The Third Pig

Source: Flickr by timcullen

At the extremes, the bottoms of bear markets and the tops of bull markets, you will undoubtedly hear that buy and hold is dead. We find ourselves in the former market (we hope) thus that old refrain has returned. Over the last 10 year, the S&P 500 has seen a -2.5% annual yield (ending 4/30). Those who become disenchanted with the buy and hold strategy are folks generally uncomfortable with what feels like doing nothing. Alternatively they set to a course of frenetic trading at what seem to be opportune times. Unfortunately this approach leads to very little except frustrated investors.

The Journal of Finance published a white paper by two Cal Berkeley professors, Brad Barber and Terrence Odean which chronicled the folly of the active trading approach. Right from the abstract of the paper they write:

Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors.

So how does an investor beat the market?

Relax: The first thing to do is to simply take a chill pill. Most of what you need to beat the market comes down to your temperment. If you can keep a cool head while all the world is losing theirs you will have a tremendous advantage. Fear and panic cause investors to make bad decisions more often than not. So stay cool.

Stop trading: Transactions costs, the least of which is commission, eat away at returns. As damaging is the bid-ask spread as well as the capital gains taxes paid on any small gains made. According to Barber and Odean:

The investment experience of individual investors is remarkably similar to the investment experience of mutual funds. As do individual investors, the average mutual fund underperforms a simple market index. Mutual funds trade often and their trading hurts performance. But trading by individual investors is even more deleterious to performance because individuals execute small trades and face higher proportional commission costs than mutual funds.

Control your emotions and your ego: Consistently beating the market is difficult. For this very reason it pays to take your emotions and your ego out of it. Do you really think you will create some investment approach that is somehow smarter and more fantastical than the methods used by Warren Buffett or John Templeton? It's foolhardy to chase the latest fad in investing (or to think you'll create it) when the tried and true works like a charm.

Hold just a few positions: The investor would do well to select only the stocks of companies he understands well. By doing so he will reduce his portfolio's risk by steering clear of permanently weak companies and avoiding overpriced firms, not by excessive diversification. Increasing portfolio positions past 20 to 30 positions does very little to reduce volatility any further. Interestingly though, increasing positions past this point will continue to reduce returns. According to mutual fund manager Robert Hagstrom, concentrated portfolios of 15 securities are 13 times more likely to outperform the market than portfolios of 250 securities. In other words, excessive diversification fails to effectively reduce volatility risk yet greatly handicaps the investor’s ability of beating the market.

Buy at the right price: Even the greatest company will not make a good investment if it is overpriced. Determining the correct price for an investment is difficult as it requires many assumptions. But it is essential to a sound investment process. If bought at a price below the company's real value, all an investor really needs to do is wait until the price of the stock reflects the true value of the company. Eventually, it will.

If an investor follows these few steps, he can relax on the beach and let others worry about the ups and downs of their portfolios.

Disclosure: none

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Posted by Benjamin Taylor at 06:50 PM |
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Source: Flickr by Small Business Hawaii

Tisa Silver over at Bizzia noticed a post I did a while back regarding Robert Kiyosaki and his questionable math skills. She republished the article there and gave her own take on it as well. That article underscores why investors should always question, always investigate and always think for themselves.

Check out some of Tisa's other stuff as well here, here and here.

Below is an exerpt from the original post I wrote: 

Dear Robert Kiyosaki,

I've read a few of your books. I must say that when I first read Rich Dad, Poor Dad I loved the general premise of “become financially literate”. That made sense to me. But I must tell you, my feeling on all the subsequent books that have come out of the Rich Dad camp has been that the books (as well as your advice) have become more and more absurd. For instance, what's up with the figures in your book, Who Took My Money?. ...

... Throughout Who Took My Money?, you suggest that simply by heeding your advice, an investor can achieve returns of 180% per year. Forgetting, that we don't know how you came up with that figure, let's look at what an annualized return of 180% would mean.

Let's say a 25 year old has $20,000 to invest and is able to receive an annualized 180% return over his investment lifetime – about 50 years. At that rate of return, and at the end of that period that 75 year old would have a comfortable nestegg of…drum roll please…

$455,965,058,160,294,000,000,000,000!

This is not a misprint. That investor, by investing in single family homes, would be a SEPTILLIONAIRE 455 times over. Now, Rob, are you really telling me that I can be 455 quadrillion times richer than someone who is a mere billionaire? Seriously? If you are, I just have to say that that seems a little far fetched to me. Especially when you consider that, according to the Federal Reserve's 2001 Survey of Consumer Finances, there was only $44 trillion dollars of wealth in the U.S. that year. If we applied an extraordinary rate of growth of 5% to that $44 trillion, in 50 years total U.S. wealth would reach,

$502,905,811,102,164.

Now Rob, are you telling me that by following the investment program you lay out in your book, that in 50 years, with one $20,000 investment, I can be 907 billion times richer that the entire U.S. population? I have to say Rob, I'm not buying this. But I'm sure this letter is falling on deaf ears. However, if the New York Times Bestseller list is any indication, a lot of people are buying it.

Sincerely,
Benjamin B. Taylor

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Posted by Benjamin Taylor at 11:25 AM |
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Click here for video.

The AP reported today that Bernie Madoff will plead guilty to 11 criminal counts including money laundering, perjury and securities, mail and wire fraud and will do so without a plea deal, knowing it carries a potential prison term of 150 years. I find it kind of odd that Madoff would choose not to try and get a plea deal. But just another thing in an odd set of circumstances.

Adding to the weirdness is Madoff's lawyer, Ira Sorkin, and his family were investors with Madoff and lost nearly $1,000,000. Is Sorkin the best to represent Madoff? I know most out there don't really care about this potential conflict in interest. But I will always be a believer that everyone (even accussed money launderers) should be properly represented in court.

I have no idea if this is justice. Madoff seems to have stolen people's trust as much as he's stolen their money (now a reported $20 billion instead of the $50 billion first thought). More and more investors are going the do-it-yourself route because their trust has eroded. The tragedy is most investors going this route will fail. The most comprehensive study on the subject of individual investor performance was conducted by Professors Brad Barber and Terrence Odean. They found:

"Of 66,465 households with accounts at a large discount broker during 1991 to 1996... After accounting for the fact that the average household tilts its common stock investments toward small value stocks with high market risk… …the underperformance of average individual investor household is 3.7 percent annually.

The average household turns over approximately 75 percent of its common stock portfolio annually. The poor performance of the average household can be traced to the costs associated with this high level of trading.... Our most dramatic empirical evidence is provided by the 20 percent of households that trade the most often [with a turnover of 115%]… …the underperformance of hyper trading households averages 7.6 percent annually."

While prosecutor's have recovered about $1 billion for investors so far, how can they recover the trust that was lost? Not an easy question to answer. For our part, we will, over the next couple of days, get back to going through the10 red flags for spotting financial crooks. In the meantime check out parts one and two.

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Posted by Benjamin Taylor at 03:22 PM |
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Source: Reuters

Today Warren Buffet appeared on CNBC for 3 hours answering a multitude of questions from Becky Quick, Joe Kernen and a slew of emailers. One emailer from Cincinatti asked "How do we know that you are not another Bernie Madoff?" In response Buffett said:

"Well, that's a good question. I would say this. I--it is a problem with investment advisers. I mean, it--there are going to be a certain number of crooks in the world. And sometimes they're smooth-talking, and the best ones are the ones that kind of don't look like crooks... it is a problem who you put your trust in."

He then later agreed with Joe Kernen that an investor cannot rely totally on government regulation to catch these crooks. So what is an investor trying to protect herself to do?

I wrote a post (Part 1) back in September of last year with the intention of answering this question. This was before the Bernie Madoff or the R. Allen Stanford stories broke. In the post I promised 10 red flags which might alert an investor that his advisor is not on the up and up. I'm finally getting around to listing them. Today I'll do just a couple and get to the rest at a later date.

As a side note, The Wall Street Journal reports that the client list of Bernie Madoff became available to the public. The list contains well known and not so well known folks running the wealth spectrum. The one thing they all have in common is they are all considered sophisticated investors. The list should once and for all prove that "sophisticated" means little in the investment world and underscores my personal pet peeve with the restrictive accredited investor law. I digress.

1. Returns that (nearly) always go up:

If your advisor is reporting returns that always seem to go up, then you should regard his numbers with great skepticism. The markets are controlled by unpredictable human emotion and its movements simply can't be predicted. Madoff's firm produced returns of positive 1% to 2% in gains per month with only five negative months covering a period of 12 years. These types of returns are so improbable that an investor can almost stop here and safely speculate that they've encountered a ponzi scheme or at least an investment manager that is not telling the truth about his returns. But we'll go on.

2. Complex strategies that cannot be duplicated:

When and an advisor has to start using greek letters in formulas to explain his investment strategy, it's time to be concerned. Madoff used an investment strategy consisting of purchasing blue-chip stocks and then taking options contracts on them - a split-strike conversion or a collar. The strategy itself is not complicated. In fact, it's pretty plain vanilla. What was extraordinary are returns Madoff reportedly received with the strategy.

A few individuals attempted to perform due diligence but were unable to replicate the Madoff's past returns. Harry Markopolos was among those that tried. In an interview with 60 Minutes he said:

"As we know, markets go up and down, and his only went up. He had very few down months. Only four percent of the months were down months. And that would be equivalent to a baseball player in the major leagues batting .960 for a year. Clearly impossible. You would suspect cheating immediately... No one's that good."

The above represents a stark contrast to the investment approach employed by Mr. Buffett - value investing. Unlike the method employed by Mr. Madoff, it is niether complex nor does it produce returns that are always favorable. In fact, sometimes years go by without positive results. That's why it is so important to have a long term view as Buffett reiterated today in his interview with CNBC.

BECKY: Yeah. And on a serious note, there are people who look at the stock market and wonder how do they know the whole thing's not a Ponzi scheme?

BUFFETT: Well, the whole thing's not a Ponzi scheme.

BECKY: What--how do they know who to trust?

BUFFETT: We're talking about, you know--we're talking about American businesses that employ, just the ones on the stock market, tens and tens and tens of millions of people. They're real companies... in the 20th century, the Dow went from 66 to 11,000, you know, 400. And we had all kinds of problems during that period. Business works overall. It doesn't work every day or every week or every month, and sometimes it really gets gummed up. And then you need government invention sometimes to get the machines back working smoothly. But the machine works.

JOE: Warren...

BUFFETT: And equities, over time, are the way to do it.

Disclosure: none.

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Posted by Benjamin Taylor at 05:55 PM |
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Flickr by Mr. Keef

Last week I did a video saying that I thought we were still in a new bull market. This was a follow up to a video I did in January listing some of the indicators I follow as reasons I thought we were in the early stages of a bull market. I pointed out that even with all the bad news about the economy, and jobs, and bailouts, the S&P 500 remained above 800. I saw this as a positive sign.

Since last week, the economic news has gotten worse. There have been renewed talks about nationalization of our banking system. [Psst. We’ve basically already nationalized the banks.] In response, the Dow reached a new 6-year low, penetrating the bottom it reached this past November. The S&P 500 broke through the 800 price barrier and threatens to challenge the low of 752 it reached last year. As of this moment (9:55 a.m.) the S&P 500 is trading at 769.

So was I wrong about this being a new bull market? Technically, no if the market holds where it is. Unless the S&P 500 falls below 752 (the November 20, 2008 price), this will still (technically) be considered a bull market. Recall I pointed out in the in first video that only once has the market declined 20% or more, rebounded 20% then, broke through the previous low. Could that happen now? Well we’re very close. It’s definitely possible.

Does any of this matter? Not really. The overall point I was trying to make in the videos and the past few posts on the topic is that stocks are cheap. They remain cheap. As I pointed out in the last video, we don’t know what the market or the economy will do in the next or any six month period. But it is highly probably the stock market will generate very good returns over the next five to ten years. And an investment in stocks now makes a lot of sense at these valuations. I’m still optimistic.

Next week I will be doing another video highlighting why I’m still optimistic about the market using some specific company examples. Stay tuned.

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Posted by Benjamin Taylor at 01:28 PM |
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