Buffett's Advice for the Average Investor

This is an excerpt from a WSJ Market Watch story on Buffets recent advise to average investors.

Five lessons for the average investor:

1. You don’t have to be an expert to achieve satisfactory investment returns. Recognize your limitations, keep things simple and “don’t swing for the fences.” Don’t believe in or look for a quick profit.
2. Focus on the future productivity of the assets you are considering. Unless you can make a rough estimate of its future earnings, move on. You can’t evaluate everything, but you have to understand the actions you’re going take.
3. Avoid speculation, such as focusing on the prospective price change of an asset. “Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game,” says the Sage.
4. Think about what that asset will produce, not about daily valuations. “Games are won by players who focus on the playing field — not by those whose eyes to the scoreboard,” says Buffett.
5. “Forming macro opinions or listening to the macro or market predictions of others is a waste of time” and even “dangerous, because it may blur your vision of the facts that are truly important,” he says.

How does Buffett buy stocks? He looks at whether he can sensibly estimate an earnings range for five years out or more. If the answer is yes, he’ll buy it if he can get it at a reasonable price in relation to the bottom boundary of his estimate. If he can’t estimate future earnings, he moves on.

“In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions,” he says.

And nonprofessional investors? The good news is that they don’t need to know how to predict future-earnings power, as American businesses have done well over time and will keep headed in that direction, he predicts. The nonprofessional should not be trying to pick “winners” all the time, but “own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”

His final bit of advice for the nonprofessional? Accumulate shares over a long period, and never sell when the news is bad and stocks are well off their highs.

The full article can be found:

http://finance.fortune.cnn.com/2014/02/24/warren-buffett-berkshire-letter/

– Barbara Kollmeyer writes for MarketWatch. Follow her @bkollmeyer.

Should average Joe invest like George Soros? NO, NO, NO!

George Soros Bet $1.3 Billion The Stock Market Will Fall

The above headline is from a news story a client of mine wanted me to comment on. The story basically says that George Soros has bet $1.3 Billion that the US market will drop this year:

From my client: 

Mike,

 

Give me your comments after reading the following article,

http://www.huffingtonpost.com/2014/02/18/george-soros-stock-market_n_4810434.html?1392759577&icid=maing-grid7%7Chtmlws-sb-bb%7Cdl3%7Csec1_lnk2%26pLid%3D444081

My Response:

I wish the press did not sensationalize these types of stories. It is very bad for the average stock market investor. It makes the average investor feel that they should follow in some form. They ask themselves "if the smart money is getting out, shouldn't I?"

Soros has made his wealth by taking extreme bets that have high risk but a high return if they succeed. This time, he is betting a portion of his wealth (11%) that  the market will decline. But it is only a portion of his wealth. He can afford to take this bet.

The problem for the average investor is that 3 factors reduce their ability to do what Soros does:

1. Getting the timing correct. There is nobody (including Soros) that has successfully designed a system to get the timing in and out of the market correct. If there was a perfect system, we would just let the computer run our stock portfolios. What makes us think that Soros has a crystal ball. he isnt always correct.

2. Emotional behavior usually scares the average investor out of sticking with the types of extreme bets Soros will make.  We know from studying investor behavior that emotion trumps rationality.  Most investors will bail out before the bet pays off. Soros has the emotional fortitude to stay with his bets. In addition, he can afford to make the bets. If he loses he still is a billionaire - what is $1.3 Billion when you have $11.8 Billion?

3. Taxes can take a big bite out of the returns - even if the timing is done correctly. All the buying and selling may result in taxes that exceed 30%. Will the bet return greater than 30% versus staying in the market for the long haul.

The average investor needs to keep in mind that over the last 50 years holding the total US market and not jumping in and out of the market has resulted in an almost 10% return. Over an 11% return when international stocks are included into the portfolio.
 

Remember this statistic:  Since 1970 an investor who was out of the market on 15 best days over 52 years would have seen their return go from 9.94% to 7.47%.

So unless selling portions of your stock portfolio this year are consistent with your long term investment plan, don't try and follow Soros or any other prognosticator, stay to your plan.
And remember: Those who live by the crystal ball eat glass!

Why Smart People Make Stupid Financial Decisions

I recently received an email question, printed below, asking why do smart people make bad investment decisions?

The question:

Mike,

I am wondering if you read the front page story in the Buffalo News (2/15/2014) about the investment broker 'bilking" people out of over 7.1 Million dollars. 5 were took for $5,600,000.

What really blew me away was the belief that a number of these investors were considered "sophisticated" investors.......

I read he was offering "quick turn - around" and profits anywhere from 4x to 15 x the original investment, w/o much risk

So...here is my basic question to you. How can someone who knows how to accumulate enough of the type money they gave this guy, also be foolish enough not to "smell trouble" when promised amazing returns, absent the type risk one would associate with those type returns ?

Returns like that do exist.....at the casino...the racetrack...high stakes private poker...

Do you actually find people that lost  in your investment work ?

It amazes me....

From Ed out in Amherst NY

Response:

Great question Ed.

I think it comes down to a combination of three things:

1.  People's lack an of understanding of capital markets: how they work, their history, characteristics, and risks. In addition they don't know the first thing about the tenets of Modern Portfolio Theory, Efficient Market Theory and Behavioral Finance. There are libraries of materials, studies, and research devoted to these topics.

Yet:

2. We have a culture: movies, books, TV shows, that ignore the evidence, and science, and propagate the idea that if you are sharp enough, or hire the right person, you can beat the market or gain large returns with little risk. That is not even close to the findings of academic research and /or financial history. People have no idea that the theories and rules mentioned in item 1 above exist. All they see are the few stories (fiction and non-fiction) of those who made easy money in the market by picking the right stock or investment.

Then there is:

3. Greed: We know from MRI studies of the human brain, that the brain on cocaine looks just like the brain of a gambler. Emotion trumps rationality. The smart person falls for the promises of the  silver tongued salesman.

So, simply, many people (many of them very smart) believe that excess returns can be gained in the market by outsmarting the market. Very few learn, or can conceptualize, that beating the market is a near impossible task.

They are hard wired to chase possibilities (emotional brain) not probabilities (rational brain). 

They forget this maxim from the great economist, John Maynard Keynes: 

"Its better to be approximately right than precisely wrong"

An earlier blog post of mine emphasizes the point on how hard it is to beat the market:

Next time you think you, your mutual fund, your broker, your stock picking software can beat the market; scan the graphic below and read this short excerpt from Business Week July 16-21, 2013, "The Hedge Fund Myth"

"Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

Full Article: http://www.businessweek.com/articles/2013-07-11/why-hedge-funds-glory-days-may-be-gone-for-good#p2

Posted by AWM BLOG 

Money Magazine's Epiphany: Buy and Hold Index Funds!

The January issue of Money magazine contains their annual "Investors Guide" section.
The introduction to the section is an acknowledgement that it is nearly impossible to time the market or to beat the market through superior stock picking.
Money magazine is now recommending a buy and hold strategy with the use of index funds as the core to most peoples long term investment strategy.

For those familiar with this blog and familiar with my advise, this should not be new news.
For those familiar with academic studies on the market, this news is well over 50 years old.
Note: A great book outlining the history of academic study in this area is "Capital Ideas: The Improbable Origins of Modern Wall Street" by William Bernstein:

http://www.amazon.com/Capital-Ideas-Improbable-Origins-Modern-ebook/dp/B00BV7MN7O/ref=sr_1_1?s=books&ie=UTF8&qid=1389704240&sr=1-1&keywords=capital+ideas

A good adviser will not sell you on the idea that he can beat the market on a "risk adjusted" basis. Rather the good adviser will focus on what allocation of stocks and bonds are best for your situation, how much you need to be saving, how to minimize taxes, and finally the adviser should have a very good understanding of capital markets and human behavior so they can be your guide and therapist when the road gets rocky.

Here are a couple excerpts (the highlights are mine):

(Money Magazine)

Here are just a few of the ways Wall Street pros try to eke out an edge in the market. You can't do any of them:

With a subscription to the Bloomberg online news service (price: about $20,000 a year), traders can instantly see anything from the location of oil tankers around the globe to supply-chain maps of a company's vendors and customers.

Hedge fund managers who invest in drug and technology companies tap into "expert networks" of executives and scientists paid for their specialized knowledge. In some cases, it's been charged, traders have also illegally gotten inside information through these contacts.

Half of stock trades are made by automated "high-frequency" programs; it takes 7/10,000ths of a second to buy or sell on the New York Stock Exchange, says the Tabb Group, down from a horse-and-buggy 10 seconds eight years ago.

You can't get a jump on this crowd. You can't even compete with them. Chances are, the professional managers you hire via a mutual fund, for 1% of assets or more per year, won't be able to stay ahead either.

In October, Ray Dalio, one of the most successful hedge fund managers in the world, told a conference audience that "going forward, most investors are not going to be able to produce alpha." "Alpha" is finance jargon for outperforming the market after accounting for risk. In truth, the search for alpha has always been something of a snipe hunt; the word was first used in a 1967 article that showed that most mutual funds didn't deliver it, especially after subtracting fees.

Two things have changed since then: More pros admit the alpha game is over, and perhaps more important for you, investing has never been better for those willing to stop playing. In the words of Tadas Viskanta, editor of the finance blog Abnormal Returns, there's wisdom in reaching for "investment mediocrity."

Today, just as in 1967, most professionals can't beat an index that tracks the stock market. "The paradox," says Viskanta, "is that the less effort you put in, the better off you are." And recently, he notes, perfect mediocrity has grown more attainable, as index-based investing has moved steadily closer to free.

For as little as 0.04% of assets per year -- that's $4 for every $10,000 you've invested -- and often with no broker commission, you can buy an exchange-traded fund, or ETF, that follows most of the U.S. stock market and delivers its return.

This year's Investor's Guide starts from the idea that index funds and a buy-and-hold stance should be the default approach for long-term wealth builders. With that in mind, MONEY has rebuilt our basic investing tool set: Our list of recommended funds is now the MONEY 50, streamlined from 70. Not all the funds are index trackers, but the core choices are low-cost, highly diversified portfolios for the long run. For many investors, a portfolio balanced among one broad U.S. stock fund, an international fund, and one or two bond funds is all you need. The MONEY 50 makes building that portfolio easy.
       
                     ************************************************************************

OWN THE WORLD, FOR NEXT TO NOTHING

You can build a solid portfolio with just three investments. Here are examples using ETFs and index mutual funds:

The ETF route:
Schwab U.S. Aggregate Bond (SCHZ): 40%
Schwab U.S. Broad Market: (SCHB) 40%
Schwab International Equity: (SCHF) 20%

The index fund route:
Vanguard Total Stock Market Index: (VTSMX) 40%
Vanguard Total Bond Market Index: (BND) 40%
Vanguard Tax Managed International (VDVIX): 20% 

Either way you go, your costs will be far, far less than most active fund managers charge...

Annual fee:
ETF portfolio: 0.05%
Index fund portfolio: 0.08%
Three average active funds: 1.22%

... and you'll be diversified across the globe.

Number of stocks:
ETF portfolio: 3,144
Index fund portfolio: 4,823
Three average active funds: 289

SOURCE: Morningstar 

Nobel Prize Winning Investing Advice

I was fortunate to have a couple professors back in my college days who instilled in me the lesson that it is nearly impossible to beat the market over the long term. Investors are best served when they simply own the market.
Since college I have been a passionate student of this idea. I have observed this in academic studies and in my own experiences.
Last week Eugene Fama was awarded a Nobel prize for the underlying theory supporting investing in the market vs. stock picking.
Below is a link to a short article and video interview with David Booth who has turned Fama's research into one of the most successful mutual fund companies in the nation - Dimensional Fund Advisers (DFA).
I am proud to say that I am an approved DFA adviser and through that process was fortunate to be lectured by Eugene Fama at DFA's headquarters.

http://www.cnbc.com/id/101160690?__source=pulse&par=pulse&utm_medium=referral&utm_source=pulsenews

Eugene Fama's Contribution to the 2013 Nobel Prize in Economics

What does the Eugene Fama part of the 2013 Nobel Prize in Economics tell us?

This years prize went to Eugene Fama, Lars Hansen and Robert Shiller. All have done work on asset prices - think stock prices.

Fama is the father of the efficient market hypothesis - which states that without consistent inside information it is difficult to determine a better price for a stock other than the current price of that stock.

The argument is that stock prices incorporate all known information into the price of the stock at any given time. Which means that prices will react to new news as it becomes available. That is why they appear to bounce around in a random pattern. Thus the  term "random walk" of stock prices. There are so many people analyzing so much data that it is hard to find an edge. A 7/11/2013 Business Week story on hedge funds says it all:

" In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

This means that it is hard to pick stocks that will give you market beating returns. When an investor purchases a stock that he thinks is a good buy, there is a seller who is selling for some reason. What do they know that you dont?

After 2008 many liked to say that the efficient market was dead. Those that said that didnt understand the nuances of Fama's argument:

Fama says that markets dont always get prices correct, sometimes they get prices terribly wrong, but in a random, unpredictable manner, and therefore investors cannot develop systems to consistently outperform the market.

What should an investor do? The answer has been: dont try to time the market or outsmart the market, rather simply own the whole market. By doing so an investor owns the return on capital markets over time. The US stock market has returned around 10% since 1926. Not too bad.

This insight has lead to the growth of index funds over the last 40 years. Index funds allow investors to own the whole market at a very low cost. The lesson for the average investor is to just own the market and stop trying to outsmart all the other smart people. There is not a system to date that has figured out how to outperform the market over the long run (net of fees and taxes).

Note: the stock market fluctuates wildly at times, investors in the market need to understand that point and plan accordingly.

An Example Of Why Many In The Industry Opposing The Fiduciary Standard?

Many in the financial industry are opposing the DOL's push to require financial advisers of retirement plans (401K, IRAs) to act as a fiduciary when advising their clients. Recently, the CEO of Raymond James issued a call to arms:

http://wealthmanagement.com/raymond-james-national-conference/opposition-dol-fiduciary-gains-ground

A fiduciary standard would require the adviser to put the clients needs above their own. How is this a bad thing? Why would those who earn commissions or annual fees on investment products oppose this.

The answer is made clear in a prior blog post of mine reproduced below:

How was an adviser, who placed their client in the Highland Small-Cap investment shown above, acting in their clients best interest?

Recently, I have taken on 3 new clients. All 3 were with commission or fee based advisers prior to asking me for advice.

The chart above, produced by Morningstar, is representative of at least 10 of the funds that the new clients owned.

In this case, the client's adviser invested the clients money in the Highland Small Cap Equity fund in 2011. Highland invests in small company growth stocks.

The chart shows the following;

1. Highland's performance over the last 10 years in blue.
2. The performance of all small cap growth funds in orange.
3. The performance of the Vanguard small cap index in yellow.

The Vanguard Index is simply a fund that holds all stocks that meet the definition of small cap growth - this is known as an index fund. The fee for this particular index fund is .08%

The other funds are known as actively managed funds - which means the funds employ managers who pick stocks in an effort to outperform a benchmark (or index). In this case the managers are trying to outperform the small cap growth sector.

A review of the chart shows that the Vanguard index fund clearly was a better choice in 2011 based on a visual look at the performance.

So why would an adviser NOT place their client in the Vanguard?

A look at the the top of the chart shows that there is a 4% load on the fund and an annual expense of 2.75%. This means that for every $1,000 initially invested the adviser gets an initial fee of $40. In addition, the fund takes 2.75% off of the balance every year. In fact, of that 2.75%, 1% goes to the adviser on an annual basis.

The adviser had a choice, he could have recommended the no load, .08% annual fee Vanguard fund, yet they placed their client in the Highland fund which rewarded him a 4% initial fee + 1% of the balance annually.
How was that good for the client. It seems it was good for the adviser.

In my opinion, this is what is wrong with this industry. It is based on a system where brokers and fee based advisers earn income off of recommended investments.

One way to combat this is too work with a fee-only adviser who doesnt accept commissions or fees from products they recommend. Dont confuse fee-only with fee based. fee based can receive fees from products they recommend to you. A fee-only adviser will generally charge an hourly rate or base the fee on the dollar amount of assets managed.

Note: Michael Angelucci MBA, CFP is a fee-only adviser.