Don’t Do Something, Just Stand There

Another week, another all time in the stock market. North Korea’s saber rattling and the devastation wrought by the hurricanes don’t seem to have put a dent in the market’s relentless ascent. Furthermore, with this being the “most hated” bull market in history (or so they all say), things don’t seem primed for a major collapse. A mild pullback on the order of 5-10%? Sure, perhaps it will happen within the next year, but a major recession doesn’t seem to be in the cards.

What’s the best mentality for an average investor to have? The same as always – don’t change your long-term strategy due to short-term circumstances. Ignore the noise going on around you and robotically invest what you won’t touch in the next 5-10 years. The mantra that my mentor in medicine told me, which brings “do no harm” into the modern world, is encapsulated by the title of the post. Sometimes it’s simply better to do nothing than to react like a jumpy cat to every slight movement.

Take this advice of this article for instance:

“If you don’t want to invest in equities because you fear a market crash, then you should never be in equities, because equities always crash,” Ritholtz said, speaking at Morningstar’s annual ETF conference.

He noted that there was a bear market in equities—defined as a 20% drop from a peak—every five years, on average, although the recent market environment has been bereft of even much smaller declines. Current valuations have led to concerns that such a crash could be imminent, but “If you’re under [the age of] 50, you should be rooting for a market crash, because it would be nice to have a 20% discount and then 20 years to compound that discount.”

He added, “there’s no escaping this: markets go up and down, that’s what they do. But if you’re still worried, you should significantly lower your expectations for future returns” by buying safer—but lower growth—alternatives. He noted that over the past century, U.S. stocks have returned about 10 times what Treasurys have, although they also experienced numerous massive selloffs over that time, something the government bonds hadn’t.

“The risk you assume when you buy equities is that there will be a significant drawdown in the 20 to 30 years you own them. But you get rewarded for that risk. Treasurys don’t have the same kind of drawdowns, but don’t deliver the same kind of returns.”

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Secrets to Successful Investing

It feels like we’re always hammering the same points on investing over and over again. Don’t watch your portfolio. Stop tracking the market’s daily gyrations. Focus on the long term. Stay diversified. Don’t try to stock pick or market time. Stick with the asset allocation determined earlier and rebalance. Stick to these tried and true principles based on solid research and you’ll be fine.

Sometimes, we feel that we can be exceptional or lucky and we try for the moon. Humans are poor learners from others’ failures, and rather learn best from a strongly emotional personal experience (like a major loss in the market due to a self-inflicted error). I believe everyone should learn that by starting out playing single stocks with small amounts of play money, ideally earlier in life rather than later, so we can quickly return to the right path having learned our lesson in a way that sicks.

In other words, use the “the martyr system” to your advantage, letting the hippocampus impart the long-term financial scars from personal failures that will leave lasting memories of what not to do.

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No Regrets

My last post touched briefly on the nature of regret in missing out (selling too soon, buying in too late). However, this is not a healthy mindset to have. As Marketwatch pointed out today, very few people have the intestinal fortitude to ride out the market’s gyrations and hold for the 10+ years needed for wealth to compound exponentially. How many of us would have sold out during one of the times when bitcoin or Netflix crashed >50%?

This Morningstar article serves as a reminder that we are our own worst enemies:

Well, it’s really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You’ve got tremendous diversification. They don’t cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to ’08, ’09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.

The best returns actually came from disciplined boring investing. As Monevator likes to say, keep investing as boring as watching paint dry, so you won’t be tempted to buy and sell all the time. As another former mentor once told me, “Don’t just do something, stand there!” That is really the approach to take when investing.

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Take More Risk in Tax Advantage Accounts

The Bond King Bill Gross likes to philosophize about profound emotions such as joy and melancholy in his investment rants, and this post is driven in part by the emotion of regret seeing Bitcoin hit all time highs, and even surpassing the price of gold.

Such is the case for many in my field. When I was finishing my last year at Berkeley, I came upon news reports of the fancy new cryptocurrency idea called Bitcoin. Independently at the same time, so did my fiancee’s brother, childhood friend, and cousin-in law (all techies). We didn’t think much of it, and as risk averse as I was, I didn’t even bother putting $50 or so of play money into there. If I did, it would be worth almost a million! Similarly, my fiancee’s aunt regrets not buying Apple stock when it was down in the dumpster right before Jobs took over (seriously, most smart money was on the company going bankrupt, not staging a phoenix-like revival).

While we can all regret not doing the most “optimal” thing (life doesn’t have a save/reload button) in hindsight, we can also never with certainty predict what the future will hold. What we can do, and it will sound boring, is to make sure we have the right types of investments in the right places, and to stay allocated to assets in a way that allows us to sleep well at night. If we do dedicate a small (e.g. 5%) portion of our portfolio to lottery ticket bets on small cap stocks, that’s fine. Just make sure to do it in the tax advantaged section of the portfolio.

Standard portfolio theory suggests that we should make sure that our money is invested in the way that takes advantage of legal tax shelters to our benefit, as much as possible. Just to recap, there are in general three big categories of holdings: taxable, pre-tax 401k/IRA, and Roth 401k/IRA. Here’s what we should put in each:

  • Taxable: The goal here is to hold for as long as possible and to minimize the number of transactions and income generated, since each sale can generate a huge tax bill for capital gains. The best choice is a low fee total stock market index fund (Vanguard, iShares, and Schwab are all good choices) that is held and not sold until death. Then we can take advantage of the tax free basis step up when we bequeath to heirs. The small amount of dividends generated is taxable, yes, but at a much lower rate than the marginal rate. Bond holdings should be in tax-free municipal bonds as much as possible, doubly so if you’re in a high tax bracket.
  • Pre-Tax: We have to pay tax on the whole thing anyway but not until we cash the money out from the account. That quirk makes pre-tax accounts ideal for traders, stock pickers, and market timers who move in and out of positions with regularity. It’s also a good place to stash taxable bond funds and high dividend funds that throw out a lot of periodic income.
  • Roth: This is where you should make your highest risk “lottery” type bets. Let’s say you could (and want to) invest in bitcoin, startups in their infancy, micro cap stocks, penny/value stocks, turnaround stories, Greek bonds on the verge of default, and foreclosed homes. You would do so here. The bigger the potential gains, the better it will be. Whether you stumble upon a 10-bagger or 100-bagger doesn’t matter. You won’t pay any tax on it at the end.

So in summary, you want to use the right tool for the job. A balanced portfolio should consist of stock funds, bond funds, and maybe a dash of play money. Instead of making each tax category holding the same, we should concentrate our investments in the type of account that is best-suited from a tax perspective. Big gainers should be in the Roth, slow steady accumulator broad market funds should be in taxable, and income spewing investments in the pre-tax account.

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Passive Clearly Beating Active

These past few years have not been good to actively managed funds, or their managers. As this Morningstar article shows, funds are continuing to lose investor money and as a result, they have to lay off their fund directors. Shed no tears for them though, as they’ve had several years of high six figure+ income without providing a corresponding return to their investors.

Let Uncle Warren and Jack Bogle light the way. It’s no secret why the biggest indexer, Vanguard, is growing more than everyone else combined!

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The Few Proud Stock Winners

Remember my exhortation against stock picking, due to the few winners driving gains and the majority of stocks being meh or losers? This Morningstar article posted an insightful finding based on a recent study:

Half of U.S. stock-market wealth creation has come from 0.33% of listed companies.

Please note, that figure is not 33%. It is one third of 1%—one security out of 300.
Of the 26,000 stocks that appear in CRSP’s database, 86 provided half the aggregate wealth creation, 282 are required to reach the 75% figure, and 983 account for the full 100%. That is, after the 983 highest wealth creators, the remaining 25,000-plus securities are net neutral. Some made money for their investors, and some lost, but overall they were a wash.
Let’s re-emphasize. 86 stocks drove half of the gains of the market as a whole. If you were to randomly pick a stock to place your bets on, you would only have a 0.33% chance of picking a major winner. What’s the lesson, Morningstar?
In other words, do as your columnist prescribes, not as he does: Diversify. Widely and broadly.
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There’s a Reason They Promote Active Management

Just saw this ad on Morningstar:

marketwatch ad

Investors have started to wake up to the high fees and poor performance seen with active management, and as a result, big financial service firms are trying to stem the flow of money away from active funds to passive funds. As a result, they’ve ramped up advertising trying to sell potential customers with fear. “Now is a turbulent time,” they say. “In an uncertain world, it’s not good to be passive.” “Have an expert guide you.”

But really, if they have to work that hard to sell you on something, it’s probably a bad investment. Just remember: they’re worried about profit, not about working in your best interest. They (apart from Vanguard) have little incentive to sell you on low-margin passive products.

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Why Boring is Best in Investing

Are you a solo investor trying to imitate the big boys? It may not be such a good idea. You may have seen hedge funds, institutional investors, and big university endowments delve into “alternative” investments, meaning esoteric low-liquidity products that ordinary people wouldn’t have access to. Financial service providers, hoping to capitalize on a trend, created mutual funds and ETFs allowing ordinary people to buy into these supposed hot new strategies. Warning: they just want to charge high fees.

The performance has been dismal. As the chart on the link shows, a boring tried and true approach with stocks and bonds has outperformed all of these newfangled products.

The article goes on to explain the reason for the discrepancy:

Ben Johnson, Morningstar’s director of global ETF research, says many alternative ETFs have serious flaws. “Those guru-type portfolios are just equity strategies taking the long side of some well-known hedge-fund managers’ positions and following them on a lagged basis,” he told me.

“Oftentimes what you see in these ‘mimicking’ strategies is the derivative of the underlying asset that is many times watered down or is otherwise not directly connected to the…real asset.”

In other words, the ETFs are very poor substitutes for the real thing. Institutions like Yale get to pick the best private equity and hedge funds, and can buy, say, actual timberland rather than the WOOD ETF.

So yeah, if you can buy and operate an acre of farmland and know how to run it profitably, you may do ok. But for the rest of us, just stick with a diversified collection of stocks and bonds.

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Are ETFs Too Risky?

There’s a lot of news out there about ETFs lately, focusing on their negatives. They’re an untested instrument. The bid-ask spreads are too wide. They tempt people into trading when they should be holding on to their investments.

My book on wealth recommends using ETFs as the instrument with which to build a diversified mix of stocks and bonds, a time tested approach to accumulating wealth over the long haul. Just in time to discredit the rash of negative reports is a great Schwab article on the facts of ETFs.

Like anything, ETFs are an instrument, and can be used for good or evil. Like any instrument, the ETF in question can be sharp or blunt. Here’s the lowdown on why they’re still useful and things to look out for:

  • You don’t have to worry about the wide bid-ask spread at times. If you’re using ETFs as a mutual fund substitute, you shouldn’t be looking at daily prices and being tempted to trade in and out. Broad market stock or bond ETFs are meant as vehicles for investing. Even though they offer you the ability to trade in or out at any time as easily as individual stocks doesn’t mean we should. Moving too much incurs frictional trading expenses and incurs taxes.
  • For the same reason, you shouldn’t worry about temporary fluctuations in value versus the underlying asset. 99.9% of the time the two will be correlated. When things are derailed, it will be temporary (usually minutes at most), so hold on to your investment through the panic. Chances are you won’t even notice that anything happened unless you obsessively follow the market every day, which you shouldn’t be doing.
  • Stick to the tried and true (broad market funds). Don’t get suckered in by fancy ETFs such as triple inverse or super sector specific funds. Those exotic instruments usually have much higher expenses (you can see how much on Morningstar) and offer no benefit for long-term investors.

As you can see, ETFs are not to be feared, but rather something that the wise ones can control. Use ETFs like this and stay on the slow but steady well-trod path to wealth. Tune out the noise and you will prosper.

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Declining Worth of Hedge Funds

Maybe it’s because of the high fees, persistent underperformance, or the recent spate of movies about the greed of Wall Street. Whatever the reason, investors are withdrawing money from hedge funds. Maybe some of them see the light at the opposite end of the spectrum, with low cost index tracking funds. Aside from Vanguard, the 800 lb gorilla, other brokerages are getting into the act as well, including my own Fidelity. Undoubtedly, they are responding to consumer demand. Those who have read my book on wealth know how much I emphasize the importance of tax-optimization and low fees are to returns. Maybe more people are naturally starting to realize this.

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