Archives for October 2009

Black Swan Investing

Carl from Behavior Gap recently posed an important question over at Morningstar’s blog. He asks whether laziness is a significant motivator in investment advisors’ tendency to steadfastly recommend a buy and hold strategy. Carl writes,

“I have found that there is a subculture in the advice industry that dismisses any inquiry about the economy, the markets, or anything other than buying and holding, as speculation.”

He then continues,

“I have recently asked questions about:

The fact that total debt to GDP is over 350% and that is 2x higher than it was in the 1920’s (see chart).

Nassim Taleb’s great books: The Black Swan and Fooled By Randomness.

The work of Benoit Mandlebrot on risk (see this book and this Morningstar Conversation).

…People dismiss the questions as foolishness without even considering them.”

I absolutely agree that it’s worth thinking critically about investment strategies. Whatever strategy you choose to follow, you must have a deep understanding of why you’re following it, otherwise you’ll be unable to stick with it.

Placing Bets

On the other hand, I have my doubts as to the value of attempting to work economic indicators into one’s investment strategy. Take, for example, the above-mentioned 350% debt to GDP ratio. What do you do with that piece of information? In order to make use of it, you need to actually change your strategy in some way.

You have to make a bet. Overweight or underweight something relative to a simple market-cap-weighted portfolio. Or, rather than buying and holding, attempt to use that information to predict where a particular asset class is heading next.

Instead, I choose to bet against anybody’s predictive abilities (including my own).

Planning for the Unpredictable

Incidentally, a large part of my reasoning is exactly what Carl referenced in his post: the concept of the “unknown unknown” or, to use the current catch phrase, the black swan.

Say you know Fact A, and you believe that A will cause Event X to occur. In a vacuum, you may be completely correct. But in the real world, there are also Facts B, C, D, and an infinite number of other facts that you’re entirely unaware of. And any one of those could potentially cause Event X not to occur.

And judging from history, what tends to happen is that while we’re debating whether Events X, Y, or Z will occur, Event Q sneaks up out of nowhere and screws up our plans beyond recognition.

My understanding is that the entire point of the black swan concept is that, rather than looking at some fact (350% debt to GDP ratio) and predicting a particular result, we should accept the fact that we’re not good at predicting major events. We should attempt to build a portfolio (and investment strategy) that recognizes that reality and deals with it appropriately.

My method of planning for the unpredictable is to:

Create a portfolio consisting of thousands of companies from across the world,
Minimize costs (because no matter where the market goes, costs matter), and
Buy & hold rather than attempting to predict what the market will do next.

Do I think that’s the only way to respond to an unpredictable investment environment? No. Not at all. But I have yet to encounter any strategy that I’d say is better than this one.

October 14, 2009

College Savings: Roth IRA, 529 Plan, or Coverdell?

A commonly-given piece of financial advice is to use a Roth IRA to save for your children’s college. For the most part, however, this isn’t a great idea.

Yes, it’s true that money inside a Roth IRA grows tax-deferred, and yes it’s true that money withdrawn from a Roth IRA will be free from the 10% penalty if it’s used for qualified higher education expenses. What many investors overlook, however, is that unless you’re 59½, disabled, or dead, withdrawals of earnings from a Roth IRA are still taxed as ordinary income–even if they’re used for qualified education expenses.

This means that the earnings will be taxed according to your tax bracket at the time of the withdrawal. In contrast, if you had simply invested in tax-efficient investments (like ETFs) in a taxable account, both the dividends and long-term capital gains would be taxed at a maximum rate of 15% rather than at your ordinary income tax rate.

A Better Method: 529 Plans

In contrast, money withdrawn from a 529 plan comes out free from taxes (regardless of your age) as long as it is used to pay for qualifying higher education expenses. Also, in many states, contributions made to a 529 plan qualify you for a state tax deduction. Deductible on the way in and tax-free on the way out? Not bad!

What If My Child Doesn’t Attend College?

Many people worry about the risk of setting up a 529 plan for their child, only to see that the child doesn’t end up attending college. In reality, this risk is fairly minimal. Anyone can be named as the beneficiary, and you can change the beneficiary at any time. So if your first child doesn’t attend college, you could use the 529 to:

Pay for the education of your other children,
Pay for your own further education, or
Pay for college for a niece or nephew.

Basically, as long as somebody you know ends up attending college, you’ll be able to make use of the 529 plan.

Coverdell Education Savings Accounts

A third college savings option is to fund a Coverdell education savings account. Coverdell accounts work much like 529 accounts: Contributions are not deductible, but distributions are tax free as long as they’re used for qualifying education expenses. Also, like 529 accounts, anybody can be named as the beneficiary, and the beneficiary can be changed at any time.

The primary differences between 529 accounts and Coverdell accounts are that:

Coverdell accounts can be used for grade school or high school education expenses,
Contributions to a Coverdell account are limited to $2,000 per year (In a 529 plan, the limit is set by the state–usually far above $2,000 per year.),
Contributions to a Coverdell do not qualify for a state income tax deduction, and
You can invest the money in a Coverdell account in any way you choose.

So Which Option Is Best?

For the reasons mentioned above, I generally don’t think that a Roth IRA is ideal for saving for college expenses. Whether a Coverdell or a 529 is more suitable depends upon whether 529 contributions are deductible in your state and upon whether it’s more important to you to be able to:

Use money in the account to pay for schooling other than college, or
Contribute more than $2,000 to the account each year.

October 13, 2009

Review: The Little Book of Bull Moves in Bear Markets

I recently finished reading Peter Schiff’s The Little Book of Bull Moves in Bear Markets. I found the book to be absolutely fascinating, even though (or perhaps because) I didn’t agree with everything in it.

For background: Peter Schiff is famous for predicting the collapse of the housing bubble and the calamity that came with it. He’s the president of Euro Pacific Capital (a broker/dealer in Connecticut) and is now running for Senate.

The premise of Bull Moves in Bear Markets is essentially that the U.S.’s deficit spending and imbalance of trade over the last several years have been fueled by inflationary monetary policies. Schiff makes the case that if the U.S. (both the government and its citizens) continues on the track it’s on, hyperinflation will be the result.

Schiff on Investing

Given Schiff’s belief that extreme inflation is likely to occur in the near future, his investment suggestions are no surprise:

Stay out of U.S. dollar-denominated fixed income investments,
Invest in gold,
Invest heavily in non-U.S. stocks–specifically stocks from emerging markets.

Something that I particularly appreciated about the book is that Schiff isn’t afraid to get into specifics. For example, he goes over all the different ways you can invest in gold (buy it directly, buy stocks of mining companies, buy commodities funds), and he runs through the pros and cons of each method.

My biggest hang ups with his investment approach are that:

He’s far more confident in an individual’s ability to successfully pick stocks than I am, and
He doesn’t really address the fact that many of his predictions should already be priced into current market values.

Schiff on Frugality

There’s an entire chapter in the book dedicated to the idea that frugal living is the best way to get through an economic downturn. This makes sense to me, and most of his suggestions are good, if not particularly original: look for ways to cut down on recurring costs, save/invest your raises and bonuses rather than spend them, etc.

Side note: I sometimes joke that the best investments for a crisis are not bonds but rather food, guns, and ammo. Schiff says exactly the same thing. The difference: I don’t think he’s joking. Immediately after suggesting that you stockpile cornflakes, Schiff says the following:

“It might also be a good idea to buy a handgun and lots of extra ammunition to protect your supply.”

Maybe that has something to do with why he’s sometimes called Dr. Doom.

Schiff on Politics

Schiff’s political views are quite different from my own–the presence of a back cover blurb by Glenn Beck should have been a giveaway–but I’m in agreement with his general premise that we can’t keep spending money we don’t have.

I think it takes a brave person to publicly state (while running for office) that a lower standard of living isn’t a problem to be avoided, but rather the solution to many of our problems.

Should You Buy It?

While I’m not entirely on board with many of Schiff’s suggestions, Bull Moves in Bear Markets is certainly a thought-provoking read. Added bonus: It qualifies for free shipping if you buy it together with my latest book. 😉

October 10, 2009

Testing Investment Strategies

At least a couple times every week, I’ll get an email or comment on the blog explaining why I’m an idiot for recommending a buy & hold index fund strategy. Usually, the writer is kind enough to share a strategy that they’ve been using successfully to earn “very impressive” returns.

The following are the 3 questions I ask about an investment strategy to determine whether or not it’s worth looking into further.

How has it performed in the past?

If I read about a strategy and I see that it’s underperformed the market for the last 20 years, I’m unlikely to be interested. Similarly, seeing that a strategy has worked well over the last 12 months isn’t terribly meaningful. At a bare minimum, I’d want to see how it has performed during both up and down markets.

Why has it worked?

While respectable past performance is necessary, it certainly isn’t sufficient. From 1983-1993, butter production in Bangladesh famously proved to be a nearly perfect predictor for performance of the S&P 500. Yet (thankfully) I don’t know anyone who actually invested their money based on butter production levels.

If–even with the benefit of hindsight–there doesn’t appear to be a reasonable explanation for why a strategy has worked, I’d steer clear.

Why should it continue to work?

Without a doubt, this test is the hardest one to pass. In my opinion, for an investment strategy to be worthwhile, there must be reason to think that either:

The strategy will never become widely known, or
The strategy will continue to perform well even if it does become widely known.

For most market-beating strategies, the reality is that they’ll stop working soon after they’re discovered by the major market players. That’s simply the nature of a market with literally millions of competing investors.

Buy & Hold with Index Funds

To date, a buy & hold indexing strategy is the only one I’ve found that provides answers that satisfy me.

As to their performance: Index funds have consistently outperformed the majority of their actively managed competition.

As to why they perform well, it’s plain common sense:

And the best part: The strategy will continue to work just as well even as it grows in popularity. You buying and holding index funds does not hinder my performance in any way, despite the fact that I’m using precisely the same strategy.

October 6, 2009

Fear, Responsibility, and Investing

Two recent snippets of news:

My guess is that investors are slowly but steadily learning that actively managed mutual funds simply don’t live up to their promise. That is, the overwhelming majority of them do not outperform their respective indexes.

What amazes me, frankly, is how much money is still invested outside of index funds. Granted, many investors are probably just unaware of their superior track record (and the reason behind it).

But at the same time, if you ever read personal finance blogs, magazine articles, or discussion boards, then you’ve seen that countless investors do know about index funds and about how poor an investor’s chance is of beating the market on his own, but then they opt to try and beat the market anyway.

It’s Not Just My Money.

To me, depending upon your circumstances, ignoring all the evidence in favor of index funds seems irresponsible. To use myself as an example: I can’t imagine having to explain to my wife someday that she won’t be able to do all the things she has planned simply because I put my ego first by picking stocks, trying to pick hot funds, or some other similar strategy.

Now perhaps if I was single, had no intentions of marrying, and had nobody financially dependent upon me in any way, then I might dabble in the exciting stuff. I might try to look for undervalued companies. I might make guesses about where the market is going next month. I might try to prove that I’m smart enough to beat the market.

But as it stands now, with somebody else’s future on the line as well, I simply can’t justify it–especially not when I know that if I just decide to accept the market’s return and save/invest diligently, that we will be able accumulate enough money to fund our goals.

What about you?

Do you attempt to outsmart the market in one way or another? Or have you, like me, decided to take your stock-picking, Wall-Street-Journal-reading, CNBC-watching, 200-day-moving-average-monitoring ego and shove it away somewhere where it’s unlikely to show its face for the next few decades?

October 1, 2009