Are you an investing Ahab?

"I need Facebook IPO" phone calls and a recent WSJ article on zombie funds leads me to reflect on the fact that most investors are like Moby Dick's captain Ahab. Ahab was obsessed with catching the white whale, Moby Dick. An obsession that lead him down a path of his own destruction.

Many spend their money paying advisers to produce market beating returns and in the end don't do better than a simple buy and hold strategy. Then there are those who invest with the Madoff's of the world and end up losing much more than a good return.

They somehow believe that they can get instantly rich in the market, they spend money on  software systems or advisory services. They spend hours watching CNBC, and watching the market, and worry about whether they should own more gold or Facebook. 

Unfortunately, many drive themselves into an Ahabian obsession with finding the great return.  They ignore the fact that a simple buy and hold strategy of holding an index of the US stock market since 1973 would have earned 10.5% through 2010. Holding the US market since 1927 would have earned 9.8%. 

Two years ago I attended the Get Motivated seminar at HSBC Arena in Buffalo NY. It is more of a day of infomercials interspersed with motivational speakers. One of the pitches that day was a stock picking software system - just buy on the up arrows and sell on the down. The crowd swarmed to the sales desks by the thousands to purchase the system. They were never told about trading costs or  short term taxes, nor was there discussion about what to do when negative news on one of your stocks hits the market when you are out golfing. I just shook my head at the power of a great sales pitch and the desire of humans to get rich quick and easy.

Study after study shows that over the long run very few outperform the market on a consistent basis. Yet so many sail the seas trying to beat the market. In the end it is the brokers and advisers that sail the seas in their customer paid for yachts. 


 In fact when Harry Markopolos, author of the book No One Would Listen, tried to warn regulators in 2000 that the 15% sustained return promised by Madoff was impossible in the capital markets no one would listen. The point here is that Markopolos knew that those kind of consistent returns dont exist in the stock market. So why do so many continue to reach for returns that have never existed?  Probably because we believe in America that we can get rich overnight, that we can time the market, pick the winning stock. In the end, those tasks are nearly impossible to achieve. Therefore, most investors would do themselves a favor and just purchase a diversified portfolio of index funds that give them exposure to the US stock market, the global stock market and the bond market and relax while the Ahabs of the world make themselves crazy. 

The "Perfect Portfolio" - great advice from the Oblivious Investor

Below is a short section of a recent blog from one of my favorite financial bloggers: The Oblivious Investor (http://www.obliviousinvestor.com). It is about as perfect advice on portfolio structure that you can get.

Forget about Perfect

Even the idea that it’s possible to have a perfect portfolio is problematic. It can make people want to change their portfolios all the time based on the most recent convincing-sounding argument they’ve read. (I know this personally, because I used to struggle with it myself.) And it can keep people from focusing on other things — such as savings rateor retirement age — that are generally more important than asset allocation.

Instead of searching for a perfect portfolio, I’d suggest the following approach:

1. Work out a “good enough” portfolio.
2. Recognize that it will not be perfect and that there will always be well-reasoned portfolios/strategies that have outperformed you over any particular period you choose to examine.
3. Implement the portfolio anyway and move on with your life.

What Makes a “Good Enough” Portfolio?

As far as what makes a portfolio “good enough,” it’s not anything tricky:

• It should be diversified. (This does not necessarily require several mutual funds.)
• It should have a roughly appropriate asset allocation for your risk tolerance. (Consider limiting your stock allocation to twice your maximum tolerable loss.)
• It should have low costs.

Investing Insight from "How We Decide"

"The secret is there is no secret" this quote is from:
Lehrer, Jonah (2010-01-14). How We Decide (Kindle Locations 1088-1098). Houghton Mifflin Harcourt. Kindle Edition.

"How We Decide" by Jonah Lehrer is wonderful. If you have any interest on how the brain works I highly recommend this interesting and readable book.

In the quote below he summarizes how the brain effects investing decisions: the dopamines in your primal/reactive/lizard brain want to see patterns in the world. This usually spells disaster for investors:

"The lesson here is that it's silly to try to beat the market with your brain. Dopamine neurons weren't designed to deal with the random oscillations of Wall Street. When you spend lots of money on investment-management fees, or sink your savings into the latest hot mutual fund, or pursue unrealistic growth goals, you are slavishly following your primitive reward circuits. Unfortunately, the same circuits that are so good at tracking juice rewards and radar blips will fail completely in these utterly unpredictable situations. That's why, over the long run, a randomly selected stock portfolio will beat the expensive experts with their fancy computer models. And why the vast majority of mutual funds in any given year will underperform the S&P 500. Even those funds that do manage to beat the market rarely do so for long. Their models work haphazardly; their successes are inconsistent. Since the market is a random walk with an upward slope, the best solution is to pick a low-cost index fund and wait. Patiently. Don't fixate on what might have been or obsess over someone else's profits. The investor who does nothing to his stock portfolio—who doesn't buy or sell a single stock—outperforms the average "active" investor by nearly 10 percent. Wall Street has always searched for the secret algorithm of financial success, but the secret is, there is no secret. The world is more random than we can imagine. That's what our emotions cant understand."

Book Review: "Are you a Stock or a Bond"

 "Moshe Milevsky's book can be looked at as 2 books. Book 1 is how to save for retirement. He argues that you are the CEO of YOU Inc. and that you need to manage your lifes balance sheet. He argues that if you have a job that is very stable and offers a good defined benefit plan (the old classic - when you retire your employer will pay you a constant payment in retirement) , that plan is like owning a safe bond. You can then invest more heavily in stocks. Conversely, if you make your money in a  volatile industry or in a field that is effected by the stock market then you should save more in bonds - this serves as a hedge or insurance against a bad stock market on your (YOU Inc.'s) balance sheet.
Part 2 of the book, in my opinion, is great. He develops a decision model for retirees to protect their life's savings. He recommends that a person break their retirement into 3 types of funds: Lifetime annuities, some sort of limited time period guaranteed annuity payment, and an investment account. The model he presents takes into account a retires spending needs along with estate planning desires to develop a probability of success strategy that limits downside risk of running out of money while in retrement. Something that, as we are living longer, needs to be an important part of the retirement planning process.

I Bonds: Limited to $10,000/yr, But Great Safe Savings Option

In an environment where earning a good return in a safe, savings vehicle is very difficult, I Bonds offer a wonderful and safe option - provided that you dont need the funds within a year. Think of the I bond as a 12 month CD.

Below is an excerpt from a 3/10/2012 WSJ article by Ruth Simon:

"I Savings Bonds, issued by the U.S. Treasury, offer one of the best deals for savers, though in small doses. Unlike a typical supersafe investment, the interest rate on I Bonds has two parts: a fixed rate that lasts for the life of the bond and a variable inflation rate that is adjusted twice a year based on changes in the consumer-price index. Currently, the fixed rate is 0% and the inflation rate is 3.06%, meaning investors receive a 3.06% yield.


"With I bonds, you are at least guaranteed to keep pace with inflation," notes Mel Lindauer, co-author of "The Bogleheads' Guide to Investing," a resource for fee-wary investors. I Bonds also have several tax advantages. Among them: They are exempt from state and local taxes, and interest income is tax-deferred.


One downside is that investments are limited to $10,000 per person per year, though you can also receive a tax refund of up to $5,000 in the form of an I Bond. The bonds generally can't be redeemed in the first 12 months, so they are best used as part of a multiyear emergency fund. Between years one and five, you will pay the last three months' interest as a penalty for cashing in early. After five years, the bonds can be cashed in without penalty."

Below is information from http://www.treasurydirect.gov/

I Savings Bonds In Depth

As of January 1, 2012, paper savings bonds are no longer sold at financial institutions.  This action supports Treasury’s goal to increase the number of electronic transactions with citizens and businesses. See the press release.

I Bonds are a low-risk, liquid savings product. While you own them they earn interest and protect you from inflation.  Once sold and redeemed solely as a paper security, they’re now also available in electronic form and in paper form through your IRS tax refund. As a TreasuryDirect account holder, you can buy, manage, and redeem I Bonds online.

A new program called SmartExchange^SM allows TreasuryDirect account owners to convert their Series E, EE, and I paper savings bonds to electronic securities in a special Conversion Linked Account within their online account.

Buying I Bonds through TreasuryDirect:

• Sold at face value; you pay $50 for a $50 bond.
• Purchased in amounts of $25 or more, to the penny.
• $10,000 maximum purchase in one calendar year.
• Issued electronically to your designated account.

Buying Paper I Bonds:

• Available only through your IRS tax refund
• Sold at face value; i.e., you pay $50 for a $50 bond.
• Purchased in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000.
• $5,000 maximum purchase in one calendar year.
• Issued as paper bond certificates.

If you redeem I Bonds within the first 5 years, you'll forfeit the 3 most recent months' interest; after 5 years, you won't be penalized.

My Thoughts:

Lets assume that you buy $10,000 of I bonds and redeem after 1 year and forfeit 3 months of interest, your return will still be 75% of the inflation rate (CPI), after 2 years 87.5% 0f CPI, after 3 years 92% of CPI.  

If you invest today and earn the current stated rate of 3.06%  for the next 1 year (this adjusts every 6 months, so unlike a CD your rate will fluctuate). You then withdraw the funds after the 1 year waiting period. Your return will be approximately 75% of 3.06%, or 2.30%. Comapre this to current 1 year CD rates of  slightly over 1%.

Active vs. Indexing: Excellent WSJ Article

In a column in todays WSJ,  Karen Damato points out that in 2011 80% of active stock fund managers did not beat their respective benchmarks. But, so far in 2012, 64% are beating their benchmarks. She asks are they suddenly smarter?

Not necessarily; she points out that generally they are not suddenly smarter but rather the stocks that they are investing in are in favor. She writes:

"John Cochrane, a finance professor at the University of Chicago Booth School of Business, says investors are misguided if they think fund managers add—or subtract—value based on how savvy they are at picking individual stocks.

Managers typically have a strategy that favors certain kinds of stocks, such as those with rapid earnings growth or very low prices relative to earnings or rising dividends. Stocks with a common trait tend to rise or fall in market favor together. So the performance of a fund versus a benchmark can be better viewed in terms of the various factors a manager overweights or underweights, Mr. Cochrane says."

At the end of the day investors need to ask a couple questions:

1. If I am actively managing a portfolio, am I comparing the performance to the correct benchmark?

2. Am I earning a benchmark beating return for the fees I am paying?

What most will find is that it is a better long term solution to invest with low cost index funds.

For the complete article:

http://online.wsj.com/article/SB10001424052970203824904577215381237716676.html?mod=ITP_thejournalreport_0

Warren Buffet, Peter Lynch, David Swensen: Investing Advice

"If professionals do indeed have the game rigged in their favor, we should see evidence of that in terms of better performance. Yet consistent professional outperformance is nowhere to be found. It doesn't matter whether you look at institutional investors, pension plans or hedge funds, the evidence is the same.

If the evidence isn't enough, perhaps you should consider the advice from three legendary investors."

Peter Lynch
"[Investors] think of the so-called professionals as having all the advantages. That is total crap. ... They'd be better off in an index fund."

Warren Buffett
"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."

David Swensen
"Unless an investor has access to "incredibly high-qualified professionals," they "should be 100 percent passive -- that includes almost all individual investors and most institutional investors."

The above is pulled from larry Swedroe's CBS Moneywatch column on 2/13/2012.

For the full column: 

http://www.cbsnews.com/8301-505123_162-57374574/is-investing-rigged-to-favor-pros/?utm_source=twitterfeed&utm_medium=twitter&utm_campaign=Feed%3A+LarrySwedroeMoneywatch+%28CBS+Moneywatch+-+Larry+Swedroe%29&utm_content=Google+International