Archives for February 2009

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Diversification: The Only Free Lunch

One of the most basic principles of economics is the idea that “there’s no such thing as a free lunch.” In other words, every good/service has a cost to somebody somewhere, regardless of whether or not the person consuming the service is the person paying. (Example: Google is free to users, because it’s paid for by a massive network of advertisers.)

That’s why I was fascinated to read (in Peter Bernstein’s Against the Gods) that in 1952, a gentleman by the name of Harry Markowitz proposed the idea that diversification is in fact a “free lunch.” That is, it offers benefits without any cost.

The more I think about it, the more I’m convinced that he was right. If you compare the likely returns between:

  • a group of 5 stocks, or
  • a group of several thousand stocks

…the “expected return” for either group of stocks should be the same. That is, there’s little reason to expect that either group will outperform the other.

What is different between the two groups, however, is the predictability of long-term returns. With a group of just 5 stocks, returns are extremely unpredictable. In contrast, we can at least make some sort of ballpark-estimate of the long-term returns of a group of several thousand stocks.

And you know what? Predictability of returns is kind of nice. 🙂

So what makes this “lunch” free?

I think we can all agree that this predictability offered by diversification is a beneficial thing. But what makes it unique is that it literally has no cost.

Sure, there’s a reduced chance of earning spectacularly high returns with a thousand-stock portfolio. But at the same time, there’s a reduced chance of earning spectacularly low returns. The two should precisely offset each other.

What about the actual costs involved with acquiring (and owning) a diversified portfolio? With low-cost index funds, or ETFs purchased via discount brokerage firms, they’re pretty close to zero as well. Or more to the point, they’re no greater than the costs involved in acquiring and owning a undiversified portfolio.

It’s always been obvious that diversification is a good thing, but I’d certainly never thought about it in these terms. Something beneficial that costs you literally nothing. Might as well take advantage, right? 🙂

Treating Mutual Funds Like Stocks

Let’s say you own a stock, and over a 3-month period, the share price declines by 40%. What do you do?

Some people would say to hold onto it in order to avoid “selling low,” but that ignores the possibility that the stock may have declined precipitously for a good reason. It may well be the case that the company is in serious trouble, and it’s facing a real possibility of going out of business. If that’s the case, it’s potentially a good idea to get rid of any shares that you own–no matter how little you get for them.

To put it differently: With individual stocks, there is a very significant amount of long-term risk. With any given stock, there is no guarantee that you’re going to earn money, even if you have the patience to own it for 30 years. (In fact, as we discussed last week, there’s a substantial chance that you could lose all of your money.)

Mutual funds work differently.

Well-diversified mutual funds (index funds being the most obvious example) are not subject to the same type of long-term risk.

Let’s say you own an index fund that tracks the Wilshire 5000 (which represents basically the entire U.S. stock market). If it declines 40% in value over three months, it’s fairly safe to say that it didn’t happen because the entire U.S. economy is about to “go out of business.” Therefore, if you hold onto your fund, you can be confident that you’re going to (eventually) make money.

This lack of long-term risk is a big difference between mutual funds and individual stocks. And that seems obvious. It’s the very foundation of the concept of diversification.

So why do people treat mutual funds like stocks?

What’s so I find fascinating (and unfortunate) is the fact that many people seem to deal with mutual funds like they do with stocks. They see a 40% decline in share value, and they go running, seemingly unaware of the fact that if they’d just hold on, they’d eventually turn a profit.

I wonder if this is partially due to the fact that stocks have been around for much longer than mutual funds. Perhaps there are certain facts about stocks–things like “Stocks are risky” and “If a stock price drops, it could mean there’s a problem.”–that have reached a point where essentially everybody in our culture knows them.

In contrast, a real understanding of mutual funds has not yet reached that level of collective awareness in our culture. Instead, we make due with what we have. We (mistakenly) apply our knowledge of stocks to the behavior of mutual funds, assuming that we should deal with funds in the same way that we’d deal with the stocks of which they’re composed. Seems rational at first glance, but what unfortunate consequences!

Mint Review: Why I Use Mint.com

About a month ago, my wife and I were noticing that our number of accounts at various financial institutions was becoming a bit unwieldy. We had:

  • A 401k at one place
  • An IRA at another
  • Checking accounts at two different places (one personal, one business)
  • Two savings accounts (one personal, one business) at the same institution as each other, but at a different institution than any of the other accounts.
  • A credit card with yet another financial institution
  • Student loans with yet one more institution.

Yikes! The thing is, they all made sense for various reasons, and to try to move them all to one place would have meant sacrificing something worthwhile (whether rate of return with the savings, a great cashback rewards plan with the credit card, or very convenient locations with the bank).

Enter mint.com. With a (free) account at mint we can now look at all of our info in one place.

Mint automatically pulls information from all of our different accounts, so there’s no need for us to update anything manually. (My previous system was to keep it all in a manually-updated spreadsheet. It got to be a bit of a pain in the neck!)

So that’s why we created an account. And it completely solved the problem. After having an account for a while though, I realized something else it does for us:

It tracks spending very nicely.

For anybody who tracks their spending, Mint is absolutely awesome. It automatically tallies up how much you spend each month with every individual vendor. What I find more useful, however, is the way that it groups vendors to give us information as to how much we’re spending in various categories.

Then it gives us nice, pretty charts. Like this:

piechart

What’s more helpful for me, however, is the ability to look at trends over time. For example, we can look at changes in our monthly grocery expenditures:

barchart

(The November number is artificially low because it only includes data for a portion of the month.)

One thing I’d advise, however, is checking how mint categorizes each of the vendors with which you spend money. It gets most of them right, but probably 1/15 categorizations will be completely incorrect. (For example, it placed our dental insurance payment in the “entertainment: sports” category.) Luckily, changing the categorization of a vendor (or creating entirely new spending categories) is quite easy.

Security concerns?

I’ve heard a few people voice concerns about security with online systems like this. Rather than try to answer them myself, I’ll just point you to this video from the CEO of mint. (It covered all the concerns I had, as well as some others.)

In short

  • Mint lets me see all our accounts in one place.
  • Mint tracks our spending for us, making it easy to spot trends.
  • It’s costs me nothing, and they don’t send me any spam.

Just thought I’d share my thoughts on it, as it’s been quite helpful for us. I hope you find it as helpful as I do. 🙂


Side-Effects of a Recession

My sister recently sent me a NYT article discussing the cultural effects of a recession. Toward the end of the article, the author cites research showing that “a generation that grows up in a period of low stock returns is likely to take an unusually cautious approach to investing, even decades later.”

That scares me. I’m afraid that investors will “learn” from this recession that the stock market is a dangerous place for their money. As you know if you’ve been reading here for a while, I don’t see an “unusually cautious approach to investing” as a good/safe thing.

Today’s investors are faced with unique challenges:

  • Longer retirements than any previous generation.
    • More years of retirement quite simply means that we’re going to need more money to spend.
    • Decades of inflation will eat away at our investment returns and demolish the value of assets kept in “safe” investments.
    • We’ll likely incur huge amounts of medical costs during our last couple decades of life.
  • No traditional pensions (for most of us anyway).
  • Legitimate concern as to whether the Social Security system will be able to provide the benefits that it has promised (and that we have paid for!).

In short, we need a lot of money in order to be able to retire. (For example, for anybody my age, less than $2 million is unlikely to be enough unless you have passive income–via a pension or a business–or you plan to rely at least in part on Social Security.)

There’s simply no way to accumulate such a sum of money without a stock-heavy asset allocation during our working years.

Boy oh boy do I hope that my generation doesn’t swear off investing in equities.

Performance of Original Companies in S&P 500

A few years ago, I read and enjoyed Jeremy Siegel’s The Future for Investors. In the book’s appendix, Siegel provides a list of the original 500 companies in the S&P 500, as well as how they had performed up until the book was written (i.e., from 1957-2003).

I went ahead and plotted their respective annual performances on a graph, because I was curious if it would look like a normal distribution/bell curve. Here’s what it looks like:

original-sp-bellcurve

What we can learn:

It looks a lot like a bell curve, but with one giant exception: There are a whole list of companies that went to zero. This does not occur with a normal distribution.

Over this same period, the S&P 500 earned an annual return of 10.8%. In other words, 215 companies did better than the whole index. 285 did worse.

This is in keeping what I had guessed: More companies underperform than outperform. That’s because it takes multiple poor performers to make up for each superstar stock (such as the one that earned an almost 20% return per year).

The way I see it, this is an argument in favor of extreme diversification. If you pick stocks, your chances of picking one of the ones with a “negative 100% return” far outweigh your chances of picking one of the few at the far right of the graph.

Last point of note: In case you’re curious, the one stock with an almost 20% annual return is Philip Morris. Does that make anybody else a bit sad?

GDP Down: I’m Not Worried.

The big news last week was that 2008 Quarter 4 real GDP was down from Q3 real GDP at an “annualized rate of 3.8%.” Everywhere I looked, people were talking about how bad that is. My opinion? It’s not really that bad.

Let’s take a look at the numbers. (Data is from the U.S. Bureau of Economic Analysis.)

  • Quarter 2 GDP (in year 2000 dollars) was $11.727 trillion.
  • Quarter 3 GDP (in year 2000 dollars) was $11.723 trillion.
  • Quarter 4 GDP (in year 2000 dollars) was $11.599 trillion.

So from the peak, we’re off $128 billion, or just under 1.1%. Sure, it’s not good. But it hardly seems catastrophic.

For comparison–and I’ve mentioned this before–from 1929 to 1932, real GDP fell by 27%. A 27% decline is an entirely different sort of thing than a decline of barely 1%. So please, let’s stop pretending this is anywhere in the ballpark of a depression.

Also of note: The 27% decline in real GDP during the Depression corresponded to a roughly 80% decrease in share values. So far, our 1.1% decline in real GDP has corresponded with a roughly 40% decrease in share values. Anybody else think the markets might be overreacting?

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