MarketRiders Blog

Herd Mentality – Are You Chewing the Cud?

Thursday, June 16, 2011

So it appears that the Delphic oracles have emerged from the modern day temple of Apollo, that being Wall Street, to share their wisdom. What is their sage advice you may ask? Sell! Sell your stocks and hunker down in a more defensive position.

The numbers are in – employment growth down, real estate down, manufacturing down, debt problems at home, debt problems abroad and so the financial pundits have come forth from their glass towered temples to offer their counsel. And like well-behaved cattle, the mooing masses have left their fair pasture and are being herded through the rancher’s gate to some unknown but new destination that will provide the hoped for upgraded cud for the chewing. Or might it be the slaughterhouse?

Herd mentality is well researched and highly documented amongst philosophers such as Søren Kierkegaard and Friedrich Nietzsche , scientist Wilfred Trotter, psychologists Freud and Jung, and economists such as Thorstien Veblen to name only a few. It is easily seen in investing through the cyclical frenzied buying (bubbles) or frantic selling (crashes) of the stock market. These sudden swings are rooted in irrational investing practices and driven by emotion – greed in bubbles and fear in crashes.

New economic data is acted upon within seconds by leading professional portfolio managers armed with cutting edge rapid response technology. These “in-the-know” active managers move the market. The media then reports. Articles grace the front page of national publications and prime-time television. Jim Cramer starts banging and bonking his toys while he yells out “sell, sell, sell,” and the frenzy is afoot.

Our current market is characterized by plenty of mooing these days. Six straight weeks of market losses have not been seen since 2002, and have pushed the Dow Jones industrial average below 12,000 after an exuberant eight-month run in which corporate profits and share prices soared. Just when retirement accounts of ordinary Americans began to look healthy again, bang! We are thrust back into dark times.

And boy, does this type of news preach! This is when the herd really gets moving. Investment advisers are inundated with bleating customers asking to be moved into defensive positions. With herd-like agility, these investors have a knack for timing the lows with perfect precision. Never mind the fact that the system is rigged to slaughter the slow moving cattle that seem to always make their move a bit too late. Still, year-after-year, these retail investors are easily rounded up for the slaughter by the pros that know how to really make a real profit.

Investors forget the fact the stocks do not rise steadily over time. They do so in a rather abrupt series of fits and starts with a few days of large gains sprinkled randomly throughout the year. According to finance professor H. Nejat Seyan, if you missed the ninety best-performing trading days from 1963 to 2004 your annual returns plummet from 11% to 3%. Indeed, you would need to be an oracle to accurately pick the 90 best days out of 14,694!

Suffering from collective irrationality, these investors are like sheep without a shepherd, lacking any sense of long-range vision and guiding principles to anchor their portfolio management. They are unsheltered, exposed and ready to become prey. They are ships without moorings. Their portfolios are tossed to and from in the market’s choppy seas.

The First lesson of Wall Street is to exploit mass-market psychology by acting in a contrarian fashion. Studies by economists and psychologists have found that investors are most influenced by recent events — market news, political events, earnings, and so on — and ignore long-term investment and economic fundamentals.

As a retirement investor, you have a few clear and simple choices. You can enter the active management fray and compete with the big dogs, you can follow the masses and fall prey to the bloodletting, or you can rise above it all by rooting your investment philosophy in proven science and long-range planning. Driving fees mercilessly down, embracing basic global asset allocation and contrarian rebalancing will deliver you from cud chewing and into a Kwai Chang Caine, Zen-like peace. Instead you can rule your portfolio with long range and academically proven principles, and invest effectively and with peace-of-mind.

Are You Afraid Of Money?

Thursday, June 16, 2011

It seems there’s a new medical condition introduced every week. Did you know there’s even a condition related to the fear of money?

“Chrematophobia” is the abnormal and persistent fear of money, according to WebMD. It comes from the Greek “chrimata” (money) and “phobos” (fear). Some of its symptoms include heart palpitations, anxiety attacks, sweaty palms, and an intense desire to flee. Sufferers worry they might mismanage money or that money might live up to its reputation as “the root of all evil.”

If you have it, maybe you can blame it all on your brain. California Institute of Technology neuroscientists discovered that a fear of losing money is tied to a brain structure called the amygdalae, which generates emotional reactions to money.

Researchers found two subjects with damaged amygdalae and asked them to participate in an “experimental economics task” in which they were faced with variety of financial gambles, each with a different possible gain or loss. The subjects took risky gambles much more often than control subjects of the same age and education. In fact, they showed no aversion to monetary loss whatsoever, a sharp contrast to the control subjects. Researchers believe that the amygdalae is critical for triggering a sense of caution toward making gambles.

If you don’t want to blame your brain, blame your folks. Others contend that a fear of money is related to subconscious beliefs from religion or parents who told us that money is the root of all evil, is power (and power corrupts), will change your life, and can’t buy you happiness.

Are you chrematophobic? Here are some telltale signs:

–Not opening bank statements, bills, or mortgage statements
–Not checking account balances, or refusing to track net worth or spending
–Being defensive about a lack of financial literacy
–Trusting someone else too much with your money or letting someone else make your financial decisions
–Worrying excessively, but refusing to think about finances at all
–Not planning for the basics such as retirement, and forgoing life insurance and wills
–Overspending or over-saving

So let’s say you’ve got a little chrematophobia — what does that mean for retirement investing? It gets down to whether you should hire an adviser to help you, or if you can invest on your own.

There are two tasks involved in retirement investing: putting together a financial plan, and implementing an investment strategy. The plan should be built with you by a professional, paid by the hour who can learn your individual circumstances and map out an appropriate plan. This plan will assume a rate of return on your investment portfolio and a savings rate. For example, the plan may show how, if you save and spend certain amounts and achieve a 6 percent after-tax rate of return, you can retire at 65 and have plenty of money.

After you have a plan, you have to decide whether to invest on your own, or hire an investment professional. Today, with software and online brokerage accounts, anyone can build and manage a low-cost retirement portfolio. But the real test happens when the market plunges. In these “emergency” situations, does your fear of money prevail or are you able to stay the course?

If you know you are prone to panic, chrematophobia will cost you. Investors who did not stay the course and got out of the market in March 2009 have missed the nearly 100 percent bounce back.

Pilots spend 99 percent of their time training for the rare life-and-death events that occur less than 1 percent of the time. Like a pilot who is paid well for the emergency situation, a competent adviser with low fees will help keep you on course, talk you off the ledge, and make sure your emotions don’t lead you to bad decisions. Knowing yourself and whether you can handle market ups and downs as a do-it-yourselfer is the first and most important decision you can make as a retirement investor.

Filed in Financial & Retirement Planning | Comments (0)

How to Invest During a Weak Growth Economy

Friday, June 3, 2011

The news is in. Manufacturing growth crept to its slowest pace in 20 months with the index of manufacturing activity experiencing its biggest decline since 1984. Payrolls were also shockingly weak according to ADP, adding a mere 38,000 jobs in May, down from 177,000 in April. And sadly, this is not just a U.S. problem. This month’s manufacturing reports have just come in from China, Russia, Poland, Hungary and Japan and they were all down with more underwhelming data expected as the month of June rolls on.

This is the moment that the anxious investor begins to panic. Last year it was all about raising stock prices, commodity investments and the emerging market boom. Now economists are talking about extended weak growth, how we have kicked the debt can down the road and now must pay. So what now should an investor do? Is it time to change “lanes”, to move from one overly weighted allocation model to the next in search of economy defying returns?

An investor who is constantly shifting his allocations in search of returns is similar to a stressed out driver trying to make his way down Interstate 405, the nation’s busiest stretch of highway according to the highway patrol, on a Friday afternoon before a holiday. Traffic is at a near stand still, but he is determined to get to his destination on time in spite of the fact that statistics show some 320,000 other drivers are trying to do the same.

This harassed driver seeks to dart from one lane to the next in hope of finding some small advantage. His lane grinds to a crushing halt while the drivers four lanes over seem to be effortlessly slipping by. So with great consternation, the driver slowly but determinedly works his way over, one lane at a time, rudely nosing his vehicle into spaces not fit for the common car to finally enter the sought after lane of freedom.

And for a few brief moments a wave of satisfaction washes over the driver as he hits his accelerator and pops up from 5 to 30 miles per hour finally passing that old lady who had crept along in front of him in the silver Camry, oblivious and out of touch.

But then suddenly it happens. His new lane grinds to a sudden and dangerous halt. He is at a stand still. The frustration builds. Then, as he looks to his left, he notices that the lane from whence he came is now moving freely. And as he tries to creep his way back, right there before him the silver Camry slips by with the happy old lady smiling away, at peace in the midst of the 405 storm.

This driving metaphor provides an interesting allegory for investing behavior. As globally diversified investors, one participates in the industry of millions of hard working men and women and the growth of their companies and economies. Sometimes these economies enjoy stretches of unfettered growth that is celebrated and enjoyed by all, not dissimilar to flying down the 405 on a Sunday at 8 AM. Then there are times when these businesses and economies become cramped and overburdened. Growth painfully slows as these businesses and economies sort themselves out, a sort of traffic jam.

The wise investor learns that these patterns are essential and expected components of all economies and should not have much effect on investment patterns. By accepting the simple fact that she cannot outperform the market, the wise investor can rest at ease knowing that a well diversified portfolio will reap a reward. Like the happy old lady on the 405, this investor is not happy the economies are moving slowly, but is happy because her plan accounted for slowdowns and she knows that this too will pass.

The wise investor accepts that disruptions are part of the investment journey. Although she enjoys years of high double-digit returns, she accepts that her portfolio will also be slow moving at times. There is no need to change lanes. Making significant changes to a portfolio’s allocation is expensive and usually unfruitful. Tax friction and trading costs burden such lane-changing investors with a disadvantage that must now be overcome with dramatically increased growth. And as often happens, once such an investor adjusts their allocation, as we saw this week, the news hits, economists speak, and it is time to once again, make more changes.

During slow growth, each investor has a choice. He can chase after the fast moving lane, jumping from one allocation to the next in search of a miracle, or he can accept the seasonal slow down, trust his allocations, turn on his favorite radio station and, like the old woman on the 405, enjoy the journey.

Filed in Uncategorized | Comments (0)

How to Play the Coming Tech Bubble

Thursday, May 26, 2011

There’ s a gland that must be in the body that doctors have never found. But we know
it is there. We call it the “ greed gland.” Wikipedia says a gland is an “ organ in an
animal’s body that synthesizes a substance for release such as hormones… often into
the bloodstream or into cavities inside the body or its outer surface.” When we hear that
others are profiting from an investment and getting wealthier and we’ re not, this gland
starts excreting the envy chemical. Envy is an emotion that “ occurs when a person lacks
another’ s (perceived) superior quality, achievement or possession and either desires it or
wishes that the other lacked it.”

Greed glands were on fire last week when LinkedIn went public. Maybe this was your
mental ticker tape: “ How could I have gotten in on that action? Why did I miss Linkedin
and now Yandex? When Zynga, Facebook and Foursquare IPO how can I get shares?
How about all those Silicon Valley geeks getting rich again and I’ m not! Are new social
networking companies going to become another tech bubble and will I profit from it?
Am I going to just sit on my hands? Maybe I’ ll just buy LinkedIn now at $90. It is a
good company. I use it. It will eventually go higher.”

That’ s the greed gland talking. There’ s no doubt that LinkedIn is a fantastic business!
This professional network has over 90 million members will soon have revenues of $400
million and has a model with all of the wonderful characteristics of a web-based business.
But it is likely not worth anywhere near $9 billion today. Fortunes have been lost buying
great businesses at the wrong price. Fortunes have been made buying bad businesses at
great discounts (Warren Buffett called it “cigar-butt” investing).

The greed grand and its secretion of envy will drive you to buy when you feel you are
being left behind. Those who fall prey to it become speculators. It might be wise to clip
the following words and read them when your greed gland starts convulsing:

When you invest or loan your money to companies that operate in our capitalistic system,
you as an owner will be paid. Over the time period that retirement investors care about,
say 20 or so years, that return has been in the 8% – 10% range. Think of capitalism as a
train. If you get on it, your money will grow just because the system demands a return
on invested capital. Over the journey, the train will slow down, backtrack, or speed
up, but it will keep chugging along. Eighteen years ago in 1993 you could have bought
the S& P 500 in a newly minted product called SPY (the first Exchange Traded Fund)
for $33. Today SPY is worth four times that – $132. You’ d have made no decisions,
clipped some dividends and paid minimal taxes without breaking a sweat. No CNBC, no
commentary, little anxiety. Just by owning your small piece of American capitalism.

If you get off the train, you become a speculator, thinking you can get farther than the
rest of us who are on the train. Speculating is thrilling and it cures the temporary itch of
the greed gland. But there are two problems that few overcome. First, you pay taxes on
the gains so your winnings are automatically cut by one third to one half. You have to
run even harder and faster. And second, all speculators make mistakes. Few investors
like to talk about investment mistakes, but everyone makes them. Every seasoned
professional investor knows that avoiding and limiting the inevitable mistake is the single

most important characteristic of investment success.

If you think you have a talent for buying LinkedIn and other IPO shares and sprint ahead
of the train, you may get a town or two ahead this year. But sooner or later, you will
make a mistake. You’ ll buy too high on an oversized bet and feel pain as your losses pile
up. Like all speculators, the train will pass you or run over you at some point in the next
10 or 20 years. Your friends will be having fun on the train and you’ ll be roadkill. So
please, just stay on the train, buy yourself a drink and enjoy the ride.

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

Three Investment Lesson from the Fall of the Insider King

Friday, May 20, 2011

Raj Rajaratnam, founder of the Galleon Group Hedge Fund, was found guilty this past Wednesday in what has become the new high-water mark for insider trading convictions.

Lining his own pockets with over $63.8 million in illegal windfall from his insider scam, this once humble Sri Lankan son of a sewing machine company manager grew in physical, egotistical and financial stature. Through his swollen cheeks he crowed to friends about his $7 billion hedge fund empire, stating that Raj, which stands for “King” in Sri Lankan, makes him the “King of Kings”. How about the Insider King instead?

Indeed, Raj Rajaratnam, did gorge himself like a king, but on more than just Kobe beef. Using techniques once reserved form organized crime, drug trafficking and terror plots, the Justice Department was able to convict the Insider King of 19 accounts of security related fraud. And his conviction involved a complex web of over 23 known complicit parties ranging from corporate executives to hedge fund managers revealing just how deep this insider culture truly runs among the Wall Street elite.

With the spotlight temporarily on this aspect of the malevolent hedge fund underworld, it behooves us to pause and underscore a few key lessons for the everyday investors.

Lesson #1 – The Little Guy Can’t Win

Every now and again you run into that day trader or active investor who has discovered the “golden cross” of technical analysis or has gained some yet-to-be perceived insight into the global economy which he is poised to exploit.

Forget the fact that thousands of financial researchers churned out of the top ivy league schools are employed by leading hedge funds, equipped with staggering research budgets, sophisticated analysis technologies and shocking financial rewards for success. Forget that these researchers are probably a bit smarter than you. Forget that they crunch data like auto bots, day after day looking for any edge. Forget that even if the playing field were level, you would have to be a bit deluded to want to compete against such a formidable opponent. Then add to these facts the simple Insider King illustrated reality that these organizations sometimes get trading information first – illegally, and the answer becomes simple. The little guy cannot win.

For the individual investor, active stock trading is nothing short of Popeye fighting Bluto with no spinach in site. Such a contest is so one-sided that it goes from being entertaining, past pathetic to downright disgusting. As the Las Vegas adage goes, “look around the poker table and if can’t spot the sucker, it’s you.”

Lesson #2 – Fees Really Do Matter

What does 2 and 20 mean to you? Probably not much unless you have read the prospectus for a hedge fund. The going rate for playing in the hedge fund game is a 2% annual management fee on assets under management and then a 20% profit share on all earning. This is the fee burden the hedge fund manager must overcome to return value to the investor group.

With such a heavy fee burden, how then does long-short equity hedge fund manager return value? He does so through building teams that perform deep research, astute analysis, and rapid response systems which exploit the smallest window of opportunity. And sometimes he do so, as the Insider King has shown us, through insider information. Surprisingly, even with all these resources and advantages, many hedge funds over time fail to even beat the market. 2 and 20 is a lot to overcome.

Lesson #3 – Some Things Never Change

Yes, the Galleon verdict is an encouraging example of justice, but just how deep is the insider problem? According to the Cayman Islands Monetary Authority, there are over 5000 hedge funds representing over $2.3 trillion in investments. And although many of these funds conduct ethical enterprises, the dollars at play provide a substantial motive for misbehavior. Galleon is just the tip of the iceberg.

When malfeasance turns up, however, investors are frustrated by the fact that many cases are lost in court or end with nothing more than a wrist-slap. The not-guilty verdicts for Bear Stearns hedge-fund managers accused of misleading clients, Angelo Mozilo’s multi-million settlement to erase fraud charges with the Securities and Exchange Commission, and the lack of indictments against Wall Street executives for misdeeds in the financial crisis are all examples of injustice winning the day. One commentator likened these efforts to a fruitless and frenetic game of whack-a-mole. You may strike a mole here and there, but a lot more disappear into their hole to never face any consequence for their action.

Although we applaud the conviction of the Insider King, remember that when it comes to Wall Street, some things never change.

The individual investor, however, need not despair. Through simple indexing and global diversification, you can tap into the value of corporate productivity and global economic growth and thereby side step the rigged world of active trading. Add to this the discipline of vigilantly driving down all unnecessary fees within your portfolio, and in the end, you may in fact have the last laugh, even on the Insider King.

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

Is Your Money Safe With Your Broker?

Friday, May 13, 2011

When Lehman Brothers went bankrupt in September 2008, most investors faced a question they had never considered: Is my money safe with my broker? What happened to Lehman brokerage accounts, and what makes one broker like Fidelity safer than another?

To get to the bottom of this question, I caught up with Michael Hogan, CEO ofFOLIOfn Investments Inc.

When stock markets began, brokers physically traded share certificates of a company’s stock and had armed guards moving certificates between brokers and their vaults all day. In the 1960s there was a back-office crisis as trading volume went from 5 million shares daily to 15 million shares. The paperwork burden was overwhelming and brokers and stock exchanges came together to form the Depository Trust and Clearing Corporation (DTC).

Fast forward to our highly automated world—there are virtually no share certificates, but only records of how many shares are owned and by whom. The DTC is the heart of the system, and tracks the shares of all securities that all brokers have. After trading is done each day, the brokers settle between one another through the DTC. Your IBM stock held in your Schwab brokerage account is held in Schwab’s name, or “street name” at the DTC. If you sell 100 shares of IBM to someone at Merrill Lynch, that night, the DTC will transfer shares from Merrill to Schwab and cash from Schwab to Merrill. Schwab keeps track of which clients own how many shares. DTC is like a huge file back-up system for everyone’s stocks, bonds, and cash in brokerage accounts.

Anyone can pass a test and become a broker. But a “clearing broker” is part of the elite group plugged directly into the DTC system. There are hundreds of clearing brokers, and thousands of “introducing” brokers. All introducing brokers need to “clear” through a clearing broker.

Clearing brokers hold money and securities and need a multi-million-dollar IT infrastructure to process orders and keep accounts and the capital to deliver securities or pay for them. “The bar is high,” Hogan says. “Clearing brokers must demonstrate to regulators that they have the capability to be part of this highly regulated system. They must reconcile cash and securities on a nearly daily basis with the DTC and all other firms and are audited every week.”

The Securities Investor Protection Corporation (SIPC) restores cash and securities to investors with assets in the hands of bankrupt and otherwise financially troubled brokerage firms. SIPC provides up to $500,000 of protection for brokerage accounts and estimates that no fewer than 99 percent of persons who are eligible have been made whole in the failed brokerage firm cases that it has handled.

Brokers go broke because of bad management or fraud. Lehman went bankrupt because of bad management. SIPC and the DTC quickly restored investor accounts at another broker. As long as the records of the brokerage firm are accurate, and there was no fraud involved, you get your securities and cash back or moved to another broker within a month or two.

When fraud is involved, it is generally with introducing brokers who are able to cash your checks, and create a set of fake books. It is nearly impossible for clearing brokers to commit fraud. Hogan says, “The main way the system breaks down is when you deal with an introducing broker, and you’re told to deposit money with their firm. They steal it and circumvent the system and create statements with a color printer. You’re disconnected from reality and don’t have a cross-check.”

Hogan offers two pieces of advice if you don’t use a clearing broker. When introducing brokers, only make out your check to its clearing broker, and get access to the clearing broker’s website so you can see your account. While introducing brokers have their own branded websites and statements, you should have online access to the clearing broker. Check your balances frequently. In addition, make sure regulators have never sanctioned your broker.

As long as you have your securities and cash with a clearing broker that has been around for at least 10 years, is run by competent management with a strong financial statement and an unblemished regulatory record, your money is safe.

Filed in Stock Brokers | Comments (0)

How to Inflation Proof Your Portfolio With ETFs

Thursday, May 5, 2011

Inflation is a sneaky pickpocket that slinks into your wallet in the form of higher prices on food, gas and other necessities, quietly robbing you of wealth. It’s the invisible tax or the hole in your water bucket. Because of this, investors are becoming increasingly attentive to the evolving inflation story.

What many investors don’t know, however, is the Federal Reserve’s dirty little inflation secret. When the Fed reports on inflation, it reports on core inflation, a calculation that excludes food and energy costs.

The Fed has not always calculated inflation in this way. In February of 2000, the Federal Reserve rejected its old method of calculating inflation, which included food and energy, in favor of this new core inflation method, claiming that highly volatile food and energy prices made their influence impractical in determining monetary policy.

When you hear of the inflation rates of the late ’70s for instance, you are hearing about a number that included food and energy, whereas today’s number is skewed lower. Similar to how unemployment calculations have been skewed lower, using the 1970s method, both inflation and unemployment are higher today than most people realize.

The Fed has clearly revealed it wants inflation that is high enough to globally weaken the U.S. dollar, promote exports, and debase U.S. debt, but also low enough to keep investor confidence high and the economy moving forward. Fed chair Ben Bernanke has stated that the Fed is looking to stoke inflation to a rate of around 2 percent a year.

Unfortunately, inflation is not so easy to control. Inflation has a history of suddenly lurching out of control. Like a careening car that unexpectedly fishtails to one side, driver overcorrection will suddenly send the car dramatically sliding in the opposite direction and potentially out of control. Knowing this, the Fed wants to keep investors calm regarding the inflation story. Just last week, Bernanke suggested that inflation is not a threat and that the U.S. base interest rate will stay close to zero for an “extended period.”

What does this mean for you? Historically, developed economies have maintained an inflation rate of around 2 percent, while emerging economies have maintained a blended rate of around 6 percent. Strangely, these same economies tend to grow at similar rates as well.

People who live in emerging economies spend approximately 50 percent of their income on food and energy. In developed economies like the U.S., that drops to around 20 percent. Essentially, the poorer you are, the more your dollars must go to basic needs like food and energy. For the poor, their inflation tax goes up. Sadly, recent inflation of food, energy, and other basic commodities coupled with the deflation of the U.S. dollar is hitting many Americans harder than they may realize.

To respond to the inflation threat, every retirement portfolio needs to be inflation proofed. Start by allocating a part of your portfolio to Treasury Inflation-Protected Securities (TIPS). TIPS pay a stated dividend and also add the Consumer Price Index rate—a common measure of inflation—to the underlying value (PAR value) of the bond bi-annually.

Additionally, by adding exchange-traded funds like iShares S&P Global Energy (symbol IXC), iShares Dow Jones US Oil & Gas Ex Index (IEO), and iShares Dow Jones US Oil Equipment Index (IEZ) to your portfolio, you gain diversification to more than 300 companies impacted by the price of oil and gas.

Finally, add some precious metal exposure to your portfolio though ETFs like SPDR Gold Shares (GLD) or iShares Silver Trust (SLV), both of which will give you low-cost exposure to gold and silver. Beware of farming and food related ETFs because they involve futures contracts and are unpredictable.

But before you run out and turn your entire portfolio into an inflation hedge, remember that like inflation, deflation is also an ever-present risk. Just as quickly as the economy can careen toward inflation, a sudden overcorrection by the Fed can send the economy sliding wildly towards deflation.

Through global diversification and disciplined rebalancing, you can get the inflation pickpocket out of your wallet and rest assured that no matter which way the economy slides, you stand prepared to emerge a winner.

Filed in Asset Classes, Benefits of Asset Allocation, Portfolio Diversification, Rebalancing | Comments (0)

Double Your Money With Compound Returns

Friday, April 29, 2011

The law of compound returns is a force of nature and understanding this concept is critical to your success as an investor. It is how the rich keep getting richer, but maybe not how you are led to believe.

Simply put, the law of compound returns says money left alone creates more money. Einstein said, “Compound interest is the eighth wonder of the world.” Ben Franklin echoed that thought, saying, “Money can beget money, and its offspring can beget more.” Warren Buffett’s partner Charlie Munger expressed a similar sentiment about money: “Never interrupt it unnecessarily.”

Think of the law of compound returns as a small snowball rolling down a hill gathering 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.

Your job as an investor is to find a level of risk that you can live with and then structure an efficient portfolio accordingly. Then you must let the law of compound returns work its magic.

No one can give you a longer hill, but your investment choices will determine if your snow is wet. Taxes, investment fees, and underperformance interrupt the law of compound returns and lower your returns. They dry out your snow.

Using exchange-traded funds can lower fees by 80 percent, which helps you keep more of your returns. But remember: Trading ETFs frequently can increase taxes and take a bite out of the snowball as it rolls down the hill. The less trading you do the longer you can defer taxes, which leaves more money to snowball year after year. After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate. And because most ETFs track indexes, you will never lose your money betting on investment themes that don’t pan out.

The “law of 72″ helps us understand compounding. Divide your yearly return by 72. The result is the number of years it will take for your money to double. Money doubles every 12 years with a 6 percent return and every eight years with 9 percent. That means if you are 40 years old, a $100,000 investment with a 6 percent return will double twice to $400,000 by the time you are 64 years old. At 9 percent, it will double three times to $800,000! If you achieve a consistent higher rate of return for many years, your wealth can snowball into a fortune. But you have to live some with volatility.

Inflation is the dark side of the law of compound returns and determines how your savings deteriorate over time. Assuming real inflation is 4 percent per year, with the law of 72 that means every 18 years prices double, and your money will buy half of what it did before. As an investor you fight the reality that 20 years after you retire your money will lose 50 percent of its buying power.

The law of compound returns is a slow, powerful, and largely invisible force that you can’t ignore. Because of how it operates with inflation, your money will be worth half of what it is today in 18 to 24 years. But if you can reduce your fees, taxes, and increase your returns by just 2 to 3 percent per year, you’ll double your savings in 24 years.

Filed in Law of Compound Returns, Modern Portfolio Theory | Comments (0)

Are Commission-Free ETFs Worth It?

Friday, April 22, 2011

Over the past year or so, the four leading trading houses have offered a suite of exchange-traded funds (ETFs) that trade for free. Schwab lead the charge by offering free trades on their ETFs. Vanguard, Fidelity, and TD Ameritrade followed suit with similar offerings.

And now just this week, FocusShares entered the game by launching 15 of the lowest cost ETFs ever offered in the public markets. (They also trade for free at Scottrade.) You can own the S&P 500 for 0.05 percent annually and no trading costs? What has Wall Street come to? Real value?

This revolution is good news for the everyday retirement investor. Gone are the days of having to sort through mutual fund brochures and Morningstar ratings. Now the big challenge is to analyze the free-trade allure to discover the best ETF building blocks worthy of their retirement dollars.

How should an investor decide which ETF to use? Should free trades trump expense ratios in making such selections? Here are a few things to consider when sorting through your ETF options:

Let purpose trump cost. The purpose an ETF serves in your asset allocation is more important than splitting hairs on cost. For instance, many of our MarketRiders portfolios concentrate on small-cap value stocks in a portfolio, even though these ETFs tend to have higher expense ratios. It is better to embrace the slight fee increase to achieve your desired asset allocation targets than to skip on the proper allocations in search of lower fees.

Understand the key areas of cost. Another important step in analyzing the value of commission-free ETFs is to understand the three main sources of ETF costs.

Trading commissions. Most of the leading discount brokers charge around $8 to $10 a trade. If you have a globally diversified retirement account consisting of 14 ETFs and rebalance that account four times a year, you are making 56 trades. At $10 per trade, you are adding an annual $560 fee drag on your portfolio’s growth. For larger portfolios, these trading fees become less meaningful, but with smaller portfolios these fees can become significant. For example $560 in trading fees on a $500K portfolio represents less than .11 percent annually. On a portfolio of $50K, this annual burden dramatically increases to 1.12 percent.

Fund expenses. While ETFs are run by sophisticated computers and have attractively low fund expense ratios, not all ETFs are created equal. When you look at the common indexes for U.S. large-cap stocks as supplied by the leading ETF providers, the fees vary slightly. Vanguard’s S&P 500 ETF (symbol VOO) costs 0.06 percent, while Schwab’s U.S. Large-Cap ETF (SCHX) costs 0.08 percent, State Street Bank’s SPDR S&P 500 (SPY) costs 0.09 percent, iShares S&P 500 Index (IVV) costs 0.09 percent, and now FocusShares Morningstar Large Cap ETF (FLG) costs 0.05 percent. A $100,000 investment in SPY versus FLG will differ a mere $40 annually because of their expense ratios. This is probably not a big reason to choose one ETF over another. The fund expense-ratio story can change, however, when you move into more specialized indexes. Take the emerging market index, for instance. While Vanguard offers MSCI Emerging Markets ETF (VWO) at 0.22 percent, Schwab offers its Emerging Markets Equity ETF (SCHE) at 0.25 percent, State Street offers SPDR S&P Emerging Markets (GMM) at 0.59 percent, and iShares offers MSCI Emerging Markets Index (EEM) at a whopping 0.69 percent. It is not surprising VWO just trumped the long standing emerging market leader, EEM, in assets under management, with an expense ratio differential of 0.46 percent and a great history of tracking the same index with excellence.

Bid/ask spreads. While trading costs and expense ratios are easy for investors to understand, they often overlook a third cost: the bid/ask spread. The “ask” is the market price at which an ETF can be purchased and the “bid” is the market price at which an ETF can be sold. The bid/ask discussion can quickly become highly technical, but what investors need to know is that ETFs with lower volumes tend to have larger spreads, which essentially becomes another type of transaction cost. An ETF can trade for free, but because the ETF has poor volume, or weak market maker competition, the bid/ask spread can cost as much as the trading expense on larger transactions.

So what is the answer? Is it better to construct your retirement portfolio with commission-free ETFs offered at your broker, or to choose ETFs with the lowest expense ratios, or look at volumes and bid/ask spreads? Even with the three variables above, the answer becomes a very personal one that requires a bit of thought. How often will you trade? How much money is in your portfolio? Who’s your broker?

Filed in ETFs & Index Funds, Index Funds Versus Mutual Funds, Investment Software | Comments (0)

Why You Should Buy U.S. Treasuries

Friday, April 15, 2011

When PIMCO Total Return (symbol PTTAX), the largest bond fund in the world, not only sells, but shorts—or bets against—treasuries, it is as if Moses has descended with tablets and has a frown on his face. True to herd mentality, large bond funds like the Loomis Sayles Bond Fund (LSBDX), and Templeton Global Bond Fund (TGBAX) have liquidated treasuries as well. And just last month, another bond crisis centered around municipal bonds. Faced with pension obligations spiraling out of control and lower tax revenues due to high unemployment rates, every water district, hospital, town, city, and state was going to put up a “going out of business” sign and default on their bonds.

Everyone knows inflation is around the corner, the U.S. is going deeper and deeper into debt, and if you own a bond, it will only go down in value. At some point the U.S. is going to have to “pay the piper.” The Tea Party may not prevail upon the government to stop spending ourselves into oblivion.

If you are getting anxiety just reading these paragraphs, then you understand why the smartest investors in the world don’t engage in this conversation.

It has always been a bad idea to bet against America and our ability to prosper even against overwhelming difficulties. America will cut back its spending, innovate, and pay off its debts. We will earn our way out. It’s just how we do it. Selling treasuries is a bet against our ingenuity, work ethic, and our breed of capitalism that has made more dramatic changes to the world in the last 100 years than during any other period in human history.

When deciding how to invest, consider this: Actively-managed bond funds are the least likely of any funds to beat their benchmarks. A Standard and Poor’s study shows that from 2003 to 2008, only 7 percent of bond funds beat their indices. And while Bill Gross has “rock-star” status, his track record of predictions has been abysmal. Google “Bill Gross New Normal” and you can read about one wrong prediction after another since 2009. Gross cares that PIMCO’s assets keep growing because they generate over $12 billion per year in fees. Dire predictions in the media bring in new investors.

Large bond mutual funds control a miniscule portion of the $14 trillion of U.S. debt. The Federal Reserve holds $1.2 trillion, foreign countries hold nearly $5 trillion, and insurance companies, pension funds, and regular investors also hold their fair share of treasuries. There is no more efficient market than treasuries, and the Fed has the ability to manipulate it—irrespective of Bill Gross’s predictions.

But forget the chatter. The critical issue is the function of treasuries in your portfolio, not whether they should be in your portfolio. While treasuries generate income, they don’t come close to the returns from owning equities. From 1925 to 2003, treasuries only appreciated 5.4 percent per year or 61 times, while large stocks appreciated nearly 10.4 percent per year, or nearly 3,000 times. The other price you pay for holding bonds is inflation, which is bad for long-term bonds. While bonds increase in value in a deflationary environment when prices are dropping, this is a rare economic circumstance.

Treasuries protect you against catastrophic events in the world. They are your “go-to-sleep-at-night” funds. They went up in value after 9/11 and during the 2008 financial crisis. That’s why you own them. If you listen to Bill Gross and sell your treasuries, you’ll regret it the next time the sky starts falling.

The best and simplest way to own treasuries is to buy Vanguard’s Total Bond Fund ETF (BND), which is a basket of nearly 5,000 bonds and yields more than 3 percent a year. Worried about inflation? The average duration of all the bonds is only 5 years—only 8 percent of these bonds have durations greater than 20 years, and 25 percent are between one and three years. BND consists of 43 percent treasuries, 28 percent U.S.-guaranteed mortgages, and about 5 percent in foreign bonds. The rest is in investment-grade corporate bonds. For Vanguard to buy, hold, and rebalance, the annual fees are a paltry 0.12 percent.

Next time your heart palpitates as you read that the treasuries you own is a bad idea, consider the source and the function it has in your portfolio.

Filed in Asset Allocation, Asset Classes | Comments (0)

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