Another Reason to Tune Out Market Gurus

If the examples in my book didn’t already convince you of this, the latest flip flop on Marketwatch should convince you that the so-called experts don’t know what they’re talking about.

On Jan 24, the head of the world’s largest hedge fund said, “if you’re holding cash, you’re going to feel pretty stupid.” That’s the gist of it, but if you click through you’ll hear some blah blah justification about how the market is rising, valuations are reasonable (even though by CAPE they’re expensive), and that there’s still room to run.

Then we had the 10% market swoon in the beginning of February.

The next time we hear from the same guy, he’s singing a different tune: “I think we are in a pre-bubble stage that could go into a bubble stage.” He goes on to say that the chance of a recession are 70%.

Luckily, though Marketwatch doesn’t call him out on the rapid change in tone, it does provide helpful links to his prior comments. Any discerning reader with even a modicum of financial knowledge would think that this guy is utter crap and going along with the prevailing tone, fanning the flames in a bull market and turning on a dime at the slightest whiff of panic. Why would you entrust your money to someone who doesn’t know what he’s talking about?

It amuses me to have recently received mass emails from both Fidelity and Schwab advising clients to stay calm in the recent market turbulence. It seems that with each boom-bust cycle, we attract new speculators without any inkling of what it means to truly invest. What am I doing? Tuning out the noise, rebalancing, and overall staying invested in a stock:bond ratio that matches my risk tolerance and time horizon. The market’s short term gyrations don’t matter a whit.

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To Buy or Not to Buy at Market Highs

There is always a bit of fear when evaluating buying in at all time highs. The sentiment is understandable. Everyone is afraid of buying in at a market peak and eating the recession that follows. After all, after almost a decade of uninterrupted growth, aren’t we due for a downturn?

However, the data analysis (done by someone else!) and existing scholars such as Tobias Moskowitz supports momentum investing. In other words, when the market or an individual stock is rising, it’s more likely than not to keep rising than to suddenly reverse.

Applied to current market highs, I would still encourage ordinary people to invest their new capital in accordance with prior allocation ratios, to achieve a healthy rebalance despite stock market highs. More likely than not, the market will be even higher (even after adjusting for inflation) in the next decade. If prior trends hold, we may be on the cusp of a 1-2 decade run of sustained all time highs.

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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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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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Illustrating Why Not to Pick Stocks

If you’ve read my book on wealth, you know that I highly discourage trying to time the stock market or to cherrypick which stock to buy. In today’s stock market, we have another great example of why. The market overall has been wobbly, with a few stocks (Facebook, Google, Amazon) shooting into the stratosphere and the rest of the market essentially in recession-level pricing (especially the energy and industrial sectors). This is great if you have concentrated your wealth correctly in those few stocks that are doing well, but most people didn’t guess right and are instead dealing with huge portfolio losses.

Let’s illustrate this point with a simple example. Assume a stock market with four different stocks.

  • A has dropped by 20% in the past year
  • B has dropped by 25% in the past year
  • C has gained by 150% in the past year
  • D has dropped by 10% in the past year

Assuming that each stock is weighted equally in the market, this means that the entire stock market as a whole has increased by 23.75%, all on the back of stock C.

Now we have fifteen different people each with a different approach to the stock market, scattered on the spectrum between concentration and diversification. We also list their gains. For math/stats geeks, we are essentially enumerating all the possible combinations of choosing among four options.

  • Person 1 concentrates all wealth in stock A (-20%)
  • Person 2 concentrates all wealth in stock B (-25%)
  • Person 3 concentrates all wealth in stock C (+150%)
  • Person 4 concentrates all wealth in stock D (-10%)
  • Person 5 buys two stocks (A and B) (-22.5%)
  • Person 6 buys two stocks (A and C) (+65%)
  • Person 7 buys two stocks (A and D) (-15%)
  • Person 8 buys two stocks (B and C) (+62.5%)
  • Person 9 buys two stocks (B and D) (-17.5%)
  • Person 10 buys two stocks (C and D)  (+70%)
  • Person 11 buys three stocks (A, B, and C) (+35%)
  • Person 12 buys three stocks (A, B, and D) (-18.33%)
  • Person 13 buys three stocks (A, C, and D) (+40%)
  • Person 14 buys three stocks (B, C, and D) (+38.34%)
  • Person 15 is the closet indexer and buys all four stocks equally (+23.75%)

In short, the more stocks you buy, the closer you get to the index average and thus are more likely to get a positive return. The fewer stocks you buy, the greater the chances of scoring a home run hit, but with a greater chance of losing money as well. The effect is magnified even more when only 3/500 stocks in the S&P index are outperforming the index. This example illustrates the value of diversification. In a world where most of the gains come from a few stocks, and where most of the gains come on a few days, missing out on those days or those stocks can be catastrophic for the overall portfolio. This should serve as yet another point in why low-cost index funds, with their instant diversification, are the only correct way to invest in the market.

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