Archives for December 2008

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Investments: When to Buy and When to Sell

I thought I’d share with you one of my favorite pieces of financial advice:

When to buy: When you’ve got money to invest. (“When you can”)

When to sell: When you need to liquidate something in order to pay your bills. (“When you have to”)

Note that none of the following words are included: market, attractive, up, down, high, low, P/E, indicators, chart, floor, ceiling, timing, bear, bull, analysis, economy, or prediction.

It’s so simple that people have trouble believing it. (Admittedly, believing the simplicity of the buy/sell decision is made more difficult by the fact that there’s an entire industry that depends on convincing us that it’s not simple.)

What to Do When You Can’t Diversify

A reader recently asked me what I’d suggest for situations in which somebody has a large portion of their assets tied up in something that can’t be diversified.

The most obvious example of this type of situation is, of course, when you own a house. But a similar type of scenario arises when a person has a profit-sharing plan through their work in which they’re required to invest in company stock.

My first suggestion (assuming you’re already investing as little as possible in your company stock) is to simply create a pie chart or something similar and see how your current asset allocation looks in terms of both:

  • Stocks vs. Fixed Income
  • Industry allocation within the stock portion of your portfolio.

…Because those are the two things that are likely thrown out of whack by being heavily invested in one particular asset.

Debt vs. Equity Allocation

This is the easy part, as there’s really only two pieces you need to balance: Stocks and fixed income. Just take a look at where your allocation is now and how it compares to where you’d like it to be. (Given that, by default, you’re still working if you’re in this scenario, I’d of course recommend a fairly high allocation toward equities.)

Then just do your best to adjust the rest of your portfolio to get as close as you can to your ideal allocation. Of course, it may not be possible to get there exactly, but the closer the better.

Industry Allocation

This is the part that probably gets more severely messed up by having a big amount in one particular company. It’s also the part that’s a bit more complicated to fix, because an ideal allocation involves more than just 2 separate pieces.

My advice would be, again, to take a look at where you are now and see how that compares to an ideal sector-by-sector allocation.

For reference, the S&P 500 index (as of 9/30/08) has the following sector breakdown:

  • 16% in Information Technology
  • 11% in Industrials
  • 13% in Health Care
  • 16% in Financials
  • 13.5% in Energy
  • 12% in Consumer Staples
  • 8.5% in Consumer Discretionary
  • 3.5% in Utilities
  • 3% in Telecommunication Services
  • 3.5% in Materials

Then you can use sector-specific ETFs (ETFs are essentially index funds that are bought and sold like stocks), or if you prefer, sector-specific actively-managed funds to try and balance out your portfolio. (This probably sounds way more complicated than it really is. In actuality it shouldn’t take all that long to do.) Then perhaps rebalance on a yearly basis.

Of course, the importance of doing this customized portfolio creation depends entirely upon just how out of whack your asset allocation is at the moment. So without a doubt, the first step is to put together an Excel spreadsheet or something similar and get an idea of where precisely you stand right now. Then, at least, it will become clear how urgently you need to rebalance as well as in what direction(s) you need to move your portfolio.

Past Performance and Future Results

We all know that choosing a mutual fund based entirely on past performance is a pretty poor idea. Well, we “know” it, but that apparently doesn’t stop us from doing it anyway. After all, the reason the mutual fund companies spend so much time and money promoting the results from their best-performing funds is that it brings in money. Lots of it.

And, if I’m honest with myself, I have to say that I do it as well (on some level at least). For example, if a fund had:

  • An investment strategy that was 100% in-line with my own,
  • A team of managers with plenty of experience,
  • Low costs, and
  • A long track record of poor results…

…would I be reluctant to invest in it? You bet I would.

In fact, I can’t even imagine investing in a fund without looking at its results.

So, given that most of us really do make investment decisions based (at least in part) upon past results, my question is this:

Why not look at results from relevant time periods?

Everywhere we look, we see 1-year, 3-year, 5-year, and 10-year records of performance. If we’re looking at equity funds, the only one of those that matters at all is the 10-year record. And what about the 20-year and the 30-year records? I’d like to see those too, please. Doesn’t it make sense to look at periods of time that are roughly equal to the amount of time we foresee holding the fund?

In other words, if we’re going to hold a fund for 20 years, how about looking at how it’s done over 20-year periods?

And if we’re going to use past performance, why don’t we at least broaden our data set? Rather than just look at the last 10-year period, how about looking at all the 10-year periods since the fund has been around? Let’s see the best, worst, mean, median, etc.

I’m far from convinced that we can use past performance to accurately select funds that are likely to perform highly. But if we’re going to attempt to do so, it seems like we might as well try and use data that could be relevant, rather than this 1-year and 3-year return garbage.

Regardless, I still think that which fund you invest in isn’t nearly as important as your ability to stick with your plan.

High-Cost Mutual Funds: Betting Against the House

As far as casino gambling goes, blackjack is one of the better games to play. Your chances of winning any given hand are fairly decent: Less than–though not much less than–50%.

However, because your chance of winning a hand is less than 50%, the more hands you play, the less chance you have of coming out ahead in the end.

Mutual funds work the same way.

Study after study has shown that the higher the operating costs of a fund, the worse its chances of beating the relevant index in any given year. This shouldn’t really come as any surprise. For every additional percentage of operating costs, the fund managers must outperform the market by 1% in order to justify the use of their fund over an index fund.

Of course, not every manager can succeed because, for every dollar that outperforms the market, there’s a dollar underperforming by an equal amount. So (prior to considering costs) half of all dollars in non-index funds outperform the market, and the other half underperform. Therefore, when looking at after-cost returns, we must conclude that greater than half of all non-index-fund-dollars will underperform the market each year.

So if your probability of outperforming an index fund is less than 50% each year, what are your chances of outperforming over a multiple-decade period? It’s rather like playing 30 hands of blackjack and expecting to come out ahead, isn’t it?

Takeaway: If you’re going to invest in actively-managed funds, make darned sure they’re low-cost ones.

You’re Buying Shares, Not Dollars

Miranda‘s comment on last Thursday’s post reminded me of a conversation I had about a few weeks ago with my friend Shannon.

Shannon is just getting started investing, and she already has a great system in place: Automatic deposits from her checking account into diversified mutual funds in a Roth IRA. Perfect.

As happens so frequently these days, the conversation turned toward the current economic turmoil and the accompanying market meltdown. When I asked Shannon how she felt about all this (primarily downward) volatility, she gave the perfect Oblivious Investor reply:

“Well, I just keep putting money in, and–while watching the value isn’t fun–every month I’m buying more shares than I bought the month before. Once things finally pick back up, I think things will work out pretty well for me!”

What a wonderful distinction. When we invest, we’re buying shares of companies. However, given that most of us have the bulk of our money in mutual funds rather than individual stocks, it’s easy to miss the fact that we own real shares of real companies that earn real profits.

When we look at our account statements (or check our accounts online), we see that we have X dollars in funds A,B, C, and D. It doesn’t say anywhere that we own shares of Google, Proctor & Gamble, Pepsico, Merck, and so on.

The lower the better (for most of us, anyway).

When looking at our statements, it’s easy to focus exclusively on that one bold number: Current Account Value. Unfortunately, when all we focus on is current value, we completely miss the fact that we’re picking up more shares every month. In fact, as Shannon pointed out, we’re currently picking up more shares each month than we did the month before. That’s a good thing.

For anybody still in the accumulation stage (that is, anybody who isn’t yet retired and selling their investments for money to pay the bills), a lower market is just an opportunity for IRA/401k contributions to buy more shares per dollar.

John Bogle on the Market’s Decline

Last week I wrote that, yes, our economy is obviously ailing. However, the primary cause of the current plummet in the market is simply investor fear. Our economy hasn’t declined anywhere near the amount it would have to in order to justify a 40% market drop.

And just the day after writing that post, I came across this interview with John Bogle, founder of Vanguard. (Update: Unfortunately, this video has been taken down from the Forbes website.)

It looks like Bogle agrees with me. 🙂 Here’s what he says:

I don’t think the value of corporate America has dropped by almost half. I mean, these are companies with capital – they make useful products and services, they’re efficient, competitive, innovative. Does anybody really think the value of American business changes by a trillion dollars a day? Well, they may, but I don’t.

Exactly. If shares of stock are shares of ownership in real companies–and they are–then what could we possibly be seeing in the economy that would make us think that these companies are worth only 60% of what they were worth a few months ago?

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