Sticking to Your Guns

I always feel the need to qualify the fact that I'm not a Warren Buffet acolyte, for some reasons beyond the scope of this blog. But, I'd be a fool not to learn from him when appropriate. He clearly knows a thing or two.

Meb Faber points out (in this article from a year go) that many investors could simply ride Buffet's coattails through  Berkshire Hathaway's B shares. That would result in a good overall return, but would also mean sticking through some periods on underperformance to get there.

DIY Personal Finance for Doctors

I just finished a very good book called The White Coat Investor by Dr. James Dahle, which shares a name with his website. The author tired of shoddy financial advice that doctors get and set out to learn as much as he could on the subject, and has made a pretty good go of it. 

The book covers a good deal of financial items specific to doctors, such as medical student loans and malpractice insurance, but it also covers a fair amount of material that is relevant for any small business owner. This would include corporate structure, taxation, retirement savings and asset allocation. And he also has a lot to say about living within your means, a subject that is important to us all.

Dr. Dahle achieved financial independence at a pretty young age and managed to turn his story and expertise into a side business. It's pretty impressive how much he has managed to learn about finance as a sideline gig, but that's the power of "want to". Personal finance is like exercise-you can pay someone to help you, but at the end of the day, you've got to be responsible for the results and some things simply can't be outsourced. 

Some people may not have a choice in the matter, but for many people, their financial situation can be as simple or as complex as they want to make it. But, the good news is that money is one of those subjects where one can learn a great deal through individual reading and experience. Now, some things are going to be too hard to master solo while thumbing through a book on the beach, but there's a lot to learn before you hit that wall.

Dahle has a good deal of less than glowing things to say about financial advisers, but at the end of the day, such opinions generally have an element of truth to them and I am in no position to argue with an individual's experience. Many of his complaints fall into one of these categories:

1) Lack of transparency

2) Cost

3) Misaligned incentives between practitioner and client

I would also say those elements are also present in the healthcare industry, but I won't quibble right now. When and if I  become enough of an expert on the subject to write my book about the medical field (don't hold your breath) I can expound on that. Bottom line is that  any professional that followed the advice outlined in this book would be well on their way to success, as they will be a few steps closer to figuring out what he can do alone. Also, since the realm of personal finance includes everything from investing to insurance to taxes to estate planning, there's going to be areas where people need help. No one (amateur or professional) can completely do it by without help. For times such as those, this book will leave the reader much better armed to find the right expert at a fair price.

The Importance of Persistence...Again

Ben Carlson's (not Carson's) website is one of the better in the financial world. Substantive content, easy to understand, delivered in a matter-of-fact manner with no inflammatory hot takes. I read his book (like his website, titled A Wealth of Common Sense) last summer and enjoyed it. It is full of good content, but one part in particular is worth re-visiting.

[Note: These numbers aren't audited. I used his data as a starting point and extrapolated some more myself with the help of Excel. I make no warranties, but since he is a Charted Financial Analyst and I majored in math, I am hoping we are at least in the ballpark.]

Carlson lays out the story of Bob, the world's worst market timer (the story is also found here on his website). Basically, it describes a guy who starts his career in 1970, saves progressively more cash each decade and happens to plow it into the market at the 4 worst times in the last 45 years. No dollar cost averaging. Only bad luck and bad decisions. 

[Note: Carson has the explanations of the funds/indexes used at the bottom of his page.]

Bob does have one redeeming aspect to his investing, though: he never sells. So, largely on the back of that single discipline, he parleys his $184,000 of investments in $1.1 million by the end of 2013. I did some back of the envelope calculations and that's about a 9% annualized rate of return. The annualized rate of return of the S & P 500 during this time was about 10.5%, but he didn't get that because he deployed his capital at the worst possible times.

But, all things considered, that is a pretty good return considering Bob demonstrated zero investing skill beyond a rigid "no sell" discipline. Now, he had to go through hell to get that return, but he did it. Carlson calculates that dollar cost-averaging would have gotten Bob about $2.3 million. 

Now, there is at least one big caveat: these numbers work out so well partly because Bob was 100% in stocks. Probably not a wise idea unless you have a really big appetite for risk. Most other people would have probably mixed in some bonds there, thus dampening returns. 

But, as Carson points out, the biggest takeaways are that 1) it generally pays to be biased towards optimism and  2) think long term. Also, you could probably put in a third item: as he would have been twice as well off had he bought into the market every month, consistency generally trumps guessing.

The Rise of Robo-Advisers

Betterment, a prominent robo-adviser, has decided to add humans....which kind of defeats the point of robo-advisers. But, that aside, if they are trying it, you can bet that another big robo-adviser (I'm looking at you, Wealthfront) will try it , too.

For those of you not familiar with them, a robo-adviser is an online wealth management tool that provides inexpensive, algorithmic investment services  based on individual risk tolerances without a human financial planner. They basically provide cheap, customized passive investing. You enter some data and risk tolerance info, it spits out an appropriate portfolio that doesn't try to beat the market, merely to follow it.

Many see these as a threat to human advisers. I guess they are, if you think an adviser's job is to beat the market (wrong: it's to help you reach your goals). We probably won't know for sure how good these is until it endures a severe bear market. Some people also have problems with how they measure risk, but that's likely an issue for human advisers as well. And there is also the chance that the algorithms could snowball during a sell-off and create a self-perpetuating mess. I admit, this concerns me, but it seems like there is enough algorithmic activity going on in the markets that this possibility is always present in this day and age, with or without robo-advisers.

The point of all this is merely to say that human advisers are certainly using more technology (to make their jobs easier, serve the client better and reduce costs) and now we see that robo-advisers are using humans. Like most things in life, it's not generally an either/or. Sure some investors who have small nest eggs or are price sensitive may prefer the strict robo-adviser without human interference. And maybe some people prefer the old model where you pay 1.5% for the gray-haired guy in a suit in the oak-paneled room. But, many of us will find a balance in the middle. One of my favorite bloggers, Meb Faber, said (and I paraphrase), "The future belongs to advisers who integrate technology seamlessly and provide value through behavioral coaching". In short, a good adviser will keep the computers running and keep you from shooting yourself in the foot. 

To Flip-Flop Or Not To Flip-Flop?

I've been talking with some other advisers lately and getting into the weeds on best practices, hopefully, practices that serve both the business and the client. The two shouldn't be at odds, an adviser can't have a business without clients and they aren't doing their clients any favors by going out of business. And if an adviser is doing his clients a favor by going out of business, then he shouldn't be in business anyway.

During these talks, the subject of change has come up, and this can be a big problem for both advisers and investors. At the end of the day, people are people and a lot of the axioms of investing are pretty rock solid throughout the decades. But, also, the democracy of data and speed at which we have access to it has certainly made its mark. Some strategies that worked for prior generations don't work as well now. Or it could be that the strategy is undergoing a typical period of poor performance, which is pretty much inevitable. So, during the down periods, investors are constantly wondering if  they should just right the storm out, or if something about the markets has permanently changed. Or maybe, the markets haven't changed, but the investor is simply wondering if his initial assumptions had any merit at all.

The question is "when should we change our minds?" As this blog says, "the graveyard of investors is filled with people who refused to change their mind." True, we may know the guy who is still waiting for the whole internet fad to play itself out, but we also probably know someone who sold in 2008, who may well mostly still be in cash, missing out in very real gains. Flexibility is great, spinelessness is not.

Maybe one of the better ways to think about this is to look at one of the lions of modern finance, Eugene Fama. He made his hay off of the Efficient Markets Hypothesis, which basically said that stocks are all priced correctly, so don't bother trying to beat the market. He later modified his views into the Three Factor Model (developed with colleague Kenneth French), which said that a stocks return could be attributed to overall market return, the size of company,  and price-to-book ratio (or value, as in "is this stock cheap?"). It was later expanded to the Five Factor Model by adding profitability and what they call an "investment factor". Defining those isn't important right now. The fact that they modified their opinion is. Also, in the midst of this, Fama and French also came to the uncomfortable (for them) conclusion that momentum (a stock's recent movement) exists, as well. Although, how much merit they place in it is still up for debate.

It's also important to note that to Fama, this isn't merely an academic.question. He also serves as consultant, board member and thought leader for Dimensional Fund Advisers, so real money is on the line here. What he does and says has consequences. He's got every reason to remain entrenched in a position, but he still is curious and intellectually honest enough to modify his beliefs. Furthermore, the fact that he has made past adjustments isn't getting in the way of his acting on his current ideas, and making money for himself and others in the process.

Part of the difference between what people like Fama and French are doing and what the average investor is doing is familiarity with the data. For most, the only feedback they get with regard to investing is their current return. Not to sound like Johnny Cochran, but, if it's bad, they get mad. Then, they change things up at the worst possible time, a fool's errand when investing virtually assures that even the best strategies will give us a pretense to be dissatisfied at one point or another.

Performance alone, or lack of it, isn't a good enough reason to change course. Investors need to look for the reasons behind the performance-the explanatory factors-in order to determine whether  a change is warranted. Results are important, but they don't tell the whole story. At any given time, investing results could be bad. That's life. That isn't a reason for massive change any more than a passing mood is. In the same vein, the 2-3 days a month we generally spend in a depressed state isn't a reason sell the house, quit the job and follow Widespread Panic on the road.

Advisers need to be on guard for this as well. My general rule has been to make changes slowly, although I hope this doesn't prevent me from someday making a quick change if the facts are overwhelmingly obvious. That's where judgement comes in, and that comes with experience and knowledge. If you have these things yourself, you very well might not need an adviser. If you don't, that's where one can help. For all the knowledge that advisers like to think they have, with the proliferation of data and robo-advisers, their best service might merely be serving as a firewall between a client and a bad decision.

Rick Barry's Open Secret

Continuing yesterday's theme on index/passive investing, here is an article on Abnormal Returns about free throw shooting and investing.

The Cliff's Notes version is this:  an episode of Malcolm Gladwell's Revisionist History podcast talked about NBA legend Rick Barry's unorthodox style of shooting free throws: underhanded (or "granny style" or "potty shot"). He had some success teaching it to poor free throw shooters because, from a physics standpoint, it is an objectively superior way of shooting. But few stick with it, because it looks ridiculous.

Although index investing doesn't exactly look ridiculous, some people shun it for similar reasons as they do underhanded free throw: it's not as cool as active management. The bottom line? Whether it is textbook passive investing or something similarly mechanical and boring, forget being cool and seeking action. Go with what works. And with this style of investing, at least you don't have to do it in an arena full of spectators.

Passive Potpurri

This has been dealt with before, but it's worth repeating. A couple of things to keep in mind with "passive" investing (or "index" investing):

-"Passive" isn't exactly the best term. If you decide to invest passively, this still raises a host of questions. Which stock index do you use? What percent do you allocate to bonds? To foreign assets? Any precious metals? You haven't cut out decisions altogether, but you have reduced their frequency.

-To that point, once you decide to passively invest, buckle up for a potentially wide ride. If you put all of your money into a U.S. stock index fund, you could see it cut in half. If you dice it up more ways, you might be able to avoid such a dramatic turn, but you likely sacrifice upside returns.

-If you invest passively, it's unlikely that you will ever been the smartest one in the room, or the dumbest. But, the vast majority of investors fail to achieve index-level returns, so don't confuse "passive indexing" with "average". You would be much closer to the head of the class than the rear.

Passive/Index investing isn't the only way to invest, but it is among the simplest. But you must stick with it for the long haul. Passive investing is patient.

Dividends: Don't Lose the Forest Through the Trees

Meb Faber has a great piece on why dividends are overrated. Now, the "overrated/underrated" debates are kind of cliche, but caring too much (or caring at all) about dividends could be costing you money.

Here's a quick primer on dividends. Stock ABC is trading at $10. It declares a $1 dividend. The investor gets that dollar in their pocket, but the stock drops to $9. It isn't free money. That dollar represents one less dollar that the company can reinvest in itself. And if a company doesn't declare a dividend, anyone who needs income can simply sell enough stock to match the dividend they need/expect, so it's easy to replicate.

Combined with things like debt paydowns and stock buybacks, dividends can be useful (as seen in this book by Faber), but in isolation, they aren't that great of a metric.  It's important to remember, absent taxes, transaction costs and some psychological factors, dividends are a neutral transaction. Don't be fooled by the shiny object. There are things that matter in investing, but, in and of itself, a dividend likely isn't one of them.

When Dallas Is In Trouble, No One Is Safe

Big city promises big pensions to its public service sector, kicks the can down the road, thus creating a time bomb for future generations to deal with as they have to decide whether to stiff the retired cops and firefighters or the currently serving ones. Its a common tale, one that we normally associate with California or the Rust Belt, but Dallas? That's the grim scenario laid out in this New York Times article (not always the most trustworthy of sources, but I think this article is mostly on point, I vetted it with Zero Hedge).

Trading and investing off of the news is not a good idea. But, the news can remind us of larger truths. In this case, it's that you likely can't borrow forever. I hope to let you know for sure in about 10 years, once this latest experiment has run its course.

Many investors might have gotten over the election night  jitters that plagued the futures markets as Trump marched to an unlikely victory. The prospect of less regulation and taxation even has some one-time Trump opponents cautiously optimistic. However, that doesn't change the reality: our economy has some serious obstacles that would challenge any person not also capable of turning water into wine. Dallas is a healthy city in a healthy state, and it's still staring into the eyes of an intractable fiscal crisis. You can't invest by trying to time that latest meltdown, but your investment plan has to take into account the fact that meltdowns will happen. 

Have an emotionless method for investment (as opposed to a series of useless predictions) and be sure not to overestimate your risk appetite. Rough times are always ahead, the key is trying set yourself up to absorb them.

Book Review: "Chain of Title" by David Dayen

The good news is that this only potential effects people who own or want to own a house. The bad news is that that includes most people. David Dayen is a freelance writer whose first book is a very thorough and disturbing look at foreclosure fraud in America, particularly in Florida. It is the story of a cancer nurse, an employee at an auto-dealership and a lawyer (among others) who independently decided to fight their foreclosures and discovered massive fraud.

Most people are somewhat familiar with the idea of mortgage fraud, which is basically lying to get a loan or more favorable lending terms. Foreclosure fraud is the other side of the coin as holders of the loan foreclose when they don't actually have a standing to do so, generally by not having proper documentation and/or actual proper legal ownership. Mainly this is due to loans being repeatedly bought and sold so quickly that the paperwork is either behind or non-existent. In the rush to securitize these mortgages in the years leading up to 2007-2008, county offices such as the register of deeds or recorder were often bypassed by MERS, an online registry that was sloppily maintained. As a result, oftentimes, the company doing the foreclosing didn't even own the loan, and if money ever even properly changed hands, there was no proper proof that it happened.

Some might say, "So what? If the homeowner didn't pay their bills, who cares if all the i's were dotted?" This is a problem for a few reasons. First, there's a rule of law issue. With respect to justice, procedures are arguably as important as outcomes, this is what "due process" is all about. And if rule of law is important for right-wingers when they criticize the president over various issues,  then it is an equally valid basis for legitimate populist causes such as individual homeowners fighting Wall Street. From a pure capitalist standpoint, orderly property transfer is a important part of a free market economy.  Without it, things start breaking down as trust erodes.

The second problem is that in many cases, the homeowners were up to date with payments and the banks made errors. Dayen speaks of cases where the homeowner was behind by mere pennies due to an honest mistake and at least one case where they were ahead in their payments. Sometimes, a homeowner who was experiencing financial hardship requested a modification was informed by a rep from loan servicer that no one would pay any attention until they were actually behind in their payments.   Then, once they intentionally withheld money as a way to begin the negotiations, they were foreclosed on anyway (admittedly, there were also  cases where the banks didn't act for years). Simply writing all of these people off as deadbeats isn't appropriate or true. Were there owners how bought too much house and couldn't pay up? Yep, but there was also a fair amount of bank misbehavior.

Which brings us to the last issue: many of these loans shouldn't have been made in the first place. A lot of these homeowners simply bought too much house. Certainly, they were complicit in this error and need to answer for it and likely give up their house, but the banks also made such overreaches easier by failing to verify job or income status. If everyone had too much to drink at the party, the homeowners shouldn't be the only ones to deal with the cleaning up and fighting hangovers.

If there's any bright spot of this, it's the bipartisan aspect. It seems the Democrats handled this slightly better than the Republicans, but both parties didn't really do homeowners any favors, so finger pointing doesn't really get us anywhere. The Obama administration paid lip service to the problem, but action was largely slow or nonexistent. And there is certainly evidence that Florida AG Pam Bondi (of the GOP) tried to stand in the way of the investigation. Both parties left themselves wide open to the accusation that they are in the pocket of the banks as they ignored compelling evidence as long as they possibly could.

This book shined some much-needed light of an important issue and the many people who obsessed over justice not just for themselves, but for the general public. Thanks to the fast and loose approach many banks took with respect to the rules, it could take decades to unwind some of these title issues and reading this book as a great first step in getting the average consumer up to speed on the problems we face.

The Importance of Persistence in the Markets

A frequent theme on this site is that there is more than one way to skin a cat with regards to investing. Momentum, value and passive styles all have marks in their favor. Admittedly, though, value might be a little harder to implement than the other two, as it tends to take a stronger stomach and/or more data crunching.

I just got through with a pretty good book called Heads I Win, Tails You Lose by Spencer Jakab. It's more or less about simplicity and avoiding mistakes in investing. Even as someone who has read a fair deal on that subject, there were still a few nuggets that I either hadn't considered or just hadn't given much thought. But, like a classic such as Simple Wealth, Inevitable Wealth by Nick Murray, this much remains the same: whatever you do, you have to stick with it.

The three strategies outlined above (passive, momentum and value) may be different, but they all reward persistence. Despite the fact that each of these strategies can work and are valid, switching between them will serve you no better than a squirrel changing directions two thirds of the way across a street. The method is much less important than finding something that you are familiar with and believe in enough to stay with it through thick and thin.  

Of course, this is true for the money you have in the market when it starts to go bad. When things break against you, keep at it. If you are passive, stay passive. If your momentum strategy sends you signals, follow them to a T.  But,  the other half of the equation is that things work best when you also set money aside every month. Persistence isn't just about following your plan with the money you have already committed, it's also about continuing to set money aside on a regular basis in accordance with your initial investing method. This is why real estate can often appear to be such a good investment. For all of it's risks and potential faults, the structure of a mortgage is pretty good at encouraging discipline, as it  makes panic selling a bit harder than is the case with stocks and is a de facto automatic investment plan.

Here's a calculator that illustrates that point. I looked at the period from January 2005 to Dec 2015. This is far from ideal timing, as starting in 2005 is getting in at a relative high point. Starting with $100,000 and adding $500 a month gets you an ending balance of about 327k, which is an internal rate of return of about 8% (disclaimer: those numbers are not audited and based on me using Excel so take them with a grain of salt).  This compares favorably with the S&P 500's annualized return of 7.06% over the same period (per this calculator).

Also, it's important to remember that this rate of return will change as the ratio of initial investment (in this case $100k) changes in relationship to the recurring investment ($6000 a year, in this case). For instance, if you started out with zero dollars, your return will be better because you had fewer dollars in the market in 2007-2009 when it went south. This is a classic illustration of the disclaimer: individual results will vary according to how much you start with, the rate you add money and the time period viewed. This is another great reason why it is wise to focus on your return and goals as opposed to looking at your neighbor's performance.

Lastly, remember, for non-passive strategies, underperformance is almost a guarantee at some point. As a matter of fact, if you are consistently outperforming the market over all time periods, it might be a time to worry. Long Term Capital Management was beating everyone...until it crashed and almost brought down the world economy (side note: this outfit was led by geniuses, market superstars, PhDs  and Nobel Prize much for that). You have two basic choices. First, you passively can ride the ups and downs of the market, however high or low it goes. Second, you can undertake an alternate strategy knowing that, no matter who good it is, there are going to be times when you will feel like a fool when everyone else is making easy money. If you switch your plan then, that is a recipe for disaster.

Whatever you do, plan on doing it for at least a complete market cycle (about ten years). You can always change things up, but only after careful thought and reflection. And the reason better not merely be because the returns aren't good enough. If that were sufficient, everyone would be changing strategies every 5 years, and that leads nowhere.

Almost Nothing Good Happens After 1:00 AM

This is something that college football coaches know all too well. They get a phone call at 1:30 in the morning to find out that their starting center was involved in a pier sixer in the parking lot of a White Castle after getting pulled over while drunk driving on a stolen Segway.

As this article points out, the same could be said for after-hours trading. The early reaction in the futures markets to the Trump lead was not favorable. People who sold on such news missed a pretty quick rebound. It was such an obvious overreaction (and similar to the Brexit issues of a few months back), that it is hard to believe that anyone actually fell for it and sold.

This isn't to diminish the real political differences between the candidates. If Trump is your guy, you are happy. If you voted for Hillary, you aren't. These elections will have consequences in policy, whether they are good or bad depends somewhat upon the intersection of future events with your personal worldview. But, from an economic/geopolitical worldview, such a quick downturn was largely unwarranted. Now, Trump's economic policies may be dangerous and may start a trade war, but let's not look at them in a vacuum. 

First, the fact that Trump's economic plans have met resistance from economists isn't exactly a bad thing. Economists often stink at predictions as badly as, well, the pollsters who predicted a Trump loss. Could his policy be bad? Sure, but there's not even a guarantee he would enact them. It wouldn't be the first time he backed off a position. His campaign was a dance of staying somewhat true to his nature while being somewhat malleable. Like it or not, it worked and it is likely to lead to more of the same.

Second, the fact that Clinton was allegedly a "known commodity" was counting for a little too much as these markets took a dive. Does Trump have to own his potential negatives? Yes. But Clinton also has to own her security breaches, lapses in judgement on foreign affairs and cozy relations with people who might not have America's best interests at heart. That the markets found her to be the default "safe" option seems a little odd. They both have baggage.

Lastly, let's be honest, the current situation is the perfect recipe for a one-term president. We have a serious math problem with entitlements, demographics and health-care on the economic front, not to mention an ever-changing world outside our borders with a war with terror being waged, whether we want it or not. The business of governing will be hard for the foreseeable future and it won't be smooth sailing for any person, even if he/she were Reagan, Truman and Mother Teresa all rolled into one.

The GOP was saved in the 2014 midterms, doomed  from last summer until yesterday and now it is again resurrected. It now has an incredible amount of power...and an incredible chance to shoot itself in the back of the head. Whether you like that or not, it is a testament to how quickly things can change and how things are rarely as bad, or as good, as they appear. The only certainty is uncertainty. We must live with that...and, also, stay close to home (and away from eTrade) after 1:00 AM. Seriously, nothing good happens then, especially if you are married and over 40.

Book Review: "The Index Card" by Helaine Olen and Harold Pollack

Helaine Olen is a writer for Slate who went to Smith College. Harold Pollack is a professor of Social Service Administration at the University of Chicago. To say I don't exactly have a lot in common with them is an understatement. I likely have reason to disagree with them about most things, both important and trivial.

That being said, they wrote a pretty good book. Olen's first effort, Pound Foolish, was a look at the dark side of financial services. It was  more entertaining than The Index Card, but not as useful. She told tales of many of the problems and conflicts of interest with the financial services industry, most of which was pretty fair criticism and enjoyable to read. But at the end of the day, I felt a little like she was espousing helplessness and paternalism, as she seemed to think that financial literacy was a battle many of us couldn't win.

The Index Card solves a good deal of that problem. More about action than mere awareness,  the book represents the fleshing out of a idea by Pollack: that most good financial advice could fit on an index card, such as saving 10-20% of your money for retirement, getting term life insurance, using your 401k and relying on low-cost index funds.

It should be pointed out this for most people, this likely isn't optimal advice. Individual circumstances vary widely, and while the typical family still exists as an idea, it's becoming harder and hard to find in reality. Maybe an investor started saving late, and they need to save more than 20%, maybe they have more complex retirement options than a 401k, maybe they actually need/want permanent insurance...the possibilities abound.

However, the bottom line is that, for the mentally paralyzed, intimidated or beginning investor/saver, they could do a lot worse than follow the advice spelled out in this book, especially once you factor in the simple writing style, modest size and low price. A competent adviser is generally going to give you better advice than what you find in a book. However, finding a competent adviser is a question of discernment, one that requires the client to have a point of view. And, it's even harder to find a good adviser if you haven't started saving yet. This book will get most people a lot closer to both having a point of view and gathering that nest egg.

Real Returns and Housing

Investing researcher extraordinaire Meb Faber talks about "The 5:2:1 Rule". Those are, respectively, the after-inflation returns of stocks, bonds and bills over the past 100 years. He adds in gold and housing to the "1%" category.

It might surprise some to learn that housing increases have been so modest, but this is consistent with what I've heard from Robert Shiller, who has done a lot of study on historical housing prices (I'm also guessing Shiller's numbers were used to determine the housing returns for the rule, so it is not too surprising that they are in agreement). So, returns are pretty modest, but generally, we think of our homes as great investments. What gives?

Well, for starters, a 1% real return isn't fantastic, but it is positive, so that's something. Also, when you consider that you are getting a modest real positive return  for something you are getting use out of (a place to live), that sweetens the deal.  If you break even after 10 years of home ownership (settling aside taxes), the home largely served its purpose. No such comfort exists with a stock that treads water (including dividends) for a decade. 

Real estate might not be as big a winner as you would expect, but as an investment it has a few advantages. Buying and selling a home is least, more so than buying and selling a stock. Also, it often involves a kind of automatic monthly investment in the form of a mortgage. This lack of flexibility helps keep the homeowner honest, so Americans who hold their homes for a decent period of time probably have a pretty good experience financially. That 5% stock return is attractive, but it only works for investors that are in the market and therefore, along for the ride. Because some kind of housing is a necessity,  I would argue that American active participation in home ownership is broader than active participation in other types of savings/investments. So, a 1% return on something you are constantly contributing to in the form of a home is better than a 5% return on stocks that you don't even own anymore.

So, the behavioral structure of real estate has probably led to better anecdotal experiences for U.S. investors than stocks have seen, 2007-2009 notwithstanding. Also, these numbers refer to the top-line returns of real estate as an asset class, but keep in mind that real estate as a business is a lot different. Factoring in the returns on real estate as a landlord is a different animal altogether and beyond the scope of the data. 

Finally, it might surprise people to see that stocks have done so well relative to everything else. The history is clear: people who stay the course with stocks have been far. Whether investors can actually do it and whether they will be rewarded in the future has yet to be seen.


The Price of Outperformance

Everyone wants greatness. The problem is that, most often, what drives greatness is the feeling/fear that you aren't very great. There are plenty of self-satisfied people living in their parents' basement, while lots of people with inferiority complexes are building business empires, winning MVP awards or living hovels in Africa as they work with orphans (different kinds of greatness).

So, great results and feeling great aren't one and the same. As usual, investing parallels life here. This article points out that Warren Buffet (again, in my opinion, not the god some make him out to be, but he is the archetypal successful investor) spends about half of his time underperforming the indexes. The interesting part is that, in the 30 year period observed, he was "beaten" about half the days but his overall return is 10x that of the S&P 500. 

You can't run with the herd AND beat the herd at the same time.

Too Much of a Good Thing?

My high school economics teacher led his first class with the old joke about the guy who goes to the library looking for an economics book with a happy ending. It's not called the dismal science for nothing. Case in point: take something like index investing. We could argue over whether it is the best way to invest, but it's generally thought of as something that is good, or at least, benign. It isn't a magic bullet, but it tends to be low cost and, if the investor can stay the course through the dizzying highs and lows, it can work out pretty well.

But, as proof that nothing is even too easy in finance, this article has a good high-level doomsday analysis of what can go wrong if indexing becomes too widely adopted. While the true nightmare would likely only happen if about 90% of the market indexed, we could start seeing problems at lower levels than that. This passive investing is meant to ride off the market decisions of others.  But, once the passive investing actually becomes the market, we could see liquidity dry up. All indexers could mean no buyers and sellers. 

However, it doesn't take such a massive buy-in before problems arise. If active management gets de-emphasized in favor of a semi-permanent buy and hold passive style, corporate management could become complacent. The incentive to try and innovate dries up.

So, in short, even though active management has a spotty record, it provides liquidity and keeps the companies on their toes. Too much indexing could might compromise those aspects of the markets and cause a host of unforeseen consequences.

When in Doubt, Doubt

Writing about finance is an invitation to confuse people. Not that "financial people" are smarter than other types, but it's just easy to lose people in the jargon, like many other fields. But throw in people's potentially negative emotions about math and money, and you have a recipe for glazed over eyes.

That's why it's nice to invoke guys like Malcolm Gladwell and Michael Lewis, no matter what they write about, they make sure the reader can actually understand it. Gladwell tangentially talks money and on occasion, talks about it directly (one of my favorite articles of all time is right here). Lewis tends to talk directly about money more, while occasionally and famously drifting into sports. On a recent podcast, Gladwell basically says Lewis is his writing idol. So, all of this is to say when Lewis has a story to tell, it's worth reading. It won't take long, it will be readable and you will likely learn a nugget or two.

A relatively recent book by Lewis, Boomerang, is about the effects of the 2007-2009 Global Financial Crisis on  countries such a Greece, Iceland, Germany and Ireland. We all know how it was in the U.S., but for smaller countries with more fragile economies, the effects were likely more palpable and longer-lasting. It's not quite the seller that The Big Short is, but that is largely because it's a similarly story, told more broadly and from different angles.

The book begins with the story of Iceland, a homogeneous land of only 300,000 people with no real history of complex finance. But, even they fell for the siren song of financial engineering, perpetual growth and easy money, to the ruin of basically everyone involved. Not every story is like that, though. Take Greece, for instance. In their case, the banks were pretty sane. It's just that the country ran into a fundamental problem, no one wanted to work that hard or pay taxes. Now, they aren't the only people to every have those impulses, but they are one of the few to pull of indulging both at the same time on a national level. It's like everyone saw Office Space too many times. And, they didn't exactly pull it off successfully, because the economy, like the Parthenon, is in ruins.

Some of these results were somewhat predictable. Sure, a few people warned of the consequences of audacious handouts and financial over-engineering, but enough people bought into the hype to drive the bubble forward. So, what is obvious in hindsight isn't obvious in real time. And if it is obvious, it's often not enough to discourage participation.

So, that begs the question: what are we missing now? Sure, not every bull market (such as the one we have ridden for the last 7 years) is necessarily a bubble. However, our economy had a good deal of structural problems (debt-personal and government, lack of saving, college costs, reduced manufacturing base, etc.) that haven't exactly been solved. Awareness of these problems seems high compared with the mania associated with the internet and real estate bubbles of the last 15 years. Maybe that is what has kept things from getting too insane. Everyone is still gun-shy, and a little but too ready for the other shoe to drop. Busts rarely happen when so many people are expecting it. as seems to be the case now. So, the bull market has just enough energy to chug forward, but, ironically, also too much pessimism to produce the circumstances for an actual correction.

This isn't an invitation to try to time the end of the market. That likely won't end well. If you have a plan, it should be one that takes ebbs and flows into account beforehand, so you aren't left to make awful predictions and guesses when the world is going to hell. But, it is an invitation to adopt such an investment plan, and likely to spread your money around. Diversify, but merely diversifying within the stock market is likely to get you only so far. Stocks tend to go up and down together.  

One of the best definitions of risk I have seen is from Carl Richards. He said risk is what is left over after you have thought of everything else. What are we missing right now that will only be obvious in hindsight and does your investment plan attempt to address it? Even if you have an answer to that question, it's best to emotionally gird yourself for the possibility that, even after you have accounted for everything, you can't ever truly account for everything. Investing tends to punish hubris and Lewis's books are proof that we keep falling for the unexpected.

What LIKELY Works in Investing

In the investment world lately, there had been a fair amount of positive press about Odds On: The Making of an Evidenced-Based Investor by Matt Hall. There were a lot of 5-star reviews on Amazon, and they were so quick and positive that I couldn't help but wonder if this was an orchestrated campaign or sincere praise.

The book basically focuses on Hall's journey from being a broker trainee at a firm only focused on their own profits (and relying only on their half-assed guesses) to finding success as an adviser by focusing on the client’s needs and what really works in investing. Admittedly, I found the book a bit flimsy… at first. But, it’s really a memoir more than a how-to book, so I gave it some grace. The long and short of it is this: investors are best served by focusing on buying and holding a broad array of asset classes (x% in U.S. stocks, y% in bonds, y% in foreign stocks, etc.) as opposed to trying to get lucky by predicting the market’s next move. This approach basically gives up any hope of beating the market, but it tends to work a lot better than the gut-level approach-a fool’s errand that almost ends in poor returns. This approach, also known as “indexing” or “asset allocation”, is based on the theory of Efficient Market Hypothesis, which basically says that market prices reflect all available information, so trying to beat the market is unlikely to succeed.

Hall eventually finds his place at Buckingham Asset Management, an evidence-based (data driven) firm whose chief researcher and dragon-slayer is well-known author Larry Swedroe. Swedroe has had a lot of success in investing and favors the “shock and awe” approach as a way of divesting people of their pre-conceived notions. So, Swedroe clearly on a crusade, as by this time in his life, he had already made a lot of money and didn’t need any more. After 5 or 6 years, Hall leaves BAM with fellow employee Rick Hill to start the Hill Investment Group in 2005. Happily, they leave on very friendly terms and the two entities (Hill and BAM) continue to have a business relationship to this day. As he attempts to build his business, a lot of Hall’s efforts involve trying overwhelm prospects with information, albeit in a slightly more diplomatic manner than his former mentor, Swedroe. This involves a lot of data and attempts to painstakingly answer all client questions and concerns.

Hall encounters resistance, but the business slowly grows, thanks in large part to Rick Hill (who is a lot older and more established) bringing a substantial book of business to the table. Things change, however, when Hall gets sick (the fact that the story contains and “Hall” and a “Hill” doesn’t make this easy). He loses his energy, feels awful and after a lot of searching, finds out he has leukemia. He gets an appointment with an expert, and in the weeks leading up to the meeting, drives himself mad with possibilities and what-ifs. At the meeting, though, his doctor basically says, “I hear your concerns, but the best course of action is to take this drug called Gleevec, put your concerns on the shelf and live your life”. Gleevec isn’t 100% effective (or at least it wasn’t at this point), but it gave Hall the best odds of survival and worrying about the chance of failure wasn’t going to help and might even hurt his chances of beating the disease.

Long story short, Hill shuts up, trusts the expert (and just as important, trusts the data), takes the drug and the disease goes into remission. As this happens, he begins to think about how this approach applies to his work. What if he spent less effort trying to answer all client questions and alleviate all concerns and instead just said, “Look, I hear you, but, based on the data this approach gives you the best chance for success and quality of life”? In short, it’s no guarantee of success, but such a guarantee doesn’t exist anyway and this beats the alternative of buy and hope.

So, at the end of the day, it’s a good, compact read. But, it got me thinking about what truly works in investing. Clearly, Hill’s approach has a lot of merit, but his method is one of a few statistically robust approaches. When it comes to investing, the data supports this: asset allocation, momentum and value. And while the book does concentrate on the asset allocation/indexing end of things, it does give a nod at the end to the fact that data supports momentum and value, as well. Let’s look at each.

Asset Allocation-As seen previously, this involves dividing up your assets over a variety of broad indexes (S & P 500, Russell 2000, government bonds, etc.). The exact percentage would vary based on age and risk tolerance. Your account value will go up and down (and sometimes be cut by 50%, as in 2007-2009). The good news is that the market has always bounced back and dollar cost averaging (investing a fixed amount each month) tends to result in opportunistic buying-when the market goes down, you mindlessly buy more shares because prices are cheaper, which helps when the market recovers.

So, what’s the catch? Well, lots of people are buy and hold investors…until they aren’t. The market takes a dive and they start asking existential questions about what really works, sell at or near the bottom and jump back in long after the recovery has begun. We’ve seen two 50%+ declines in the market in the last 16 years-it’s likely to happen again. Hanging on was bad enough during the last two recoveries, which were pretty quick. How would you fare during the Great Depression, when it took about 15 years to get back to even? In light of current government spending and total US debt, it would be foolish to dismiss the possibility of such a once-a-century decline. It would also be foolish to bet heavily against the US economy. The end of the world has been coming for about 30 years and, yet, here we are.

So, there’s the rub. This approach takes faith and consistency. If you can’t handle the dizzying highs and lows, the choices are to 1) find a conservative asset allocation that has a relatively smooth ride or 2) find another approach. As a final word consider this: the exact mix of assetsdoesn’t matter all that much when it comes to return (although some approach get you to the same place with a lot less stress than others).

Momentum- There are a few ways to apply momentum (also called “trend following”, although seem people think there is a slight distinction between the two-we will ignore that for now), but it comes down to this: sticking with the hot hand. Also, successfully applying momentum requires discipline, just as asset allocation does. It’s not merely buying what looks hot and has been on the cover of Smart Money. It requires a specific set of criteria for buying and selling decisions. And the data shows it works. Momentum has been called one of the persistent anomalies by none other than Eugene Fama, a lion of the efficient markets hypothesis-a theory generally at odds with momentum. By “persistent anomaly”, Fama basically means it is something that has worked in the past as a viable strategy and seems likely to continue, based on the best data available, assuming it is applied correctly and diligently. One of the main benefits of it is that it basically boils down to one thing: price. No pouring over balance sheets and cash flow statements or relying on the advice of analyst’s buy/sell recommendations when they may or may not being peddling garbage. So, in short, the data is so solid on momentum that even people who don’t like it have to recognize that fact.

When done correctly, momentum can reduce drawdowns (declines) by half and can provide a few extra percentage points of return per year. However, while I believe market outperformance is possible, any adviser selling based solely on it is dancing in dangerous territory, especially if advisory fees are involved (the fees can really eat into the outperformance quickly). Additionally, any system is going to see periods of underperformance relative to the market. This especially true in bull markets. Because of the buying and selling rules, momentum strategies aren’t going to capture all of an upswing or a downturn. So, during market comebacks like the one we have seen over the last 6-7 years, it’s likely that a momentum strategy would perform worse than a dartboard and a clown. It’s generally during the downturns that these methods justify their existence, as they tend to stay in cash while everything else goes down in value. During the bull markets, everyone thinks they are a genius and that they don’t need a methodology (or an adviser).

Also, it’s not just about the ups and downs. Markets have choppy periods when they don’t trend either way. During these periods, it is common to get “whipsawed”, which means a series of trades in and out of positions. These can result in poor performance, gray hairs, gnashing of teeth, and, tragically, abandonment of the strategy. The true uptrends and downtrends are easy compared to the false alarms that such a system can generate.

But, I think the best mindset for momentum is just to look at it as a way of smoothing out returns. If it gives you a strategy that has a reasonable chance of avoiding deep declines and that you can stick with, it has done its job. Outperforming the market is gravy, just don't pay too much for the hope of outperformance.

Value-Made famous by such investors and Benjamin Graham and Warren Buffett, value investing is simply investing in companies that have been beaten down by the market. Like momentum, the value anomaly is so pervasive that it is generally recognized by the proponents of the efficient markets hypothesis, even though they wish it weren’t true.  The “value premium” exists, in that much academic literature has validated the idea that value stocks outperform “growth” (think “non-value”) stocks. As to a formal definition of what the value premium is, this works.

So, value investing is viable. It has downsides though. One of the problems with this is that, unlike momentum, price alone isn’t a sufficient indicator. A stock trading at 10 that used to be worth 20 isn’t a bargain if it is really worth 5 (and headed that direction). You need to a set of criteria that can get rather involved, as opposed to merely compared today’s price to a previous higher price. The book Quantitative Value  is a good place to start, but a word of warning: even I got bored reading it. And while the authors can run circles around me in terms of statistics and data, the set of investing criteria was so large and expansive that I couldn’t help but fear that they were “curve-fitting” the data. This is basically applying a complicated set of rules that reflect the past but won’t hold up in the future. Could I be wrong? Of course, but any time the investment rules are complex, this is a risk.

Another issue with value investing is that, while returns can beat the market, the ride to get them could be just as bumpy as that of the market as a whole. So, the road to be the next Warren Buffett is littered with dead bodies for a reason.

In closing, there are some caveats here:

  1. This doesn’t cover every type of investing. Closely-held real estate, small businesses and other non-liquid investments don’t follow the same rules. Stock and bonds follow these rules because there are transparent (mostly), liquid markets for them. Private, thinly traded stocks and bonds and similar investments are a different game, as is a business that you are directly involved with and can control.
  2. I wouldn’t say the three methods outlined above are the only ways to invest. I am the first one to admit that I don’t know what I don’t know. Companies are making a killing doing high-frequency trading (a whole other game with a high cost of entry) and there is a ton of work being doing in the fields of artificial intelligence and neural networks. But that is cutting edge and also would likely have a high cost of entry. Furthermore, lots of methods tend to work for a while, but their advantages get exploited by the market and disappear. That is one of the fundamental problems with value investing. While it still can work, the market environment is fundamentally different than when Warren Buffett got started. It is more dependent on information than momentum or asset allocation and therefore, the recent democratization of data has made it a trickier playing field. That being said, value still has a place, so the three methods outlined here are just the ones with what I believe is the best data.
  3. Some people have had really good results with old school stock picking and predictions. I can’t argue with anyone’s experiences, but anyone making such claims must realize that their results aren’t the norm and replicating such results is difficult, if not virtually impossible. Say what you will about asset allocation, momentum and disciplined value, they can be replicated to one degree or another (again, value is the diciest).
  4. Knowing yourself is the ultimate form of aggression. Don’t pick a method that you will abandon when it hits the fan. And even when you do pick a plan that you think you can stick with, you won’t really know how much conviction you have until it is tested. As the great felon/philosopher Mike Tyson said, “Everyone has a plan until they get punched in the mouth”. If you feel the need to gamble with gut-level predictions and can’t help yourself, set aside a small percentage of your money for that and have a more diligent plan for the rest of your money. Just recognize it for what it is: speculation.

So there you have it. It isn't just about what does work, it's also about eliminating what doesn't work: guessing, predictions and emotion.


Podcast Potpurri

My favorite investment researcher (yes, I have a favorite, doesn't everyone?), Meb Faber, just launched a new podcast. I've listened to a few and, as usual, it's very good stuff. He gets the fact that successful investing can be as easy or as hard as you want to make it, and oftentimes, we don't need anything more than "easy".

His latest episode was particularly good, as it drove home many points he has previously made on his blog. The one that really stuck with my was over the question of asset allocation. You can have 50 different investment powerhouses with 50 different recommendations for what percent of your money to put in domestic stocks, foreign stocks, bonds, antiques, comic books, Forever Stamps, etc. 

Further down on that link with the 50 recommendations, you will find the backtested results of these recommendations from 1973 to 2015. The highest performer got 9.72% annually and the lowest got 9.19%. And adding a 1% management fee to the best performing method turned the highest into the lowest. So, the difference between success and failure is pretty thin. Also, it's worth noting that getting both of these sets of returns was simple, but not necessarily easy. These backtests call for rigorously adhering to a simple set of rules (that turned out to be kind of arbitrary). What is doesn't show is what the average investor did, which is likely switch tactics every two years and get substandard returns.

In short, following your rules is likely much more important than your choice of rules.

Also, in the world of podcasting, Connolly Asset Management is a sponsor for the Catholic Phoenix podcast. Makes sense, since I am the host. The first episode sponsored by CAM is an interview with Jeff Guinn, author of The Last Gunfight, a great book at Tombstone in the 1880s.