Archives for May 2009

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Fooled by Wall Street

Wall Street tells us that the ways to build wealth are to:

Unfortunately, each of these things has a less than 50% probability of increasing your returns.

But I’m starting to think that an even bigger problem than the ineffectiveness of those strategies is the fact that the focus on them is a distraction from the few things that really do matter when developing an investment strategy.

For example…

I’ve met several investors who have no difficulty spouting off several folk-wisdom tidbits about how to pick stocks, but who aren’t familiar with the concept of asset allocation.

I’ve met several investors who can tell you the 10-year return for the fund they just switched their 401k contributions to, but who never bothered to check the fund’s expenses.

I’ve met several investors who can list a whole host of reasons that the market is sure to go up (or down) over the next X months, but who don’t know (and haven’t bothered to research) whether they should be maxing out their Roth IRA or 401k first.

Why is that?

We’ve been duped!

The financial services industry makes money when we trade stocks (or when we subscribe to newsletters promising to show us how to pick stocks).

They make money when we invest in their actively-managed funds.

They make money when we jump in and out of the market (or subscribe to their services telling us when to do so).

They don’t make money when we demand low-cost investment options.

They don’t make money when we hold stocks for decades at a time.

Is it any surprise then that they’re engaged in an ongoing media blitz to obfuscate the handful of things that really do matter when it comes to investing?

Discouraging investors

Not only are investors confused, I have little doubt that many would-be investors have given up without even trying. They’ve decided not to bother learning about investing at all.

After all, it’s extremely complicated and math-intensive, right? You have to calculate financial ratios, check your stocks online, and watch CNBC all day so you can figure out where the market’s going next, right?

Better to pay someone a small fortune to do all that for you.

Improving Your Quality of Life through Investing

When we talk about saving/investing, we tend to think of it as something that will benefit us at some point down the road.

One of my favorite things about the investing principles I generally advocate is that they can actually improve your quality of life now. No need to wait 30 years to start seeing benefits.

Immediate benefits of diversification

If you’re investing in individual stocks, you’re stuck constantly monitoring them. Not only is that a giant time-suck, but it’s stressful as well.

Invest instead in an extremely diversified portfolio, and free yourself (immediately) from having to worry about what happens to any given company.

Immediate benefits of passive investing

If you’re investing in actively-managed funds, there’s always the possibility that the fund manager will make some terrible mistake. Any time you hand your money over to somebody else to invest, there’s risk involved. And–at least in my experience–with risk comes worry.

Opt for a diversified portfolio of passively-managed funds and free yourself (immediately) from the worry that a fund manager is going to make a costly mistake with your money.

Immediate benefits of automation

We all know the feeling of having some big “to-do” hanging over our head. There’s a part of human nature that prevents us from fully enjoying anything until we’ve taken care of whatever responsibilities we’ve been putting off.

If you haven’t gotten started investing yet, you’ll be surprised at how much better you’ll feel as soon as you get the ball rolling with an automatic savings plan–automated 401k contributions, for instance.

Knowing that you’re on the way to building wealth gives you a (well-deserved) sense of accomplishment and goes a long way toward eliminating worries/stress about the future.

What benefits have you noticed?

Aside from the obvious financial benefits, have you found yourself enjoying any quality of life improvements as a result of implementing a prudent investing strategy?

Meeting Your Goals without Stocks

The following comment was made on the Boglehead forum the other day:

“The financial-advice community has been seducing everyone into setting goals that cannot be met with low-risk investments, and then seducing people into drawing the logically fallacious conclusion that therefore, they should accept high-risk investments (rather than changing their goals). It’s akin to seducing everyone into accepting debt because it’s the only way to buy stuff you can’t afford, rather than not buying stuff you can’t afford.”

I found myself nodding emphatically as I read this. It’s very similar to what Carl said recently about adjusting other variables if you don’t want to own stocks.

On this blog I often suggest that investors keep rather high equity allocations. A large part of the reason I do that is because–from what I’ve seen–most investors’ goals are somewhere along the lines of “retire at 60-65, never work again, and travel the world.”

And if that’s your goal, you probably do need a good deal of money invested in stocks.

Of course, that’s not everyone’s goal for retirement. It sure isn’t mine.

If your financial goals are more modest–or more specifically, if they involve continuing to work later than age 65 or if they aren’t centered around a hobby as cost-intensive as world travel–then you very likely don’t need such a high stock allocation.

This should really be common sense. There’s no one perfect asset allocation for an investor of a given age. There are simply too many other variables. The only thing that the asset allocation rules of thumb can really provide is a starting point for discussion/analysis.

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Don’t be a (Motley) Fool.

Update: I stand by my assessment of the Motley Fool (that investors as a group would be better off without it and the rest of the stock newsletter industry). But I couldn’t have been more wrong about the contributions Brokamp would make to Get Rich Slowly. His articles have provided sound, helpful advice. Two examples:

Get Rich Slowly (the single largest personal finance blog, I believe) recently began hosting a regular column from a Motley Fool writer.

Score one for the bad guys.

But everybody loves the guys from The Motley Fool, right?

Spare me.

A few headlines to be found on Fool.com as I write this (5/7/09):

  • “5 Cold Stocks Heating Up”
  • “5 Stocks with a Bright Future”
  • “These Are the Market’s 10 Best Stocks”

Ugh. If those headlines aren’t a perfect example of a “get rich quick” philosophy, I don’t know what is.

They promote their newsletters’ performance with large green lettering: “Outperform by 40.05%.” To me, that sounds suspiciously like they’re indicating that you will outperform by that amount if you buy their newsletter. Am I the only one to whom this looks like a misleading use of past performance figures?

What The Fools do:

As far as I can tell, The Motley Fool’s entire business is built upon convincing people that it’s easy to beat the market.

Never mind the fact that only a handful of investors have ever done it for a sufficiently-extended period to give us any sort of confidence that it was due to anything other than luck.

Never mind the fact that every single trade is a negative-sum game due to transaction costs.

Never mind the fact that, in total, investors’ quest to beat the market is impossible by definition.

Never mind the fact that if we stopped paying newsletter publishers, stock selection services, active fund managers, and all the other charlatans who encourage us to engage in this fruitless endeavor, we’d be better off by $100 billion every year.

My complaint

My issue is not with the particular stock picks that they promote. My complaint is with their promotion of the idea that stock picking is a prudent form of investment.

To think that individual investors (Yes, that means you.) have any meaningful advantage over the institutional investors–i.e., the people with whom we’re trading when we buy or sell stocks–is nonsense.

If we could remove our emotions for a minute, it should be obvious that it’s rare for individual investors to know anything that the institutional investors don’t. We have less time to monitor our investments. Less access to research. Less analytical resources to use.

Both common sense and an enormous body of research tell us that our best bet is simply to stop trying and invest instead in low-cost, passively managed funds. If anybody tells you that it’s easy to beat the market by picking stocks, they’re probably either

  1. poorly informed, or
  2. about to sell you something.

Spend a couple minutes on the Fools’ website, and I think we can see which group they fall into.

The fools on index funds

Yes, I’m aware that they also promote index funds. But they do it in the most half-hearted, two-faced way possible. For every article on their site promoting index funds, there’s another article right next to it indicating that any investor with an ounce of intelligence can beat the market.

What do you think?

Am I wrong? Is it reasonable to listen to The Motley Fool? Or am I right that trying to beat the market is a fool’s errand?

Please let me know what you think in the comments.

To be clear, Robert Brokamp’s articles appear to be far more reasonable and well informed than much of the rest of the Motley Fool site. My complaint is not with him specifically, but with the principles espoused by Motley Fool in general.

Uncompensated Risk is for Suckers

We’re about to dig into something a bit more technical than we usually discuss on this blog, but I promise it’s worth it. Understanding the concept can have a direct impact on your investment results.

Risk can be broadly divided into two categories:

  1. Diversifiable risk, and
  2. Undiversifiable risk (also known as systematic risk).

In order to explain, let’s imagine that you’re considering buying stock in a given company.

Diversifiable risk is the risk resulting from the possibility that the company will fail — or at least, fail to earn a satisfactory level of profits.

Undiversifiable risk is the risk that results from the possibility that the stock market as a whole can decline in value over any given period of time.

The reason for the name “diversifiable risk” is that, if you own enough companies — that is, if you’re sufficiently diversified — then diversifiable risk is mostly eliminated. You’re no longer exposed to any significant risk resulting from the failure of one particular company.

In short, “diversifiable risk” = “risk that can be eliminated via diversification.”

On the other hand, no matter how many companies you own (except for “zero,” that is), you’re exposed to the possibility that the entire stock market will decline in value. Undiversifiable risk cannot be eliminated via diversification, hence the name.

Why the distinction matters

If you’ve done much reading about investing, you know that greater risk leads to greater expected return.

The reasoning is that, when an investment’s returns are volatile, it becomes less desirable to investors relative to investments with more predictable returns.  This lower demand results in a lower market price for the investment, thereby resulting in a greater expected return.

Here’s the catch that many investors miss: When people talk about risk being rewarded with return, they’re only talking about nondiversifiable risk.

Why? Because if risk can be eliminated through something as simple as diversification, it’s not all that undesirable. As a result, it neither decreases demand nor increases expected return.

How you can profit with this knowledge

By understanding that the market only rewards risk that can’t be eliminated by diversification, you can set yourself up to maximize your expected return relative to your risk. How?

By diversifying like crazy. After selecting the asset classes in which you want to invest, diversify as broadly as possible within those investment classes. In other words, buy index funds.

Or to look at it from the opposite perspective: investing in individual securities within an investment class (ie, picking stocks) increases your risk without increasing your expected return. Sounds like a poor bet to me.

Brains, Gains, and Losses

I recently finished reading Nassim Nicholas Taleb’s Fooled by Randomness. (Highly recommend it, in case you’re curious.)

At one point in the book, Taleb mentions that, when looking at the outcome of a transaction, our brains are set up to react primarily to whether we’ve incurred a gain or loss–not, that is, to the size of the gain/loss we’ve incurred.

Quick note: I’m certainly not a medical professional, nor is Taleb. So please keep in mind that this information is now at least 2 degrees of separation away from its source.

If the claim is true, it would certainly have some fascinating implications for investing. For example…

We prefer frequent gains to big ones.

And more to the point, we’d most enjoy infrequent losses.

Imagine that you’re given the choice between:

  • a portfolio that earns a steady 6% return per year, or
  • a portfolio that goes up in 2/3 years, down in 1/3, and earns an effective annual 12% return.

Our brains are hardwired to prefer the first portfolio, despite the fact that our wallets would prefer the second.

Essentially, this gets right at the heart of what I was trying to say a while back: A lack of volatility provides us with a mental/emotional benefit that is real and valuable (though not measurable). And that, in my opinion, is the primary (and perhaps only) reason for including non-equity investments in a portfolio that still has decades to go before liquidation.

Your thoughts?

What do you think? Is that true? Or is there some other reason to allocate a meaningful percentage of a decades-until-liquidation portfolio toward fixed income investments?

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