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.

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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.