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

3 Pieces of Investing Advice from AWM

1. There is always a correlation between risk and return - a high expected return always means that there is a greater possibility of a loss.
Generally, when you hear of an investment return that is better than yours it is because that investment is riskier. Never compare your returns in a vacuum.
So, the next time your neighbor is bragging about some great investment return, ask them if they know the amount of risk they are taking. In fact, ask them if the return relative to the risk is efficient.
I often have people show me a "great" return, but when evaluated relative to the risk it is not that great.
An investors return should only be compared to the risk they are taking.

2. Portfolios are commodities. That means most advisers, banks, mutual fund families, brokers who recommend a certain allocation are all very similar. That is because they are all using similar software - "Portfolio optimization" software which allows somebody to enter into a computer the historic risk/return statistics of different stock/bond classes and find what combination gave the best risk/return outcome. Outcomes differ a little based on the data entered, but generally the Principle's 60% stock portfolio is similar to the Merrill Lynch 60% which is similar to the Smith Barney 60% etc.
I have created my own portfolios and my 60% is close to everyone else's.
which leads to point 3.

3. What are you paying? Especially if the adviser is charging you fee's of 1%. Calculate the hourly rate on 1%. If you have a retirement portfolio of $500,000 and some adviser is charging 1% (a common fee),  that is $5,000/year. If that adviser spends 10 hours/year really focusing on your portfolio you are paying $500/hour. Nice. Even nicer when all the academic evidence says that your adviser has almost no chance to outperform an index portfolio over time. If they do outperform whatever benchmark, then they either are lucky or taking more risk than the benchmark.

An adviser should:

1. Know what your investment needs are and what your tolerance for risk is.
2. Help you allocate into a suitable portfolio.
3. Help minimize your costs.
4. Hold your hand and keep you from doing irrational things when the markets are bad.

"The Big Investment Lie"

This is a blog post copied from one of my favorite blogs: 

http://whitecoatinvestor.com/

Don’t Invest in Hedge Funds (until you’ve read this book)

Posted on February 1, 2012 by White Coat Investor

Michael Edesess’s book The Big Investment Lie is now 5 years old.  I’m afraid that far too few investors have read it.  At this time of so much discontent with Wall Street, it’s time to pull it down off the shelf for another look.  Mr. Edesess provides an insider’s look at Wall Street and its huge disconnect with Main Street.  With a brand-new PhD  in mathematics in hand, he was hired by a brokerage firm.  Due to this degree, he was able to rub shoulders with the financial academics and see the evidence of what worked in finance and what didn’t first hand. Then, he realized The Big Investment Lie.  Here’s his explanation:

    Within a few short months I realized something was askew.  The academic findings were clear and undeniable, but the firm–and the whole industry–paid no real attention to them.  It was as if theoretical physicists knew the laws of thermodynamics, but engineers spent their time trying to construct perpetual motion machines–and were paid very handsomely for it….The message of this book is not new.  It has been written many times before–though, it seems, not forcefully enough.  If the book is imbued with a sense of outrage, it is because nothing else has worked.  The lie perpetrated by the investment world to sell its services at exorbitantly high prices still works all too well.

So, what is the lie?  It is this:

Most professional investment help, no matter how seemingly respectable, is in truth hazardous to your financial health.

Michael Edesess

He then divides the book into three appropriately titled sections- How Much You Pay, How Little You Get, and How You Are Sold.  He goes far above and beyond even Jack Bogle’s criticisms of the industry.  You see the usual skewering of active mutual fund managers, but you also get well-written chapters on hedge funds, derivatives, business ethics, and on how institutional investors get fooled too.  He also gets in to behavior finance and discusses how investors delude themselves with “The Lie”.

The discussion of hedge funds throughout the book is particularly good.  I quote again:

Now we come at last to the crowning achievement of the fee-charging business, the piece de resistance, the masters of the fee-charging universe-hedge funds….In 2004, those fees totaled $70 billion on an estimated $1 trillion in hedge fund assets–an average fee rate of 7 percent.  While not all hedge funds have large ups and downs, the ones that acquire the big names, essentially carrying the whole hedge fund business in the public mystique, do experience large ups and downs.  They get famous for the ups and draw huge amounts of investment capital and then are usually not noticed so much for the downs.  But the hedge fund managers make out very well on them.

Where are the investors’ yachts?  Indeed, where are the investors’ flotillas?  Hedge fund management is not just a license to steal; it is a license to steal literally billions.  The hedge fund management business has created more billionaires than you can shake a stick at.  In 2004, according to Alpha magazine, a magazine published by Institutional Investor, the average cash take-home pay for each of the top twenty-five hedge fund managers was $251 million.  Yes, you read that right.  It doesn’t take long to become a billionaire at that rate.  And where does the money come from?  It comes literally straight out of the investors’ accounts.

He does a great analysis of perhaps the best known hedge fund manager, George Soros.  His Quantum Fund grew from $6 Million in 1969 to $5.5 Billion in 1999 when he closed it.  Much of that, of course, is new capital contributed by investors seeking great returns.  So how much did Soros get for that work?  His personal fortune was estimated at $7.2 billion, not including the $4 billion he’s given away.  So $11 Billion for the manager on a fund that was only $5 Billion at its largest!  Keep in mind there are 10,000 other hedge funds out there that have come and gone.  If this is how the most well-known/successful hedge fund did, how are the unlucky ones doing?

This book makes Jack Bogle’s tirades against Wall Street seem tame by comparison.  But if you enjoyed Bogle’s revelations from the inside of the industry, you’ll love The Big Investment Lie.  He concludes the book with the Ten New Commandments for Smart Investing, which shouldn’t be big news to regular followers of this blog:

Ten New Commandments for Smart Investing

1. Follow a wealth-building strategy, not a gambling strategy.
2. Stop searching for the Holy Grail: Give up the futile quest to beat the market
3. Stop believing that past investment performance predicts future performance
4. Don’t be duped by the false claims of investment managers and advisors
5. Fire managers and advisors who charge more than barebones fees
6. Don’t pay anyone to pick stocks for you; There’s no reward for the cost and risk
7. Avoid hedge funds like the plague
8. Know the risks of investing; Take only the risk you are comfortable with
9. Keep fees and taxes as low as possible; They can swamp your investment returns
10. Invest only in true low-cost index funds

There you have it, straight from the horse’s mouth.  If you’d like to read more, pick up a copy of The Big Investment Lie at Amazon or your local library

Fama Speaks on EconTalk: a little excerpt

This weeks guest on the podcast Econtalk is Eugene Fama, one of the giants of academic finance, specifically stock market behavior. Fama is a professor at the University of Chicago.

Below is a partial transcript of the interview. I have highlighted the relevant lessons for investors – specifically the strong evidence supporting the use of index funds.

  Fama (Guest): Ken French and I just published a paper called "Luck Versus Skill in Mutual Fund Performance," and basically looked at performance of the whole mutual fund industry--in the aggregate, together, and fund by fund, and try to distinguish to what extent returns are due to luck versus skill. And the evidence basically says the tests it's skill in the extreme. But you've got skill in both extremes. That's something people have trouble accepting. But it comes down to a simple proposition, which is that active management in trying to pick stocks has to be a zero sum game, because the winners have to win at the expense of losers. And that's kind of a difficult concept. But it shows up when you look at the cross section of mutual fund returns, in other words the returns for all funds over very long periods of time. What you find is, if you give them back all their costs, there are people in the left tail that look too extreme and there are people in the right tail that look too extreme, and the right tail and left tail basically offset each other. If you look at the industry as a whole; the industry basically holds a market portfolio. That's all before costs. If you look at returns to investors then there is no evidence that anybody surely has information sufficient to cover their cost

Russ: Which says that for any individual investing, certainly someone like me, that is, who doesn't spend any time or very much time at all looking--in my case no time, but let's suppose even a little time--trying to look at what would be a good investment. The implication is to go with index mutual funds because actively managed funds can't outperform. Guest: Well, no, it's more subtle than that. What's more subtle about it is, even if you spent time, you are unlikely to be able to pick the funds that will be successful because so much of what happens is due to chance. Russ: So, for me the lesson is: buy index mutual funds because the transaction costs of those are the smallest, and since very few actively managed funds can generate returns with any expectation other than chance to overcome those higher costs, I can make more money with an index fund. Guest: Right. Now, it's very counterintuitive, because we look at the whole history of every fund's returns, and sort them, and really the ones in the right tail are really extreme. Russ: Some great ones.Guest: They beat their benchmarks by 3-6% a year. Nevertheless, only 3% of them do about as well as you would expect by chance. Now what's subtle there is that by chance, with 3000-plus funds, you expect lots of them to do extremely well over their whole lifetime. So, these are the people that books get written about. Russ: Because they look smart. Guest: What this basically says is that there is a pretty good chance they are just lucky. And they had sustained periods of luck--which you expect in a big sample of funds. Russ: Of course, they don't see it that way. Guest: No, of course not. Russ: A friend of mine who is a hedge fund manager--before I made this call I asked him what he would ask you, and he said, well, his assessment is that efficient markets explain some tiny proportion of volatility of stock prices but there's still plenty of opportunity for a person to make money before markets adjust. And of course in doing so, make that adjustment actually happen and bring markets to equilibrium. Somebody has to provide the information or act on the information that is at least public and maybe only semi-public. What's your reaction to that comment? Guest: That's the standard comment from an active manager. It's not true. Merton Miller always liked to emphasize that you could have full adjustment to information without trading. If all the information were available at very low cost, prices could adjust without any trading taking place. Just bid-ask prices. So, it's not true that somebody has to do it. But the issue is--this goes back to a famous paper by Grossman and Stiglitz--the issue really is what is the cost of the information? And I have a very simple model in mind. In my mind, information is available, available at very low cost, then the cost function gets very steep. Basically goes off to infinity very quickly. Russ: And therefore? Guest: And therefore prices are very efficient because the information that's available is costless.