” Decades later, this character, created in 1932 during the Great Depression, has become a symbol of fiscal irresponsibility.

Today, the United States is facing its own Wimpy-esque moment in the form of the debt ceiling. The free burgers have flowed for sometime now, but the patrons have grown wise to the scam. The pitch of pushing off today’s payment until some future Tuesday has become a bit haggard and worn thin for many in America. Simply look to Greece, Portugal, Spain, and others to see what it is like to have one’s hamburgers taken away—and the forced diet does not look pretty.

Strangely, as the U.S. citizenry passionately criticizes their government for running up the budget deficit, a greater irony is afoot: When it comes to debt management, Americans are sadly worse than their government.

While government debt sits at 94 percent of national revenue, U.S. household debt sits at a whopping 107 percent of personal income. The household balance sheets of Americans are in worse condition than anytime since the Great Depression. The ratio of household debt-to-GDP is greater than anytime since 1929. And while we all are trying to comprehend a poorer nation, many American’s have not yet comprehended their own personal poverty.

A burger today? From the early 1940s through the late 1960s, an ethos of saving before spending ruled the roost. If you sought to buy a house, 20 percent was required for a down payment. Similarly, substantial savings were required to buy a car, and home furnishings, clothing, and more were paid for primarily with cash. By the 1970s, however, rampant inflation helped form a debt culture that found footing and gained steam.

If you saved, inflation threatened to erode the value of your savings, while the price of your desired purchases continued to rise. What was the point of saving when individuals could buy with little to nothing down, deduct interest from their federal tax obligations, and have those things they longed for?

Over the coming decades, American household debt ballooned, eventually doubling from $7 trillion to $14 trillion between 2001 and 2007. Debt fears, however, were assuaged by the rapidly growing value of real estate as homeowners used equity lines to buy more property, cars, and pay for vacations and toys. Burgers were flowing for all.

Then in 2008, the sudden and violent decline in house prices revealed just how bad the debt binge had been. Tuesday had finally arrived and like Wimpy, our wallets were a bit too thin to meet our obligations.

Feeding the furnace or building an engine. Criticizing government fiscal irresponsibility should in turn lead us to honest self examination. At the heart of this audit should be the confrontation of personal debt and the embracing of basic investing disciplines.

Each person must make a decision to feed the debt furnace or build a retirement engine.

Like Wimpy, we all experience the gnawing hunger to consume more than we need. Each time we reach out, through credit, for a burger today, we take our future dollars and throw them into the blazing furnace of consumption. The heat of the moment is delightful, but the end result is the poverty unfolding before our nation.

When we behave like wise and disciplined investors, we resist our pulsing appetites, take our hard earned dollars, and direct a predetermined portion to smart, long-term investments. In doing so, such investors build an engine through the miraculous power of compounding interest. Unlike Wimpy and other debtors, this interest works in your favor. Ben Franklin understood that for such savers, “Money can beget money, and its offspring can beget more.” Einstein called compounding the “eighth wonder of the world.”

Those who reject debt and invest wisely create a powerful engine, so that Tuesday’s obligations can be fully met on time, leaving a few burgers to spare.

Filed in Financial & Retirement Planning, Law of Compound Returns | Comments (0)

Why Most Market Forecasters Get it Wrong

Friday, July 22, 2011

Be it a football game, the weather, an election, or the future of Middle East uprisings, people want to know what will happen before it does. We want to know the future, and we actively seek out experts who can predict it. But facts show that in most pursuits where dynamic and multiple variables determine what will happen, experts are not good at predicting the future. And to make matters worse, those who predict are rarely held accountable for their prognostications.

Take politics, for example. Philip Tetlock, a psychology professor at the University of Pennsylvania, conducted a study that became a book called Expert Political Judgement. He tracked about 80,000 forecasts from nearly 300 political experts over 20 years regarding political events in many countries. He tracked the outcomes of their forecasts against a group of college undergraduates making subjective predictions and a group who just made random guesses. The experts did slightly better, but not much. Nevertheless, they got on TV frequently and built their names and reputations.

Christina Fang, a professor of management at NYU’s Stern business school, tracked the Wall Street Journal‘s Survey of Economic Forecasts to find out how accurate these highly paid analysts’ forecasts were when billions of dollars were at stake. Surely this would lead to more accurate predictions. Her paper, “Predicting the Next Big Thing: Success as a Signal of Poor Judgement,” draws some stunning conclusions.

Fang concludes that rather than being an indication of good judgment, accurately forecasting a rare event, such as business success, may in fact be an indication of poor judgment. On National Public Radio, she said, “If you look at the extreme outcomes, either extremely bad outcomes or extremely good outcomes, you see that those people who correctly predicted either extremely good or extremely bad outcomes, they’re likely to have overall lower level of accuracy. In other words, they’re doing poorer in general. … Our research suggests that for someone who has successfully predicted those events … they are not likely to repeat their success very often. In other words, their overall capability is likely to be not as impressive as their apparent success seems to be.”

Consider how those who predict make money on Wall Street. Because there is no way to hold financial forecasters accountable for their incorrect predictions, they get more out of making wild ones. Wild predictions pay because the downside of being wrong is zilch, but the upside is lifelong fame. When those who make them are right, they get to manage more money, sell more books, and garner tremendous publicity for many years to come.

Consider the 2008 market crash. The best-selling books today are being written about those who called the crash such as John Paulson and those featured in Michael Lewis’s book The Big Short. Those who were right will continue monetizing their correct prediction for many years to come. They are today’s seers. But literally hundreds of pundits on CNBC got it wrong. Who were they? We’ll never know—no one has any incentive to embarrass those who were wrong. Imagine seeing a pundit on CNBC with statistics showing how accurate their predictions were, like baseball statistics each time a player walks onto the mound.

We face a showdown between Congress and the president on lifting the budget deficit ceiling. The fact is, no one knows when or what deal will be cut. Those who are predicting this outcome are guessing. The ultimate effect on stocks and bonds in the short or long term is also unknown. But we keep tuning in, hoping for an answer, listening to confident and educated individuals making predictions.

As avid index investors, we make only one prediction: In a global, capitalistic economy, investors are rewarded for the risk they take in deploying their capital. If in bonds, investors will be rewarded as a lender. If in small-cap stocks, investors will be rewarded for increased equity risks. This prediction is rooted in empirical evidence and fundamental principals of our economic system. The rest is expensive and distracting noise. Predicting the ebbs and flows of that noise only serves to help money managers increase their assets under management and financial authors to sell more books and newsletters.

So next time you find yourself glued to a financial soothsayer making a prediction, stay far away from the trade button.

Filed in Active Versus Passive Investing | Comments (0)

Investment Secrets: How to Worry More and Make Less

Friday, July 15, 2011

We all love stories in which failure breeds success: Michael Jordan being cut from his high school basketball team, Thomas Edison being told by a teacher that he was too stupid to learn, Marilyn Monroe being dropped by 20th Century Fox for being unattractive and unable to act. Such inspirational stories grace the pages of self-help manuals and provide inspiration as we all struggle to learn and grow.

Unfortunately, for every account of failure turned to success, there seems to be a deep reservoir of plain old ugly failure that leads to nowhere. Whether it is the ignominy of WebTV, the demise of the billion dollar USFL and XFL football leagues, or the more recent demise of Bear Stearns, Lehman Brothers, and IndyMac Bank, the choices are plentiful.

Particularly intriguing are failures from leaders that somehow find a way to snatch defeat from what otherwise appears to be the inevitable jaws of victory. In this year’s Indy 500, JR Hildebrand was one turn away from winning the prestigious race on his first try. Then, within sight of the checkered flag, the 23-year-old Californian made the ultimate rookie mistake. After successfully racing 499.8 miles, he slammed into the wall on the final turn, and Dan Wheldon drove past him to claim an improbable Indy 500 win.

Transforming inevitable success into ignominious failure is not reserved for corporations and sports stars. Possibly the saddest example may be found in the everyday retirement investor. Recent research by Michael Mauboussin, Columbia University professor, has revealed this in three simple numbers: 9, 7.5, and 6.

Nine percent is the annual historic growth of the S&P 500. The average investor could simply buy and hold the S&P 500 Index, go play golf, and look up in twenty years to see a nice achievement—9 percent returned year after year.

If, however, a retirement investor is not happy with this 9 percent success, he can hire a professional mutual fund manager to actively manage his money in an effort to beat the market. This brings us to our second number—7.5 percent, or the historic annual returns of actively managed mutual funds. The spread between the historic returns of the S&P 500 and the historic returns of actively managed mutual funds is 1.5 percent or the amount collected in fees by these Wall Street pros.

And now on to our final number: 6. According to Mauboussin’s findings, 6 percent is the actual historic return that everyday retirement investors in America achieve over time. What is the cause you may ask? The research reveals that this shocking underachievement is rooted in one simple ailment – efforts to time the market that go awry.

Poor market timing is rooted in the emotions of fear and greed—the two mortal sins of investing. While investment giants like Warren Buffet have long understood that the wise investor should “be fearful when others are greedy and be greedy when others are fearful,” the everyday investor underachieves by following the opposite principle.

When markets are flying high the everyday investor allows greed to kick in, leading these underperformers to hold on for more or even double down on their winning stocks. Unable to embrace the portfolio management discipline of trimming winning picks and buying losers, these investors set themselves up for the next big market adjustment. Eventually, the bubble bursts. When such market corrections hit, the everyday investor lets fear take the helm. Fear demands that the underperformer exit his position and rush to the safety of cash or bonds. In doing so, the cycle is complete, leaving the everyday investor with fewer retirement dollars and more sleepless nights.

If you prefer to worry more, sleep less and lose money, you now know how the everyday investor consistently achieves these aims. For those inclined towards more peaceful living and higher returns, low cost global diversification and disciplined rebalancing win the day.

Filed in Active Versus Passive Investing, ETFs & Index Funds | Comments (0)

ETFs Keep Uncle Sam and Wall Street at Bay

Friday, July 8, 2011

You’ve got money to invest. But it seems that once you have a few bucks, everyone wants to put their hand in your pocket—and keep it there—forever! We’re not talking about your loser brother-in-law. We’re talking about real business partners who want big percentages of all your returns.

In the last 80 years, stocks have returned about 10 percent, while bonds have returned about 5 percent. An average balanced portfolio should therefore return around 7.5 percent over a long time period. If you grow your money at 7.5 percent each year, you’ll double your money every 9 to 10 years. Let us call these “returns before advice and taxes.” This is the baseline.

Paying for investment help can be very expensive. If you pay mutual fund and advisory fees of 2.5 percent, you have a silent “business partner” who is taking a third of your 7.5 percent investment profits for advice. Over a 20-year period, unless these advisers are making up the difference, which is statistically close to impossible, you lose big money—slowly, quietly, and imperceptibly. Your account will grow in good years, but it won’t grow enough. Over time, you’ll notice that everything is becoming more expensive and your portfolio is “small” when years ago it seemed much larger.

If investment advice doesn’t do you in, taxes will. Mutual funds and advisers never report investment returns “after tax” because this would dramatically reduce returns. Most mutual funds are trading machines, generating huge amounts of short-term capital gains. But taxes are never factored into the advertising. Let’s say that federal and state taxes are 40 percent on short-term gains and 20 percent on long-term gains. You invest in two funds. Let’s call them the “Furious Trading Fund” and the “Buy and Forget Fund.” If Furious is up 15 percent, you’ll net 10 percent after tax. But Buy and Forget only needs to be up 12.5 percent, to net you same 10 percent after tax. Furious has to do 20 percent better than Buy and Forget just to get you to the same place!

Smart investors don’t pay much in taxes on their investments because they don’t trade in and out their positions. They spread their money around the world in different types of stocks and bonds in percentages based upon their objectives (called “asset allocation”) using exchange-traded funds (ETFs). They own a core portfolio with most of their net worth consisting of 10 to 15 ETFs to get nearly complete diversity in stocks, real estate, commodities, and bonds. Each ETF represents an entire stock or bond market that is an essential ingredient to a portfolio. They hold these same ETFs forever.

But this is far from “buy and hold.” Over time, the relative proportions of each ETF within the portfolio will need to change. If bonds are up this year and stocks are down, it is critical to trim bond ETFs and add to stock ETFs. People age and should start shifting more of the portfolio into bonds: same ETFs, different weightings.

Here’s where taxes are minimized. After owning a passively managed ETF portfolio for one year, all gains that come from selling the ETFs are taxed at long-term rates. And ETFs have a special tax structure that rarely generates taxable income except for dividends. By trimming and adding, you only incur a small amount of long-term tax, but the gains continue accruing tax-free. The smart investor tinkers around a few times a year, but never “gets in and gets out.”

If you keep Uncle Sam and Wall Street at bay, you can keep most of your returns. If you let them into your portfolio, you may well find yourself half as rich as you could have been.

Filed in Active Versus Passive Investing, Index Funds Versus Mutual Funds, Investment Advisors and Wealth Managers, Underperformance of Managers | Comments (0)

Managing Your Portfolio By Managing Your Mind

Friday, July 1, 2011

You might be familiar with Homer’s epic tale of Ulysses and the Sirens. The mythical Sirens lived on rocky islands in the middle of the sea where they sang such beautiful melodies that passing sailors could not resist their call. Following the alluring melodies, these sailors would inevitably steer their boats toward them or even jump in the raging waters to get closer, always with the same result—disaster.

Ulysses possessed uncommon wisdom. He knew that his journey required that he pass the Sirens, but he wanted to hear the Sirens’ call. He knew that doing so would render him incapable of rational thought, so he put wax in his sailor’s ears so that they could not hear. Then they tied him to the mast so that he could not jump into the sea. He ordered them not to change course under any circumstances, and to keep their swords upon him to attack him if he broke free of his bonds.

Upon hearing the Sirens’ song, Ulysses was driven temporarily insane and struggled to break free so that he might join the Sirens, but fortunately his forethought and thorough planning worked, saving both his life and the lives of his men. Modern psychological research has revealed that Ulysses was onto something when it comes to managing the human psyche, which translates well to managing a retirement account as well.

In recent research by Dr Read Montague has uncovered ground-breaking insight on dopamine neurons. He gave subjects $100 each to invest in the stock market, supplying information on market trends and conditions from actual but not yet revealed historic market periods. Each subject participated in 24 rounds of investing, and would get to keep their earnings while Montague monitored the dopamine response in their brains.

What did Montague learn? When an investor placed a bet with 10 percent of his portfolio and saw his investments shoot up in value, the dopamine neuron pattern revealed a fixation—not on the winnings, but rather on the missed profits as his neurons calculated his possible returns relative to his actual returns.

So what would the subject do in the following investment round? He would wager more and more of his portfolio in search of the profits he previously missed in an effort to drown his regret with pleasurable dopamine. Interestingly, the longer the investment provided returns, the more the subject would grow in confidence that he had figured out the winning formula, forming a type of investment bubble that would end in utter surprise when the markets corrected and the bubble burst.

Another modern neuroscientist, David Eagleman, has provided some additional research into the brain and investing. In his recent book, Incognito: The Secret Lives of the Brain, Eagleman reveals that the conscious mind is not at the center of the brain’s action, but rather at the periphery. Our conscious decision making activity is often being directed by a staggering complex and competing neural sub-population.

One population looks at chocolate chip cookies and sees pleasure, another sees a high-energy source for survival, and yet another sees an hour on the treadmill at the gym. An unconscious democratic process unfolds inside our minds resulting in a split-second decision to eat or not eat the cookie. And while the cookie debate is fairly easily understood, the subconscious process becomes much more complex and subversive in areas such as finance. That is why Mr. Eagleman recommends that we make well-devised plans during moments of psychological clarity to help guide our minds in the important areas of life.

When it comes to portfolio management, many everyday investors do not have clear and strong investment principles to guide them. They are left subject to the Sirens of greed, fear, jealousy, and a host of other anxieties fomented by media, society, and Wall Street, which eventually lead to undisciplined and irrational investment decisions.

In contrast, professional portfolio managers work within strict asset allocation models that are rarely changed and only with strict review and committee decisions. Such institutional money managers know how to block out the Sirens and stay the course.

Ulysses was wise enough to foresee the temptations ahead and designed a plan to stay the course. Psychologists now call this mental discipline a Ulysses Pact. Do you have enough psychological clarity to know that down the road you too will want to abandon your investment ship in search of Siren songs of our day? Market swings, stock tips, bubbles, and stories of remarkable profits at cocktail parties will leave those bereft of a portfolio style Ulysses Pact tossed about by temptation, and apt to dive headlong into disaster.

The Sirens song will be strong. By forming a clear and rational portfolio allocation plan, and committing to stay the course over time through rigorous rebalancing, you can avoid the shoals and sail on toward retirement safety.

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

Why Your Broker Doesn’t Put You First

Friday, June 24, 2011

Have your heard this old tale? During a flood, a kind-hearted frog lets a scorpion ride to safety on his back. But, just as they reach the middle of the river, the scorpion stings the frog. As they both sink beneath the waves, the frog asks, “Why did you sting me?”

“It’s my nature,” says the scorpion. “That’s what I do.”

When you choose someone to help you with financial advice, it is important to know “what they do.”

In professions where the provider is helping individuals with highly personal and important areas like health, credentials mean that the person has earned the right to be trusted. There are understood standards and norms. Doctors are credentialed for his field of medicine. Chiropractors have a different type of training and certification than an oncologist. We know who we are seeing and what they are supposed to be able to do. Attorneys who have passed the bar went through law school and have the legal right to practice.

Such clear certification is very confusing in financial services. It may look like a professional broker at Merrill Lynch or Morgan Stanley provides the same service as someone who is a registered investment advisor. But nothing could be further from the truth. This distinction is critical to understand no matter how much you trust the individual.

A person who is a broker, is just that. He acts as an agent between a buyer and seller of products, usually for a commission. Legally, an individual who works for a “broker/dealer” must pass a “Series 7″ exam, which teaches one about the stock market and securities to prepare the individual to sell commissioned products. Brokers operate under a “suitability standard” under which the broker is required to make investments he judges to be suitable for his clients. He can’t sell micro-cap volatile stocks to old ladies. Brokers and their firms are regulated by a “self regulated organization” (not a government agency) called FINRA. In the industry, brokers are measured by the amount of commissions and fees that they generate from selling products. Product providers pay more for “distribution” through brokers.

Registered investment advisors (RIAs) help individuals manage their money. They must pass a “Series 65″ exam, which tests how well one knows how to help a client invest and operate under a fiduciary standard. That means an advisor is required to act in his clients’ best interests, and disclose to them all conflicts of interest. These advisors are either registered in the state in which they operate, or with the Securities and Exchange Commission (SEC). RIAs are usually measured by assets under management (AUM) because the more assets they manage, the more their fees. They submit lengthy ADV II forms online showing any conflicts of interest, sanctions from the SEC, and exactly how they are paid.

RIAs can’t use customer testimonials in advertising and must disclose when they pay for client referrals. Brokers can use testimonials and hide fees they are paid for referrals.

Under Dodd-Frank, legislators are now considering implementing a fiduciary standard for brokers. They are fit to be tied. The central issue is that if they are required to put your interests ahead of theirs, they will have to disclose conflicts of interest and fees. FINRA is spending a fortune to fight this because if they disclose all fees they receive from all parties, investors will get wise and they will earn less. FINRA’s CEO earned nearly $3 million last year, and FINRA’s top 10 employees all earn over $1 million. They don’t want their members paying them less, so everyone is pulling out all the stops.

A good analogy for the broker versus investment advisor is the difference between an optician and an ophthalmologist. An optometrist conducts eye exams and makes sure that you have healthy eyes but makes money primarily selling you glasses and contact lenses. When you have a cataract, or something serious, you go to a medical doctor—or an ophthalmologist. He has taken a Hippocratic oath to practice medicine ethically. He sells nothing. He puts your health first and can also examine your eyes.

Do you want to trust your money to someone who is just paid for advice? Or a broker who makes money providing advice in order to sell products?

Just remember: If you’re carrying someone across the river, you may want to check on “what they do.”

Filed in How Wall Street Makes Money, Investment Advisors and Wealth Managers, Stock Brokers | Comments (0)

Blog - How To Become A Better Investor