A Dying Bankers Last Instructions - from NYT

A dying Wall St banker uses his sad story to, hopefully, find an audience for sound investing advice:

http://www.parsintl.com/21964-e.pdf

3 SIMPLE RULES

Many people in the financial business try and complicate investing. Generally for their own means. There is an old book titled "Where are the Customers Yachts?" referring to a story about a client looking out into NY harbor at all the brokers and bankers yachts, then asking where are the customers yachts? The moral is: Wall St firms make money at the customers expense, and they need to make investing seem complicated in order to justify their fees.

What research shows it that, over time, investors don't need to pay for research, complicated buying and selling schemes. What one needs to do is follow a few simple rules - 3 of the best are laid out in the link below.

I like to say that the secret to investing is: there is no secret. Follow a few simple rules and you will have success. I really like the approach that Bill Schutheis promotes in his book and blog "the Coffeehouse Investor"

Follow the link to his 3 simple rules:

http://www.coffeehouseinvestor.com/investing-you-understand/the-three-principles-of-investing/

Bogle on Bond Mutual Funds

When I first read "Common Sense on Mutual Funds" 8 years ago it was chapter 7, on bonds, that stood out. It stood out partly because I had already been exposed to the evidence supporting the idea that stock funds net of costs rarely beat their relative indexes. But mostly because of the overwhelming correlation between bond mutual fund expenses and performance.

Bogle examines 4 bond sectors: 1. long term municipal bonds, 2. short term US government bonds, 3. intermediate term US government bonds, and 4. intermediate term corporate investment -grade bonds.

In 3 of 4 of the categories, over a 5 year period, the low cost funds outperformed the higher cost alternatives. In the fourth case, the more expensive bond funds slightly out performed, but with significantly more risk.

Bogle does a nice job of demonstrating this lesson with graphs that chart costs versus return. Visually one can see all the data points and see that the simple low cost bond index fund generally outperforms its actively managed, more expense peers.

He concludes:

"In general, the lowest-cost group had the lowest duration, the lowest volatility, and the highest quality. The lowest-cost group had not only the highest returns, but also the lowest risks. Bond fund investors simply cannot ignore that message.

Finally, the bond cost analysis is a math issue, similar to stock funds. It is more pronounced with bond funds because they return less than stocks, so when fees are netted out it is hard for the active fund to outperform, net of those fees.

You Must Remember This - The one sentence financial advisers wish their clients would remember

Read the Wall St Journal story below for 4 easy, one sentence, lessons everyone should learn:

http://online.wsj.com/article/SB10001424052748704243904575630643199762392.html?mod=ITP_thejournalreport_0

Style boxes, fund expense, and returns

Continuing on with chapter 6 of Common Sense on Mutual Funds, Bogle shows that In every style box (see blog of November 16, 2010), except the small cap blend category, low cost mutual funds outperform actively managed mutual funds. He goes on to then state, that in his study, the actively managed funds in each style box have higher risks than the low cost funds. Which means that from a risk/return stand point the low cost funds are much more effiicient than the actively managed mutual funds - the actively managed funds are taking on more risk and still not outperforming.

To quote from the book:

"Cost is a key determinant of the relative returns earned by funds"

"The relative risk-adjusted ratings are so dramatically in favor of the low-cost index approach as to defy even the most optimistic expectations"

This is consistent with a recent Morningstar report on the topic (see blog of August 27, 2010)

Investing as a recipe

A blog post from "The 401K Fiduciary Advice Blog" that expands on my recent post explaining style boxes.

I think this is a wonderful analogy:

http://bemanaged.com/2010/08/04/401k-investing-diversification-and-asset-allocation-in-plain-english/

Burton Malkiel author of "A Random Walk Down Wall Street" defends buy and hold.

"A Random Walk Down Wall Street" has been a huge influence on my investment approach. It is one of my top recommended books on investing. In this op-ed in todays WSJ, Burton Malkiel defends a diversified buy and hold strategy.

This is a great lesson for all investors to learn.

By Burton G. Malkiel

In the wake of the recent financial crisis, many investors believe that the traditional methods of portfolio management don't work anymore. They think that "buying and holding" is outdated, and that success depends on skillful timing. Diversification no longer works, they argue, because all asset classes move up and down together, especially when stock markets fall. In other words, diversification fails us just when we need it most. And they suggest that low-cost, passively managed portfolios are no longer useful, that today's difficult investment environment requires active management.

I don't agree with any of these arguments. The timeless investment maxims of the past remain valid. Indeed, their benefits may be even greater today than ever before.

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

Money poured into the stock market at the peak of the Internet bubble during the first quarter of 2000. Stocks and mutual funds were liquidated in unprecedented amounts at market bottoms in 2002 and 2008. Professional investors had large cash holdings at market bottoms but tended to be fully invested during market tops. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative. Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

While no one can time the market, two timeless techniques can help. "Dollar-cost averaging," putting the same amount of money into the market at regular intervals, implies investing some money when stocks are high, but also ensures some buying at market bottoms. More shares are bought when prices are low, thus lowering average costs.

View Full Image

Associated Press

While no one can time the market, two timeless techniques can help.

The other useful technique is "rebalancing," keeping the portfolio asset allocation consistent with the investor's risk tolerance. For example, suppose an investor was most comfortable choosing an initial allocation of 60% equities, 40% bonds. As stock and bond prices change, these proportions will change as well. Rebalancing involves selling some of the asset class whose share is above the desired allocation and putting the money into the other asset class. From 1996 through 1999, annually rebalancing such a portfolio improved its return by 1 and 1/3 percentage points per year versus a strategy of making no changes.

Diversification has not lost its effectiveness. Over the past several years, when stocks went down, bonds went up, preserving the value of the portfolio. And while stock markets around the world have tended to rise and fall together, there were huge differences in regional returns. Even though portfolios in the U.S. market actually lost money in the first decade of the 21st century, emerging-market stocks enjoyed returns of more than 10% per year. Every portfolio should have substantial holdings in the fast-growing emerging economies of the world.

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. Even if markets may not always be efficiently priced, index funds must produce above-average returns after costs. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns. But active managers charge substantial investment fees, and their buying and selling of securities in their attempt to beat the market generates significant transaction costs (and possibly greater taxes). Index mutual funds and their exchange-traded-fund (ETF) cousins do not trade from security to security, and they charge rock-bottom expenses (usually well below one-tenth of 1%).

The one investment principle about which I am absolutely sure is that the less I pay to the purveyor of an investment service, the more there will be for me. As Jack Bogle, founder of the Vanguard Group, says: "In the investment fund business, you get what you don't pay for."

The evidence is clear. Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time—Berkshire Hathaway's Warren Buffett and Yale University's David Swensen, for instance—are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.

The chart nearby illustrates how someone who invested $100,000 at the start of 2000 and, following my advice, used index funds, stayed the course and rebalanced once a year, would have seen that investment grow to $191,859 by the end of 2009. At the same time, someone buying only U.S. stocks would have seen that same investment decline to $93,717.

The recommended index-fund portfolios contain bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities. The diversified portfolio, annually rebalanced, produced a satisfactory return even during one of the worst decades investors have ever experienced. And if the investor also used dollar-cost averaging to add small amounts to the portfolio consistently over time, the results would have been even better.

If you ignore the pundits who say that old maxims don't work and you follow the time-tested techniques espoused here, you are likely to do just fine, even during the toughest of times.

Mr. Malkiel is a professor of economics at Princeton University. This op-ed was adapted from the upcoming 10th edition of his book "A Random Walk Down Wall Street," out in December by W.W. Norton.

Bogle: On Equity Styles

Chapter 6 of "Common Sense on Mutual Funds" is a discussion of investment style, returns, and relative index fund performance.

Over the last 30 years, academic research into the US stock market has shown that the whole US stock (equity) market can be dissected into various sectors that have there own risk and return characteristics. Below is a short excerpt from www.Investopedia.com that explains the most common style box:

The domestic equity style box, designed to assist in the evaluation of securities, is the best-known and most popular type of style box. Morningstar's domestic equity style box, shown below, provides a simple equity classification system.
The vertical axis of the style box is divided into three categories, which are based on market cap. For mutual fund evaluations, Morningstar's proprietary market cap evaluation methodology is used to rank the underlying stocks in each mutual fund in order to determine the fund's market cap. Of the 5,000 stocks in Morningstar's domestic equity database, the top 5% are categorized as large cap. The next 15% are classified as medium cap and the remaining stocks are classified as small cap.

The horizontal axis is also divided into three categories, based on valuation. Once again, the underlying stocks in each mutual fund portfolio are reviewed. The price-to-earnings (P/E) andprice-to-book (P/B) ratios are used as the basis of a mathematical calculation that results in the classification of each stock as growth, blend or value. "Blend" is used to describe stocks that exhibit both growth and value characteristics.

Analysis of the style boxes will show an investor that the smaller the sector the higher the return. Likewise, value funds outperform growth funds. In addition, as style drifts towards smaller and value, risk increases.

Understanding this breakdown is important for a couple of reasons;

1. It allows an investor to understand why and how their mutual fund performance is behaving in a certain manner. For example, over time, a small value fund should outperform a large growth fund - because it is riskier.

2. It helps explain manager performance. For many years, a mutual fund (or portfolio manager) was evaluated on pure returns. Now funds are reviewed through the risk and style box lens. A fund manager who focuses on small value and outperforms the total market will be evaluated against other small value measures not the whole market. So managers can no longer outperform by taking higher risks.and be perceived as being smarter than the market.

Next post I will explore how index funds compare against active managers in each style box.

Indexing: The Triumph of Experience over Hope

Warren Buffet in 1996:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

In chapter 5 of John Bogles's Common Sense on Mutual Funds, he makes his case for index funds.

What is an index fund? It is simply a mutual fund that holds a basket of stocks that meet a specific definition. They are not chosen by a single person, or by an investment committee, or by some formula.

The Dow Jones, S&P 500, and NASDAQ are index's. The Dow is 30 large US stocks, the S&P 500 is the largest 500 stocks in the US, and the NASDAQ is the market of technology stocks. An index fund is a mutual fund that replicates a particular index.

If you own the S&P 500 index fund, you own the 500 largest stocks in the US. Nobody picked those stocks in that fund, they are there because they meet the definition of 1 of the 500 largest stocks in US.

There are now hundreds of index funds available to investors. Including everything from a total US market fund to small cap value funds to international funds to specific industry funds, ie health care.

What studies have shown is that over time index funds perform better than funds that are managed by investment professionals.

Bogle shows that over the last 40 years the S&P 500 index earned 9% while the average actively managed equity fund earned 7.6%

To clarify:

The S&P is a good index to represent the total US market. By definition it is the average of all the investors investing in the market. And therefore, by definition, roughly half the investors will be better and half will be worse. Then, when you factor in expenses, it is nearly impossible to consistently outperform an index net of fees. A look at the above numbers demonstrates this. The average fund fees for mutual funds are approximately 1.3% to 1.5%. So if the average mutual fund earns the market average (since all equity mutual funds are essentially the market) of 9% then subtract the fees., the net return is the 7.6% . A mutual fund would have to earn better than 10% to beat the index net of fees.

It is primarily due to the fee issue that index funds outperform over time. This exists over all types of index funds. It mathematically has to: actively managed funds have higher expenses and if the index in every category is the average, the net active return has to be lower than the average (net of fees). This last argument is not mine it is William Sharpe's - 1990 Nobel prize winner in Economics.

Stock market value and the economy

A recent blog by Larry Swedroe - who is always worth the time.

He gives a brief but excellent explanation of stock market value relative to the overall economy.

http://moneywatch.bnet.com/investing/blog/wise-investing/the-economy-isnt-the-same-as-the-market/1732/

On Asset Allocation - The average investors most important decision

In Chapter 3 of Common Sense on Mutual Funds, John Bogle emphasizes the importance of getting your personal asset allocation correct.

Asset allocation means your stock to bond mix. Bogle emphasizes that bonds should be used as a moderator to your risky stocks. Not as another risky investment alternative. He says this because there are bonds that are very risky such as low grade and junk bonds. So by mix he means stable investments (short term high grade bonds) relative to risky, volatile investments (stocks).

He sites the famous 1986 study in the Financial Analysis Journal by Brinson, Hood, and Beebower that over 90% of the variation in pension plan returns studied were due to the stock bond mix. Not the particular stocks or bonds chosen.

Bogle clarifies the meaning behind the study's outcome: "Long-term fund investors might profit by concentrating more on the allocation of investments between stock and bond funds, and less on the question of what particular stock or bond fund to hold"

He goes on to emphasize that an investor needs to understand their time horizon, ability to stomach volatility, and whether the savings is for accumulating wealth or the distribution of wealth. Longer time horizons and investors in the savings stage can invest in a greater percentage of stocks. Versus an investor who is in the distribution phase of their investment cycle who should have a lower percentage of stocks. All investors should work with a trusted, competent advisor in order to develop the allocation mix that is best for them.

Bogle goes on to demonstrate that once the allocation mix is defined. The second most important thing an investor should do is fill the portfolio with low cost, preferably index, funds. Study after study show that when comparing similar funds, low cost is the best determinant of long term performance (see blog post 8/27/10).

The advice is straight forward: Determine the percentage of stocks you should own, then fund your portfolio with low cost index funds.

In future posts we will discuss what makes up the stock and bond portions. But you cant get to this question until you have determined the allocation.

SIMPLE 401K investing. Spend 5 minutes and potentially improve your wealth.

Most people get little advice an how to invest in their 401K plan. This is a SIMPLE approach. Spend 5 minutes reading the link below - simple investing advice on how you could invest in your 401K.

Remember that the more you allocate to stocks in your portfolio the greater the downs you will experience.

http://online.wsj.com/article/SB10001424052748704407804575425851977494576.html?mod=ITP_thejournalreport_0

Combine the above with this golden nugget of wisdom from John Bogle, summarizing a recent Morningstar study in the August 26, 2010 Wall Street Journal:

"A mutual fund's past returns are no guarantee of its future. Even the most sophisticated rating systems are erratic at best in forecasting a fund's performance in the years ahead. But for decades, academic experts and analysts have proven that fund costs are a powerful predictor of relative performance. Returns come and go, as it were, but costs go on forever.

A recent study by the Morningstar fund evaluation service came to this very same conclusion. In an admirable report that was the opposite of self-serving, Morningstar found that using fund-expenses ratios as a factor in choosing mutual funds was even more helpful than relying on its own carefully constructed "star ratings." Specifically, focusing on funds with the lowest expense ratio was more helpful in fully 58% of the time periods studied.

"In every asset class (U.S. stock funds, international stock funds, balanced funds, taxable bonds, and municipal bonds) over every time period," Morningstar wrote, "the cheapest quintile produced higher net returns than the most expensive quintile." Among domestic equity funds, the returns of the lower-cost funds outpaced the returns of the higher-cost funds by about 1.3 percentage points annually. That proves to be a compelling edge. Over a 50-year investment lifetime, for example, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.

These calculations actually understate the success of low-cost funds. "Survivor bias"—only the more successful funds survive to make it into the database—permeates the equity-fund data. According to Morningstar, in the highest-cost quintile only 57% of equity funds survived over the past five years. Even in the lowest-cost quintile, only 81% survived. So much for relying on most mutual funds as long-term investments.

The idea that costs matter is not new. In a 1966 article in the Journal of Management, economist William F. Sharpe concluded, "all other things being equal, the smaller a fund's expense ratio, the better results obtained by its stock holders."

Bogle on fees in todays Wall Street Journal

http://online.wsj.com/article/SB10001424052748703846604575447531979322798.html?mod=ITP_opinion_0

Occum's Razor and Stock Market Returns

In chapter 2 of John Bogle's Common Sense on Mutual Funds, he introduces Occums postulate that states: the simpler the explanation then the more likely it is to be correct.

Bogle has applied Occum's razor to all the noise that surrounds stock returns and has found that if you accept that the performance of individual securities and portfolios are unpredictable on a short term basis, one can arrive at three factors that determine long term stock performance. Those three factors are:

1. Dividend yield at time of initial investment

2. Subsequent rate of growth in earnings

3. The change in the price-earnings ratio during the period of investment.

Bogle then states that since 1926 that less than 20% of the markets return has been due to speculation. The majority of return is due to the two other factors: dividends and earnings growth.

He states that speculation is almost a neutral factor in the nature of long run returns.

This is important. It means that even if you had a speculative edge, over the long run, your advantage is not that great. Not to mention that the transaction costs involved may eliminate any edge you may have.

Occum's razor applied to the stock market: returns over the long run will equal dividend yields + long term economic growth. everything else is noise.

2 Reports from WSJ - How would Dilbert Invest & Chance

In todays WSJ there are two good articles on investing. Both emphasize the use of index funds:

http://online.wsj.com/article/SB10001424052748703724104575379281901045278.html?mod=ITP_thejournalreport_0

http://online.wsj.com/article/SB10001424052748704913304575370913870866820.html?mod=ITP_thejournalreport_0

Long Term Investor: No Excuse not to Index - a table, a chart, a graph

The following table and chart are re-creations of a table and chart published in John Bogle's Common Sense On Mutual Funds. I believe that a short analysis will explain the argument for long term investors to simply hold the total market versus paying active managers to pick stocks or sectors.

A review of the chart shows that the average 1 year US stock market return since 1802 has been 6.5% (adjusted for inflation) with a one year high of 61.4 and a 1 year low of -48.4.

It also shows that as time passes the average return on the US stock market goes up and its highs and lows go down. For example the average of all 25 year holding periods is 6.9% with a high of 11.1% and a low of 2.7%. That means that any investor that held the US market for any 25 year period never had a 25 year return higher than 11.1% or lower than 2.7%. The numbers for a 50 year holding period are even more dramatic.

Now I need to bring in the definition of standard deviation to fully make the argument for holding (or indexing) the total US market.

Standard deviation measures the spread of the data that makes up the average. So a larger standard deviation means that the data that make up the average are spread farther apart than lower standard deviation averages. The chart and table above demonstrate this: in any 1 year the US market had returns that could have been anywhere between 61.4 and -48.4. But if one held the US market 50 years the spread of returns ranged between 3.9 and 9.9 (the 50 year holding period has a lower standard deviation).

Stay with me.

Statisticians have found that most averages have data that falls within 3 standard deviations (SD) of the average and that the data points make up a "bell shaped curve"

The graph below shows this idea. Generally, 68.2% of the data points that make up the average fall within 1 SD, 95.4% fall within 2 SD and 99.6% fall within 3 SD. Standard deviation is represented below by the Greek symbol sigma ( σ ).

3.9%... 4.9% ...5.9%.. 6.9%.. 7.9% ..8.9%...9.9%

Average return for the corresponding standard deviation for 50 yr holding period

So what does all this mean for long term investors? It means this: If you had simply held an index fund of the total US market over the last 50 years you would have earned 6.9%. You would have had a fee of .20% (index funds are very cheap - there is no work to do) and your net after inflation return would have been 6.7%.

If you paid an advisor to actively manage your investments, or used an actively managed mutual fund, you had a 50% chance of being above average. Now factor in fees of 1.5% (average of mutual fund or personal advisor fees) and you would have had to had a return of greater than 8.2% (8.2% - 1.5% fees = 6.7%) to equal the return of holding the index and just being average.

Note: that actively managing means that someone is picking stocks and buying and selling based on what they feel is the best time to move in and out of certain stock positions.

If you earned an 8.2% return you would have been in the greater than 1 standard deviation range. Remember for the 50 year time period the standard deviation was 1%. A look at the graph above will show that your return would have been in the top 10 to 16% of returns.

Anything less than an 8.2% return and your performance is less than average after fees.

As an investor you need to ask: what are my odds of achieving higher than average net returns?

Finally, I want to emphasize that studies also show that the stock picker or mutual fund that does great one year or for several years does not maintain that position. So, to add to the above question, one needs to ask: can I consistently pick the advisor, mutual fund or stocks that will, net of fees, outperform the average of the US stock market.

My advise: ACCEPT AVERAGE and by doing that you are FAR ABOVE AVERAGE, NET OF FEES.

In further blogs we will explore what stocks tend to fall in the above average part of the bell shaped curve and why. Preview: they do not get there without a cost, and that cost is volatility - risk.

Yale Endowment: Superior Intelligence or Higher Risk

Are superior returns due to superior intelligence or adopting a riskier investment portfolio? This is a topic which I will explore continually. Larry Swedroe discusses David Swensen's performance at Yale.

http://moneywatch.bnet.com/investing/blog/wise-investing/is-david-swensen-lucky-or-good/1507/

Blog post on Indexing by Larry Swedroe

Short blog post by one of my favorite investing writers: Larry Swedroe.

In this post Larry gives an explanation of why investing with index funds results in superior returns.

http://moneywatch.bnet.com/investing/blog/wise-investing/do-you-want-to-be-just-average/1468/?tag=col1;blog-river

The Father of Modern Portfolio Theory Speaks

There is a collection of accepted learning in the field of financial economics known as Modern Portfolio Theory (MPT). MPT is so commonplace now that it is hard to believe that it was revolutionary 50 years ago. That was when a Phd student at the University of Chicago, Harry Markowitz, argued that there was a trade off between risk and return. He demonstrated, mathematically, that investors are rewarded for the level of risk they take He also showed, that for every level of risk taken, there is a combination of investments that is the best combination available for that level of risk. Most of us who have investment portfolios have a portfolio that combines different asset classes (US Stocks, international stocks, bonds). This type of diversification was all started by Harry Markowitz.

The portfolio model Markowitz invented was based on the statistics of mean (average) return and the variance of the data points around the mean. These models would say something like - if you invest in a 100% stock portfolio you could have a one year return of negative 50% a couple times a century. A good financial advisor should explain that to an investor.

In 2008 the market experienced one of those couple times a century years. Some in the financial press shouted that MPT failed. I have to say, that when I would read or hear this I struggled, because 2008 was not outside what the models FOR PROPERLY DIVERSIFIED PORTFOLIOS predicted. This is not to say that other models that the banks and others were using to make bets on the housing market did not fail, they did. But if you were an average investor who had a portfolio built on an MPT foundation, your return was within the prediction of the model.

Attached is a great interview with Markowitz in last months Journal of Financial Planning:

http://www.fpajournal.org/CurrentIssue/TableofContents/May201010Questions/

Here he explains and defends MPT. He is a modest genius who should be read and listened too.

Bogle on long term investing

In chapter one of Common Sense on Mutual Funds, John Bogle makes the following recommendation on stocks: He states that based on the historical evidence, if your definition of risk is the failure to earn a positive real return (your investments outperform the rate of inflation) over the long term, then stocks are actually less risky than bonds. He says that if you believe that the economy will be healthy over the long term, then the best way to outperform inflation is the stock market.

But, you must be prepared for periods of negative returns. Sometimes over several years.

It is important to note that Bogle defines risk as an investment that does not outperform inflation. Some investors cannot stomach the ups and downs of the stock market and for them, risk is having their investment earning negative returns. Outperforming inflation does not matter to them.

Also note that he is stressing this for the "long term investor." My advise on the definition of long term is 10 years or more. Therefore if you have need for your money in a period of less than 10 years the stock market may not be appropriate.

Finally, Bogle stresses the need to include Bonds in your investment portfolio. Bonds will generally act as insurance to your portfolio during poor stock market periods.

I will discuss portfolio allocations and risk issues in future blogs.

Devil Take the Hindmost - history repeats

We have been here and seen this bubble cycle many times before. In his 1999 book, Devil Take the Hindmost, Edward Chancellor documents the long history of financial speculation. Early in the book he quotes John Stuart Mill. Writing in the 1800's, Mill wrote:

"Some accident which excites expectations of rising prices... sets speculation at work...In certain states of the public mind, such examples of rapid increase of fortune call forth numerous imitators, and speculation not only goes much beyond what is justified by the original grounds for expecting a rise in price, but extends itself to articles in which there never was any such ground; these however, rise like the rest as soon as speculation sets in. At periods of this kind, a great extension of credit takes place."

Chancellor goes on to write this short description of the behaviors of bubble cycles, many of which which are playing out today:

"The governments failure to regulate or supervise the new stock market and its stimulation of a lottery "fever" were key factors in the genesis and development of the 1690's boom. This was supplemented by the venality of members of Parliament who were more interested in profiting personally from the stock market than in opposing its excesses. As we shall see, a combination of laissez-fair and political corruption is a common feature of later manias - the most notable example being the Japanese "bubble economy" of the 1980's. When the boom ended and was followed by an economic crisis, the political situation changed. The selfish and shortsighted behavior of stockjobbers and promoters suggested a limit to the economic role of self-interest, and laissez-faire was replaced by regulation of both trade and the stock market.. Other manias have also been followed by a wave of popular, if rather hypocritical, revulsion against "greed."

After the crisis of 1696, stockjobbers became a symbol for the avarice of society at large, just as the "moneylenders" (President Franklin D. Roosevelt's phrase) were castigated in the 1930's"

For the long term investor it is important to understand that the history of capital markets is filled with incidents that are similar to the one we are living through. It is not different this time. Rather, it appears to be consistent with the historical record.

"

Bogle - On Long Term Investing

Bogle starts Common sense on Mutual Funds with a lesson on the long term nature of capital markets. He quotes from the book/movie Being There - about a reclusive gardener for a wealthy man. when the wealthy man dies the gardener, named Chance, is mistaken for the rich man by an advisor for the president. Chance is asked for advice on the troubled financial markets by the presidential advisor. Chance can only answer with what he knows. He says that "growth has its season. There are spring and summer, but there is also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well."

This is a great allegory of our capital markets. there will be ups and downs and periods of stagnation, but as long as the roots of our governments and financial systems stay intact, we will be rewarded as long term investors.

Bogle demonstrates that since 1800 our nation has been through many recessions, depressions, a civil war, 2 world wars and many other difficult times. But over that period we have seen the following:

* Stock Market returns of 8% (6.9% real - adjusted for inflation). The volatility of this return has shown returns as low as -48.4% and as high as 61.4% .

*Long Term US Treasury Bonds have had returns of 5.1% (3.6% real) with a volatility that ranges from -21.9% to a high of 35.1%.

Then Bogle goes on to demonstrate that over long periods of time, the swings in a market portfolio of stocks is dramatically reduced. In any given year an investor can and WILL experience the dramatic swing in returns (winter, spring, summer, fall).

holding stocks for the last 15 years would have resulted in a 6.9% real return (4% standard deviation). Holding stocks for the last 25 years would have netted a real return of 6.9% and a 1.4% standard deviation.

Standard deviation is a measure of volatility. A standard deviation of 4% means that 66% of the the fall within 4 of the 6.9% 15 year return. So, 66% of the time the returns were between 10.9% and 2.9%. It also means that 95% of the returns were within 2 standard deviations of the average.

The lesson is that for young people investing for retirement, for trusts and foundations, who all have a long term horizon, one can expect a historical return of 6.5% and long term standard deviation of 1% if they stay in the market.

"Ignore Jim Crammer. Pay attention to Jack Bogle!"

The title quote was authored by David F. Swensen, the Chief Investment Officer, Yale University.

I could not agree more. As we will learn in the coming weeks, Jack Bogle is the founder of The Vanguard Mutual Fund Group and one of the financial industries most respected advocates of index funds and low mutual fund fees. Jim Crammer is the host of Mad Money on CNBC, a brilliant man, but in my opinion, a man who perpetuates the idea among the average citizen that he can outperform the stock market. Where as Bogle advocates for a carefully diversified portfolio of index funds and owning stocks only for the long run. Crammer makes one think that through superior insight and/or information one can pick the right stocks, time the market and quickly get rich. Who is correct is a debate that rages on Wall St.

I fall on the side of Jack Bogle. Twenty years of study and observation have strengthened this position. These ideas will be explored as I Blog ideas from Bogles 10th anniversary edition of "Common Sense on Mutual Funds"

Brett Arends of Wall St Journal on Gold

This link is from WSJ 5/27/2010.

http://online.wsj.com/article/SB10001424052748704032704575268462477689760.html?mod=rss_Money

Gold investing expanded

Roubini - renowned economist, on gold: "If you're really worried about inflation rising, buy spam. You can eat spam, you can't eat gold."

People tend to rush to buy gold when they fear that their currency's purchasing power will be diminished through a systemic collapse or inflation.

But be careful if you are buying gold in order to preserve wealth or as a an investment. Gold has a poor historical return. It also does not pay dividends or interest. Its growth is based solely on speculation. One needs to time when to buy and sell in order to profit.

A review of the chart above shows that gold is priced at a historically high price. If one buys now, how high will it go? Also beware - when it comes back down, how long before it gets back to todays prices. In addition, it will pay no interest and potentially cost you money for safe keeping. Finally, you can see that over the last two hundred years gold has not even outperformed short term US Treasury Bills.

If you are nervous about inflation devaluing your dollars. Purchase US government Treasury Inflated Protected Securities (TIPS). They are issued by the US Treasury and adjust with inflation.

I expressed Roubini's sentiment in a slightly different manner: I have said if the whole system collapses and your treasury securities and bank deposits collapse, what good will gold do you? What could you buy when the grocery stores have been looted? The canned goods owner may be the wealthy one.

In Cormac McCarthy's post apocolypotic book "The Road" about a father and son who are wondering the scorched, desolate remains of the American West; there is a scene where the man and his son find canned food and a box of gold in a fall-out shelter. The man leaves the gold.

Any way you slice it: gold, government bonds or stocks, there is the risk of loss. Historically, bonds and stocks have been a better investment.

There can be a place for some gold and other commodities in a diversified portfolio, I will discuss that in a future post.

AWM on long term stock investing

I have been asked by a number of people recently whether they should get out of the stock market now. The worries over Greece, Europe, flash crashes, global debt, oil spills. So , I have reworked a paper I emailed in the fall of 2008.

The first thing to understand is that the stock market is very volatile over short periods of time. Obviously, it is sometimes much more volatile than at other times. It moves randomly from minute to minute because it is constantly responding to news and events that effect our economy and business environment. But, over the long run, stocks follow a more rational pattern. That is because, over time, our economic system produces more good news than bad. Review the chart below. It was developed by Jeremy Siegel, Professor of finance at Wharton (note: there is debate on the accuracy of returns during the 1800's, but the trend is still relevant) :

This covers a civil war, the great depression, two world wars, the Vietnam era etc.

FYI: notice the value of gold.

For the last 400 years, since the inception of capital markets, there have been wild swings in the value of markets. There have been numerous bursting bubbles and numerous claims that this is the end of capitalism. Every time the markets rebounded and continued their upward climb.

Markets act wildly day to day, even month to month, sometimes for many years in a row. But over very long periods 10 years or more, they act very rationally. Below is a graph that shows the volatility (highest value to lowest value) of annual returns of the total US stock market between January 1926 and September 2008 over rolling 1, 3, 5, 10, 15, and 20 year periods. There has never been a period of 15 years where the markets return was negative, and only in rare cases are there periods of 10 years that have resulted in a negative return.

As you can see, that as your stock investing period of time increases, the volatility of your returns diminishes considerably.

Furthermore, this tells us that when we invest in stocks it should be for 10 or more years, otherwise we may be subject to wide swings in potential returns.

Next, look at the next chart below, similar to the chart above, it shows us that over the last 100 years the US stock market goes through stagnant periods followed by dramatic euphoric increases. The important point, with both charts, is that although we have had many bad periods, the market trends up. If you stay in long enough you will be rewarded. As long as the foundations of capitalism are secure, stocks have to return a positive amount - simply because the market will continually adjust stock prices to insure that an appropriate long term return is earned.

How does this happen? The return on a stock is the expected dividend divided by the stock price: ( Expected Dividend)/Stock Price = Return. If I own a stock worth $100 and I expect to earn $5/year in dividends then my expected return is 5%. (5/100). If I feel the dividend will go down because of bad economic news AND I demand a 5% return from this stock, then I will no longer want to hold it at $100. I will sell. When news is bad, stock investors worry about the amount of future earnings they will receive from stocks. If the market feels that dividends are going down (bad economic news), the value of stocks will go down. Likewise, if the market feels that economic news is positive the price will adjust up. For example, if I demand a 5% return on the $100 stock and good economic news leads me to believe future dividends will be $6 then I am willing to purchase my stock at $120 ($6 div/$120 stock price = 5%) and I now feel even wealthier because I own the stock at $100 and I am receiving a greater dividend return than i required from that stock.

The markets volatility is the markets way of constantly adjusting prices to changing news. Over time, there has been more positive investment news than negative. In fact it can only be that way in a Capitalist system. Otherwise the system would collapse. If we really believed that our nation and economy are collapsing then anticipated profits and dividends would be zero and therefore stock prices would be zero (see my concluding comments).

Some may look at the chart above and say “I will stay out until the market rebounds, then buy on the upswing” the problem with this idea is that one does not know when the market has bottomed. Often the market corrects itself over a few large trading days. Just read this following excerpt from:

· Charles Ellis’s WINNING THE LOSER ' S GAME. “Market timing is a "wicked" idea. Don't try it-ever. Using the S & P 500 average returns, the story is told quickly and clearly: All the total returns on stocks in the past 75 years were achieved in the best 60 months (less than 7 percent of those 800 months-over those long years). Imagine the profits if we could know which months! But we can- not and will not. What we do know is both simple and valuable: If we missed those few and fabulous 60 best months we would have missed almost all the total returns accumulated over two full generations. A recent study by T. Rowe Price shows that a $1 investment in the S & P 500 that missed the 90 best trading days in the 10 years from June 30, 1989, to June 30, 1999, would have lost money (22 cents) and would have made only 30 cents if it missed the best 60 days-but would have made $ 5.59 by staying fully invested. “

Charles D. Ellis, John J. Brennan. Winning the Loser's Game: Timeless Strategies for Successful Investing. (McGraw-Hill, 2002). Page 14.

So, what to conclude:

1. If your investing time horizon is greater than 10 years, stay the course you have decided on. If you are unsure of your course – contact me. If your investing time horizon is less than 15 years please consult with me. The answer will depend on your future plans for your investments.
2. Should you stay in the market? Yes, if you believe that our government is stable over the long period. The market may move down more or stay flat for a period of time. Again, recall the information above, As long as you have time and our nation stays strong you will be rewarded. I have also told people that if our government fails. It will not matter where your money is. It will all be worthless anyway. Our dollar, our banks, US government bonds are all dependent on our governments survival – they will all be worthless. If the US fails the consequences are too apocalyptic to imagine.
3. A decision to enter the stock market should be a long term decision with an understanding that you may, and likely will, have uncomfortable downs. The long term return of stocks of around 6.5% (after inflation) is the reward you get for accepting the wild swings.
4. Make sure that as you age, you move more of your portfolio into less risky investments. You should understand how much volatility your portfolio has, and adjust as age and life circumstances dictate.

Interesting chart

http://paul.kedrosky.com/archives/2010/05/market_drops_th.html

New Blog material

I have started to re-read Common Sense on Mutual Funds the updated 10th anniversary edition, by John Bogle. Bogle is the founder of Vangaurd and one of the most respected persons in the investing field. If there is one book I would recommend on investing this would be it. I will be blogging on important insights as I read.

3 Important Books

This past winter I have read and been influenced by 3 books that discuss what we know about the human mind and its effects on our daily lives:

Your Money & Your Brain by Jason Zweig - I have blogged on this extensively. Zweig relates what we know about the brain and how it effects us as decision makers.

Drive - The Surprising Truth About What Motivates Us by Daniel Pink. Pink explores the psychology of human motivation. He argues that todays work environment requires us to move away from traditional carrot and stick approach to management and into what he calls motivation 3.0. Motivation 3.0 emphasizes understanding the intrinsic human need for belonging, learning and creating. If you manage people this is a must read.

NUDGE: Improving Decisions About Health, Wealth and Happiness by Richard Thayer and Cass Sustein. In this book, the University of Chicago professors argue for governments nudging people into better decisions. They refer to their approach as "libertarian paternalism" They explain that we are sometimes guided by our brains into poor decisions. Since we understand this, should we not design systems that help us make better decisions related to wellness, 401k savings, energy conservation etc. ?

Your Money & Your Brain - Final Advice

Zweig ends YM&YB with the following:

T ake a global view

H ope for the best, expect the worst. Learn market history to help avoid panicking in bad times.

I Investigate, then invest.

N ever say always. No matter how sure you are of an investment, don't invest more than 10%.

K now what you don't know. Find out if people pushing it are putting their money in it.

T he past is not a prologue. Don't buy an investment just because it has been going up.

W eigh what they say. Ask a forecaster for a complete history of all their predictions.

I f it sounds too good to be true it probably is.

C osts matter. if you aren't careful expenses and taxes can easily eat up 1/2 of your return.

E ggs go splat. Don't put all your eggs in one basket.

Sounds very simple. But if the people who invested with Bernie Madoff followed this advice, many would be BILLIONS richer today.

Your Money & Your Brain - Happiness

Studies show that having wealth does not make people happy. once you have enough to meet your basic needs, more money creates less happiness than one would think.

The human tendency to be envious can rule our lives. When we buy the smallest house in a nice neighborhood we will be less happy than having the biggest house in a neighborhood of smaller houses. This envy reflex helps us to work to survive and gives us hope for the future. But unless we control this urge we will chronically be unsatisfied. There will always be someone with more. This explains why people in rich countries are only as happy as those in some poorer countries. We are constantly comparing ourselves to the "Jones"

What is the secret to happiness:

Zweig explains that your memory looks for favorably on past events as time passes. This leads to a phenomenon where past experiences grow in value as your memory of it grows warmer. Contrast this with the acquisition of items (new car, kitchen, etc.) which depreciate in value to the owner over time. Experiences trump acquisitions.

He also states that the happiest people are those that spend less time alone and had more friends.

We need to enjoy our friends, family and experiences in order to have a happy fulfilled life. This sounds like classic cliche, but it is backed by scientific research.

4 Podcasts that explain the credit crisis

Over the last couple years I have come across 4 podcasts that do a wonderful job of explaining the credit/mortgage crisis that shook our economy:

EconTalk 5/17/2010 Russ Roberts, Professor of Economics at George Mason University and host of the podcast EconTalk, does a wonderful job of presenting an overview of a paper he has written on the topic. It is a open and fair explanation of the events and circumstances that may have resulted in the crisis. Roberts focuses attention on various incentives that may have been in play.

EconTalk 9/29/08 interview with Arnold Kling - Kling was formerly employed at Freddie Mac and starts by explaining how a mortgage works all the way through the real estate bubble and its consequences. Listen to this first as a good basis.

This American Life: "Giant Pool of Money" and "Inside Job" - you may have to pay .99 to get these. They are well worth it.

Also: listen to NPR's Planet Money podcasts.

I make EconTalk and Planet Money podcasts mandatory listening every week. They are always enlightening.

Your Money & Your Brain - Surprise (READ THIS)

Jason Zweig writes the following in chapter 8: "After writing about Wall Street since 1987 and studying centuries worth of financial history, I have become convinced that the prevailing view of what the future holds is almost always wrong. In fact, the only incontrovertible evidence that the past offers about the financial markets is that they will surprise us in the future. The corollary to this historical law is that the future will most brutally surprise those who are the most certain they understand it. Sooner or later, sometimes slowly and sometimes suddenly - but with a diabolical ability to root out everyone who has ever gazed into a crystal ball - the financial markets will humiliate whoever thinks he knows whats coming"

Zweig wrote the above in 2007.

I like this because it flies in the face of all the CNBC and financial prognosticators who are so confident they know the next turn of the market or hot stock or hot sector.

In this chapter on surprise Zweig explains that it is our anterior cingulate cortex (ACC) that tunes the rest of our brain to danger. Its part of our intuitive system that helps us respond quickly to danger. In the biological world that we live in, it is more important to respond quickly to dangers versus successes.

This helps account for our panic when markets start to fall.

Zweig reminds us to:

* Remember that "everyone knows nothing" - what everybody knows is already embedded in the price, so what everybody knows does not give you an edge. Unless you have some great insight, you don't know anything that the market has already built into the price.

and that,

*High hopes cause trouble. Growth stocks that miss earnings by just a small amount can spell big losses. Conversely, value stocks tend to have low hopes and so when positive news on a value stock becomes public they tend to have large increases. Classic examples of our brain reacting to surprises.

Your Money & Your Brain - Fear

Chapter 7 of YM & YB discusses fear. The manner in which our brains process fear has a large effect on how we invest.

The more vivid and imaginable a risk is the scarier it feels, and the ensuing fear is effected by what psychologists call "dread" and "knowability."

Dread is determined by how vivid or catastrophic an event seems to be.

Knowability is how immediate or specific the consequences appear to be. Plane crashes seem more "knowable" than health dangers brought on by pesticides.

When we feel we understand the situation and are in control we underestimate the risks. We tend to be more fearful of flying than driving after having a couple of drinks. Yet, the driving is much riskier.

We have a greater fear of losing all our money in a market crash versus losing our nest egg to inflation. The dread and unknowabilty dominate our thinking.

Your brains amygdala, which is part of your reflexive brains alarm system, further contributes to potentially bad investment decisions. This part of your brain responds to all kinds of signals and even words. So when you watch a news story of a bad day on the trading floor, you see traders arms gesturing wildly, clanging bells, and you hear alarming words: crash, panic, etc.

Studies show that when you see this, your armygdala is very active and is filling you with fear signals.

Zweig recommends several tactics that you can use to keep your fears in check:

1. When you feel overwhelmed with fear. take a time out. Let your circuits settle.

2. Ask yourself:

* other than price, what else has changed?

* are my original reasons to invest still valid?

* If i liked this investment at a higher price, do I like it now that it is cheaper?

3. Resist the pull of the herd. Ask someone who may not have an interest in your investment whether the fear is reasonable and if you were in my shoes what other information would you require before making a decision.

WATCH: "Fear the Boom and Bust" rap!

a very professional rap created to explain the economic debate that has been raging in politics and economics for 80 years. Fun and well done -who doesn't love an economic theory rap?

http://www.youtube.com/watch?v=d0nERTFo-Sk

There is a great book: The Commanding Heights and PBS series, based on the book, that discusses how this debate has effected all of our lives since the great depression. I highly recommend it.

Your Money & Your Brain - Risk

In Chapter 6 of Jason Zweig's Your Money & Your Brain, Jason explains that we don't have a defined "risk tolerance." He emphasizes several areas that effect our risk tolerance: mood, framing, how we react to percentages and herd menatality.

Studies show that the amount of risk you can take is directly correlated to your mood.

From a survival standpoint, says psychologist Amos Tversky, risk was a matter of life and death. Sensitivity to losses was more beneficial than the appreciation of gains. Over thousands of generations, a "better safe than sorry" reflex has become ingrained in humans. Various studies show, that depending on our mood, we react differently to risky situations.

Secondly, we also react to how things are framed. Researchers have demonstrated this in many ways. One classic study showed that when a four ounce glass of water has two ounces poured out , 69% of people will say the glass is half empty. If the same glass starts out empty and has two ounces poured in, 88% of people will say the glass is half full. This is a perfect example of how equivalent ways of describing something should lead to equivalent decisions. But that is not what happens.

Zweig gives many examples on where framing exists in the financial world. For example, if you put 1% of your money in a single stock that goes to zero you would be very upset. But if you lost 1% of your total portfolio you would not be as upset. You would shrug it off as a routine fluctuation.

The third factor effecting risk is how we react to percentages vs. how we react to odds expresed as frequencies. That is because percentages are abstract to people. People who are told that a surgery has a 10% failure rate react less severely to a 1 in 10 failure rate. that is because we visualize that 1 person.

Finally, Zweig explains that most of us are subject to peer pressure. People in the same office tend to invest their 401Ks in a similar manner. Even, the "smart money," supposedly independent minded investors like hedge funds, insurance companies, foundations and pension funds tend to invest in the same manner.

As in previous chapters, Zweig offers some advice to help investors manage their brain:

* Always take a time out and wait a day. remember a fight with your spouse or a good round of golf may be influencing your decision.

* Look back at history. No market continually rises. There are boom and bust cylces. When the bust comes, can you handle it?

* Reframe: if someone says the odds of success are 80%, then ask yourself if you are comfortable with a 2 out of 10 chance of loss.

* Since no one has a defined risk tolerance, think in terms of how an investment decision effects your goals, objectives, and outcomes. Have a personal investment policy statement (IPS) and stick to it.

Jason Zweig's column in WSJ

Jason always has sound advise. I recommend reading todays column:

http://online.wsj.com/article/SB20001424052702304871704575160190948059722.html#mod=todays_us_money_and_investing

Great Book on Auto Industry

I have been listening to Crash Course by Paul Ingrassia, writer for the Wall Street Journal. If you are at all interested in the US auto industry this is a must read: http://www.amazon.com/Crash-Course-American-Automobile-Industrys/dp/1400068630/ref=sr_1_1?ie=UTF8&s=books&qid=1270204897&sr=8-1

I also recommend: The End of Detroit: How the Big Three Lost Their Grip on the American Car Market by Micheline Maynard. I read this several years ago and the lesson I took from the book is that Americans can compete in the auto industry if they are allowed to operate in a good system. It is Americans that are engineering and building the high quality Honda's, Toyotas, and Nissans sold in America today.

Your Money & Your Brain - Confidence

What I love about this book is that its findings and applications apply to many areas in life. At a later date, I will post a blog on how these same principles apply to social policy and human motivation.

In Chapter five, Zweig discusses the dangers of inherit in confidence. We as humans have a tendency to believe that we are better looking, smarter, funnier etc. than we really are. Studies show that we rate ourselves consistently above average on any item measured. How can that be? by definition we all cant be above average. This is not a bad thing, if we didn't have confidence we we would never take risks.

Unfortunately, in investing, this overconfidence can lead to underperformance:

* We believe we are smarter than the collective market. Surveyed investors believe they will outperform the market by 1.5 percentage points. Mutual fund investors believe the funds they pick will outperform the market. Again, how can we all beat the market?

* We put too much faith in what is familiar. This "home bias" leads to too little allocated to foreign investments and too much invested in our own companies stock (think Enron). Brain scans of investors show that when considering placing money in foreign markets their amygdala (brains fear center) kicks in. Staying close to home feels safer.

* We think we have more control than we do.

* We have "hindsight' bias. We think we predicted what occurred, which leads us to think we can predict the future.

* We hate to admit that we don't know something. Ironically, this means we are overconfident in our abilities to overcome our overconfidence.

A great point in the chapter is Zweigs discussion of "illusion of control". More than any other activity except sports and gambling this effect exists in investing. Illusion of control exists when:

* activity appears partly random

* there are choices

* involves competition

* can be practiced

* requires effort

* feels familiar

This results in what Zweig calls the Colonel Klink illusion. You think you are in control. But you are not.

What can we do to protect ourselves:

1. You need to say "i dont know" then learn more.

2. Discount your expectations by 25% before you act.

3. Write down why you made the decision you did. Write out "i think this investment will go up because_______________."

4. Learn what works by tracking what doesn't

5. Don' t just buy what you know and don't get stuck on your co.'s stock.

6. Diversification is the best defense.

This last point is huge. I have studied investing for the last 25 years, I am convinced that there is no better investing strategy other than building a well diversified portfolio that is appropriate for your capacity for risk and doing little, other than re-balancing it annually, or adjusting for changes in life circumstance.