A Must Read

Whether your interest is in marketing, education, social welfare, investing or politics, I highly recommend Daniel Kahneman's Thinking Fast and Slow.
The insights into human decision making are profound. Kahneman may be the most important psychologist of the last 40 years. he is also the winner of the noble prize in economics for his work in behavioral finance.

I will be blogging insights found in this book over the coming weeks.

A Simple Rule To Follow When Picking a Mutual Fund

Advice from Carl Richards (Bucks Blog).
Carl is highlighting studies that show that the higher the mutual fund fee the lower its performance relative to its peers.

The best predictor of mutual fund success is a mutual funds expense ratio.

Diversification 101 from Larry Swedroe. A Must Read for the Average Investor

12 years ago while preparing a presentation, I was looking for a source that could clearly explain and demonstrate the ideas behind diversifying an investment portfolio. I wanted examples that could be understood by the average investor. That is when I discovered Larry Swedroe's What Wall Street Doesnt Want You Too Know. I have been a fan of his writing ever since.

What follows is from Larry Swedroe's Wise Investing blog. It is an excellent description of the power of diversifying across asset classes. It is a must read for anyone who invests their money in the markets:

(MoneyWatch) This post is based on chapter 6 of Larry Swedroe's new book Think, Act, and Invest Like Warren Buffett. The data for today's post and the associated text have been updated through the end of 2012.

Because most investors have not studied financial economics and don't read financial economic journals or  books on modern portfolio theory, they don't have an understanding of how many stocks are needed to build a truly diversified portfolio. To effectively diversify the risks of just the asset class of U.S. large-cap stocks, you would have to hold a minimum of 50 stocks. For U.S. small-cap stocks, the figure is much higher. Once you expand your investment universe to include international stocks, it becomes obvious that the only way to effectively diversify a portfolio is through the use of mutual funds.

However, even when individuals invest in mutual funds, they typically don't diversify effectively because they make the mistake of thinking that diversification is about the number of funds you own. Instead, it's about how well your investments are spread across different asset classes. For example, an investor who owns 10 different actively managed U.S. large-cap funds may believe that he is effectively diversified. While it's true that each fund will likely have some differentiation in its holdings from the others, collectively, all the investor has done has been to create an expensive "closet" index fund. The reason is that it's likely that the return of his portfolio, before expenses, will approximate the return of an S&P 500 Index fund. After expenses, the odds are great it will underperform.

Even many individuals who invest in index funds get it wrong because they limit themselves to funds that mimic either the S&P 500 Index or a total U.S. market index. At the very least, they should also include a significant allocation (30 percent to 50 percent) to a fund such as Vanguard's Total International Stock Index Fund.

The next step is to show you how simple it is to build a more effective, globally diversified portfolio. Many investors think that diversification means owning enough mutual funds. However, the key is spreading them across asset classes. After all, 10 different large-cap growth funds still means you only have exposure to one asset class.

The Basic Portfolio

We will begin with a portfolio that has a conventional asset allocation of 60 percent stocks and 40 percent bonds. The time frame will be the 38-year period, 1975-2012. This period was chosen because it's the longest for which we have data on the indexes we need. While maintaining the same 60 percent stock/40 percent bond allocation, we'll then expand our investment universe to include other stock asset classes.

We begin with a portfolio that consists of just two investments:

• The S&P 500 Index for the stock allocation
• Five-year Treasury notes for the bond portion

We'll see how the portfolio performed if one had the patience to stay with this allocation from 1975 through 2011 and rebalanced annually. We will then demonstrate how the portfolio's performance could have been made more efficient by increasing its diversification across asset classes. We do so in four simple steps.

Portfolio 1

• 60 percent S&P 500 Index
• 40 percent five-year Treasury notes

By changing the composition of the control portfolio, we will see how we can improve the efficiency of our portfolio. To avoid being accused of data mining, we will alter our allocations by arbitrarily "cutting things in half."

Small-Cap Stocks

The first step is to diversify our stock holdings to include an allocation to U.S. small-cap stocks. Therefore, we reduce our allocation to the S&P 500 Index from 60 percent to 30 percent and allocate 30 percent to the Fama/French Small Cap Index. (The Fama-French indexes measure returns using the academic definitions of asset classes. Note that utilities have been excluded from the data.)

Portfolio 2

• 30 percent S&P 500 Index
• 30 percent Fama/French Small Cap Index
• 40 percent five-year Treasury notes

Value Stocks

Our next step is to diversify our domestic stock holdings to include value stocks. We shift half of our 30 percent allocation in the S&P 500 Index to a large-cap value index and half of our 30 percent allocation of small-cap stocks to a small-cap value index.

Portfolio 3

• 15 percent S&P 500 Index
• 15 percent Fama/French US Large Value Index (ex utilities)
• 15 percent Fama/French US Small Cap Index
• 15 percent Fama/French US Small Value Index (ex utilities)
• 40 percent five-year Treasury notes

International Stocks

Our next step is to shift half of our stock allocation to international stocks. For exposure to international value and international small-cap stocks we will add a 15 percent allocation to both the MSCI EAFE Value Index and the Dimensional International Small Cap Index.

Portfolio 4

• 7.5 percent S&P 500 Index
• 7.5 percent Fama/French US Large Value Index (ex utilities)
• 7.5 percent Fama/French US Small Cap Index
• 7.5 percent Fama/French US Small Value Index (ex utilities)
• 15 percent MSCI EAFE Value Index
• 15 percent Dimensional International Small Cap Index
• 40 percent five-year Treasury notes

The effect of the changes has been to increase the return on the portfolio from 10.5 percent to 12.3 percent -- an increase of 17 percent in relative terms. This outcome is what we should have expected to see as we added riskier small-cap and value stocks to our portfolio. Thus, we also need to consider how the risk of the portfolio was impacted by the changes. The standard deviation (a measure of volatility, or risk) of the portfolio increased from 10.6 percent to 11.6 percent -- an increase of 9 percent in relative terms. While returns increased 17 percent, volatility increased just 9 percent.

Commodities

There's one more asset class we want to consider including in a portfolio. As we discussed earlier, commodities diversify some of the risks of investing in stocks. They also diversify the risks of investing in bonds. Therefore, we'll add a 4 percent allocation to the Goldman Sachs Commodity Index, reducing each of our four domestic stock allocations by 0.5 percent and both the international stock allocations by 1 percent.

Portfolio 5

• 7 percent S&P 500 Index
• 7 percent Fama/French US Large Value Index (ex utilities)
• 7 percent Fama/French US Small Cap Index
• 7 percent Fama/French US Small Value Index (ex utilities)
• 14 percent Dimensional International Small Cap Index
• 14 percent MSCI EAFE Value Index
• 4 percent Goldman Sachs Commodity Index
• 40 percent Five-Year Treasury Notes

Most investors think of commodities as risky investments. However, you'll note that the addition of commodities to the portfolio actually reduced the volatility of the portfolio, and reduced it by three times the reduction in the portfolio's return. While the portfolio's return fell by 0.2 percent, its standard deviation fell by 0.6 percent. Relatively speaking, the portfolio's return fell 2 percent while its volatility fell by 5 percent. This "diversification benefit" is why you should consider including a small allocation to commodities in your portfolio.

The net result of all of our changes is that we increased the return of the portfolio by 1.6 percent, from 10.5 percent to 12.1 percent -- an increase of 15 percent in relative terms. At the same time, the volatility of the portfolio increased just 0.4 percent, a relative increase of 4 percent.

Reducing Risk

You have now seen the power of modern portfolio theory at work. You saw how you can add risky (and, therefore, higher expected returning) assets to a portfolio and increase the returns more than the risks were increased. That's the benefit of diversification. However, there's another way to consider using this knowledge. Instead of trying to increase returns without proportionally increasing risk, we can try to achieve the same return while lowering the risk of the portfolio. To try and achieve this goal, we increase the bond allocation to 60 percent from 40 percent and decrease the allocations to each of the stock asset classes and to commodities.

Portfolio 6

• 4.5 percent S&P 500 Index
• 4.5 percent Fama/French US Large Value Index (ex utilities)
• 4.5 percent Fama/French US Small Cap Index
• 4.5 percent Fama/French US Small Value Index (ex utilities)
• 9.5 percent Dimensional International Small Cap Index
• 9.5 percent MSCI EAFE Value Index
• 3 percent Goldman Sachs Commodity Index
• 60 percent Five-Year Treasury Notes

Compared with Portfolio 1, Portfolio 6 achieved a higher return with far less risk. Portfolio 6 provided a 0.3 percent higher return, 10.8 percent versus 10.5 percent -- a relative increase of 3 percent. It did so while experiencing 2.8 percent lower volatility, 7.8 percent versus 10.6 percent -- a relative decrease of 27 percent.

Through the step-by-step process described above, it becomes clear that one of the major criticisms of passive portfolio management -- that it produces average returns -- is wrong. There was nothing "average" about the returns of any of the portfolios. Certainly the returns were greater than those of the average investor with a similar stock allocation, be it individual or institutional.

Passive investing delivers market, not average, returns. And it does so in a relatively low-cost and tax-efficient manner. The average actively managed fund produces below market results, does so with great persistency, and does so in a tax-inefficient manner.

By playing the winner's game of accepting market returns, you'll almost certainly outperform the vast majority of both individual and institutional investors who choose to play the active game.

Active Mutual Fund Managers Not Getting Any Better

Below is a copy of a post from a blogger I follow - The White Coat Investor: A doctor who tries to help his peers through the noise of all things financial.

This is a great summary of recent performance of actively managed mutual funds relative to their respective index:

Active Mutual Fund Managers Not Getting Any Better

Posted on January 28, 2013 by White Coat Investor

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Every year Standard and Poors publishes a “scorecard” comparing active mutual fund managers to the indexes.  Every year it’s pretty much the same story- active fund managers can’t persistently beat a passive investment.  This year’s version recently came out.  Here are the highlights:

1) From September 2009 to September 2012, 23.6% of large-cap funds, 15.5% of mid-cap funds, and 29.4% of small-cap funds remained in the top half with regards to fund performance (AKA beat a low-cost index fund.)  Random chance would lead to 25% of remaining in the top half for all 3 years.

2) From September 2007 to September 2012, 5.2% of large-cap funds, 3.2% of mid-cap funds, and 5.1% of small-cap funds remained in the top half for all 5 years.  Random chance would lead one to expect at least 6.25% would remain in that category.

In essence there is no persistence of performance.  You CANNOT choose an actively managed mutual fund based on past performance and expect that to persist in any way, shape, or form.  Actually, that’s not entirely true.  There is some persistence of performance….among the bottom quartile funds.  They’re much more likely to be merged or liquidated than better performing funds.

As one part of the study they took mutual funds that performed in the bottom half over a 5 year period and took a look at how they performed over the next 5 years.  For all US Domestic funds, those in the bottom half over the first 5 years had a 36.8% chance of being in the top half over the next 5 years, a 34.5% chance of being in the bottom half, and a 28.7% of disappearing completely. Now, I think it’s safe to say that those that disappeared weren’t doing well, so in reality 63.2% of bottom half funds stayed in the bottom half.

Moral of the story?  Good funds go bad and bad funds stay bad.  If the chances of you choosing a 5 year winner are only 1 out of 20, and you have to do this for 5 or 10 different asset classes, the odds of you designing an actively managed portfolio that will outperform a passively managed portfolio seem astronomically small.  Save yourself the trouble and buy low-cost index funds.

A Concise Explanation of Efficient Markets and The Difficulty of Truly Beating The Market

Nate Silver uses the efficient market hypothesis (EMH) to demonstrate how our brains will use simplified models.

The simplified EMH - the simple statement in #1 below,  is often attacked by those who say that the EMH is invalid. But, by the time you read to #7 - which is a concise definition of the EMH, it becomes much harder to argue against the EMH.

The next time someone claims to outperform the market you should ask: Do they outperform relative to risk and transaction costs?

Nate Silver:

"Consider the following seven statements, which are related to the idea of the efficient-market hypothesis and whether an individual investor can beat the stock market. Each statement is an approximation, but each builds on the last one to become slightly more accurate.

1. No investor can beat the stock market.
2. No investor can beat the stock market over the long run.
3. No investor can beat the stock market over the long run relative to his level of risk.
4. No investor can beat the stock market over the long run relative to his level of risk and accounting for  his transaction costs.
5. No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs, unless he has inside information.
6. Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information.
7. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund.

The first approximation—the unqualified statement that no investor can beat the stock market—seems to be extremely powerful. By the time we get to the last one, which is full of expressions of uncertainty, we have nothing that would fit on a bumper sticker But it is also a more complete description of the objective world."

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 7462-7475). Penguin Press HC, The. Kindle Edition.

Beating the Stock Market: From Nate Silver's "The Signal and the Noise: Why Most Prediction Fail-But Some Don't"

" As the legendary investor Benjamin Graham advises, a little bit of knowledge can be a dangerous thing in the stock market. After all, any investor can do as well as the average investor with almost no effort. All he needs to do is buy an index fund that tracks the average of the S&P 500. In so doing he will come extremely close to replicating the average portfolio of every other trader, from Harvard MBAs to noise traders to George Soros’s hedge fund manager. You have to be really good—or foolhardy—to turn that proposition down. In the stock market, the competition is fierce. The average trader, particularly in today’s market, in which trading is dominated by institutional investors, is someone who will have ample credentials, a high IQ, and a fair amount of experience. “Everybody thinks they have this supersmart mutual fund manager,” Henry Blodget told me. “He went to Harvard and has been doing it for twenty-five years. How can he not be smart enough to beat the market? The answer is: Because there are nine million of him and they all have a fifty-million-dollar budget and computers that are collocated in the New York Stock Exchange. How could you possibly beat that?”

 "In practice, most everyday investors do not do even that well. Gallup and other polling organizations periodically survey Americans on whether they think it is a good time to buy stocks. Historically, there has been a strong relationship between these numbers and stock market performance—but the relationship runs in the exact opposite direction of what sound investment strategy would dictate. Americans tend to think it’s a good time to buy when P/E ratios are inflated and stocks are overpriced. The highest figure that Gallup ever recorded in their survey was in January 2000, when a record high of 67 percent of Americans thought it was a good time to invest. Just two months later, the NASDAQ and other stock indices began to crash. Conversely, only 26 percent of Americans thought it was a good time to buy stocks in February 1990—but the S&P 500 almost quadrupled in value over the next ten years"

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 6096-6103). Penguin Press HC, The. Kindle Edition.

Is Dogbert your Financial Advisor?

Have you really reviewed what your investment fees are?

Many dont even know what they are paying due to hidden fees in mutual funds and the way many advisers bill their clients.

A fee-only advisor will openly disclose all the fees you are paying and how you are paying them.

To find a Fee-Only advisor in your area go to: http://www.napfa.org/

For more from Dilbert's creator Scott Adams read this great piece from the WSJ:

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