Posts filed under ‘Education’
Retirement Epidemic: Poison Now or Later?
We live in an instant gratification society. The house, the car, and annual vacation take precedence over contributions to retirement and savings accounts. It therefore comes as no surprise to me that Americans spend more time on planning for vacation than they do on planning for retirement.
Given the choice of spending or saving, Americans in large part choose, “spend now, save later.” Or in other words, Americans choose to drink $10 margaritas now (spend) and swallow the more expensive poison (save) later. Spending now and saving later sounds good in theory until you reach your mid-60s and realize you’re going to have to work as a Wal-Mart Stores (WMT) greeter into your 80s while eating cat food in your tent.
To make matters worse, you don’t have to be a genius to see irresponsible government spending and globalization has compromised the health of our countries entitlements (Social Security and Medicare). Benefits are likely to be reduced over time and age eligibility requirements are likely to increase. If you fold in the dynamic of exploding healthcare costs and broad-based inflationary pressures, one can quickly realize savings habits need to change. The traditional model of working for 40 years and then relying on a pension and Social Security payments to cover a blissful multi-decade retirement just doesn’t apply to current reality. On top of the disappearance of plump pensions, life expectancy is rising (around 80 years in the U.S.), so the realistic risk of outliving your savings has a larger probability of occurring.
Surely I am overly dramatizing the situation by sounding the investing alarm bells out of self-interest…right? Wrong. As a geeky, financial numbers guy, I can objectively rely on numbers, and the statistics aren’t pretty.
Here’s a sampling:
- Empty Savings Cupboard: A 2013 study by the Employee Benefit Research Institute found that nearly half of workers had less than $10,000 saved, and according to Blackrock Inc (BLK), CEO, Larry Fink, the average American has saved only $25,000 for retirement
- Food Stamp Living: Almost half of middle-class workers, will be forced into a poor retirement lifestyle, living on a food budget of about $5 a day.
- 401(k) Will Not Save the Day: Compared to other forms of savings, the average 401(k) balance reached $89,300 at the end of 2013 – that’s the good news. The bad news is that only about half of all companies offer their employees 401(k) benefits, and for the approximately 60 million people that participate, about a fourth withdraw these 401(k) funds before retirement – out of necessity or for frivolous reasons. Even if you cheerily accept the size of the average balance, sadly this dollar amount is still massively deficient in meeting retirement needs. It’s believed that your savings should approximate 15-20 times your annual retirement expenses that aren’t covered by outside sources of income, such as social security or a pension.
If these figures aren’t scary enough to get you saving more, then just use common sense and understand the future is very uncertain. A 2012 New York Times article sarcastically captured how easy it is to plan for retirement:
First, figure out when you and your spouse will be laid off or be too sick to work. Second, figure out when you will die. Third, understand that you need to save 7 percent of every dollar you earn. (30 percent of every dollar [if you are 55 now].) Fourth, earn at least 3 percent above inflation on your investments, every year. (Easy. Just find the best funds for the lowest price and have them optimally allocated.) Fifth, do not withdraw any funds when you lose your job, have a health problem, get divorced, buy a house or send a kid to college. Sixth, time your retirement account withdrawals so the last cent is spent the day you die.
What to Do?
The short answer is save! Simplistically, this can be achieved in one of two ways: cut expenses or raise income. I won’t go into the infinite ways of doing this, but adjusting your mindset to live within your means is probably the first necessary step for most.
As it relates to your investments, fees should be your other major area of focus. The godfather of passive investing, Jack Bogle, highlighted the dramatic impact of fees on retirement savings. As you can see from the chart below, the difference between making 7% vs. 5% over an investing career by reducing fees can equate to hundreds of thousands of dollars, and prevent your nest egg from collapsing 2/3rd in value.
Source: CNBC
Lastly, if you are going to use an investment advisor, make sure to ask the advisor whether they are a “fiduciary” who legally is required to place your interests first. Sidoxia Capital Management is certainly not the only fiduciary firm in the industry, but less than 10% of advisors operate under this gold standard.
Investing and saving is a lot like dieting…easy to understand the concept but difficult to execute. The numbers speak for themselves. Rather than dealing with a crisis in your 70s and 80s, it’s better to take your poison now by investing, and reap the rewards of your hard work during your golden years.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), and WMT, but at the time of publishing SCM had no direct discretionary position in BLK, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Stock Market: Shrewd Bet or Stupid Gamble?
Trillions of dollars have been lost and gained over the last five years. The extreme volatility strangled investment portfolios, and as a result millions of investors capitulated by throwing in the towel and locking in losses. Melted 401ks, shrunken IRAs, and beat-up retirement accounts bruised the overarching psyche of Americans to the point they questioned whether the stock market is a shrewd bet or stupid gamble?
The warmth and safety of bonds provided some temporary relief in subsequent years, but the explosive rebound in stock prices to new record highs in 2013 coupled with the worst year in a decade for bonds still have many on the sidelines asking whether they should get back in?
As I’ve written many times in the past (see Timing Treadmill), timing the market is a fruitless effort. Elementary statistics, including the “Law of Large Numbers” will demonstrate that blind squirrels can and will beat the market on occasion, but very few can consistently beat the stock market indices for sustained periods (see Dart-Throwing Chimps).
However, there have been some gun-slinging hedge fund managers who have accumulated some impressive track records. Because of insanely high management fees, many overpaid hedge fund managers will swing for the fences by using a combination of excessive leverage and/or concentration. If the hedge funds connect with lucky returns, the managers can take the money and run. If they swing and miss…no problem. Close shop, hang out a shingle across the street, change the hedge fund’s name, and try again. Of course there are those successful hedge fund managers who have learned how to manipulate the system and exploit information to their advantage, but many of those managers like Raj Rajaratnam and Steven Cohen are either behind bars or dealing with the Feds (see fantastic Frontline piece on Cohen).
But not everyone cheats. There actually are a minority of managers who consistently beat the market by taking a long-term approach like Warren Buffett. Long-term outperforming managers are like lifetime .300 hitters in Major League Baseball – the outperformers exist, but they are rare. In 2007, AssociatedContent.com did a study that showed there were only 12 active career .300 hitters in Major League Baseball.
Another legend in the investment industry is John Bogle, the founder of the Vanguard Group, a firm primarily focused on passive, index-based investment strategies. Although it is counter-intuitive to most, just matching the market (or index) will put you in the top-quartile over the long-run (see Darts, Monkeys & Pros). There’s a reason Vanguard manages more than $2,000,000,000,000+ (yes…trillion) of investors’ money. Even at this gargantuan size, Vanguard remains a fraction of the overall industry. Regardless, the gospel of low-cost, tax-efficient, long-term horizons is slowly leaking out to the masses (Disclosure: Sidoxia is a devoted user of Vanguard and other providers’ low-cost Exchange Traded Funds [ETFs]).
Rolling the Dice?
Unlike Las Vegas, where the odds are stacked against you, in the stock market the odds are stacked in your favor if you stay in the game long enough and don’t chase performance. Dr. Ed Yardeni has a great chart (below) summarizing stock market returns over the last 85 years, and what the data highlights is that the market is up (or flat) 69% of the time (59/86 years). The probabilities are so favorable that if I got comparable odds in Vegas, I’d probably live there!
Source: Dr. Ed’s Blog
Unfortunately, rather than using this time arbitrage in conjunction with the incredible power of compounding (see A Penny Saved is Billions Earned), many individuals look at the stock market like a casino – similarly to betting on black or red at a roulette wheel. Speculating about the direction of the market can be fun, and I’ve been known to guess on occasion, but it’s a complete waste of time. Creating a long-term plan of reaching or maintaining your retirement goals through a diversified portfolio is the way to go – not bobbing in out of the market with cash and bonds.
At Sidoxia, we don’t actively trade and time individual stocks either. For the majority of our client portfolios, we follow a growth philosophy similar to the late T. Rowe Price:
“The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.”
Nobody knows the direction of the stocks with certainty, and irrespective of whether the market goes down this year or not, history has proven the stock market has been a shrewd, long-term bet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Aaaaaaaah: Turbulence or Nosedive?
We’ve all been there on that rocky plane ride…clammy hands, heart beating rapidly, teeth clenched, body frozen, while firmly bracing the armrests with both appendages. The sky outside is dark and the interior fuselage rattles incessantly until….whhhhhssssshhh. Another quick jerking moment of turbulence has once again sucked the air out of your lungs and the blood from your heart. The rational part of your brain tries to assure you that this is normal choppy weather and will shortly transition to calm blue skies. The irrational and emotional, part of our brains (see Lizard Brain) tells us the treacherous plane ride is on the cusp of plummeting into a nosedive with passengers’ last gasps saved for blood curdling screams before the inevitable fireball crash.
Well, we’re now beginning to experience some small turbulence in the financial markets, and at the center of the storm is a collapsing Argentinean peso and a perceived slowing in China. In the case of Argentina, there has been a century-long history of financial defaults and mismanagement (see great Scott Grannis overview). Currently, the Argentinean government has been painted into a corner due to the depletion of its foreign currency reserves and financial mismanagement, as evidenced by an inflation rate hitting a whopping 25% rate.
On the other hand, China has created its own set of worries in investors’ minds. The flash Markit/HSBC Purchasing Managers’ Index (PMI) dropped to a level of 49.6 in January from 50.50 in December, which has investors concerned of a market crash. Adding fuel to the fear fire, Chinese government officials and banks have been trying to reverse excesses encountered in the country’s risky shadow banking system. While the size of Argentina’s economy may not be a drop in the bucket, the ultimate direction of the Chinese economy, which is almost 20x’s the size of Argentina’s, should be much more important to global investors.
At the end of the day, most of these mini-panics or crises (turbulence) are healthy for the overall financial system, as they create discipline and will eventually change irresponsible government behaviors. While Argentinean and Chinese issues dominate today’s headlines, these matters are not a whole lot different than what we have read about Greece, Ireland, Italy, Spain, Portugal, Cyprus, Turkey, and other negligent countries. As I’ve stated before, money goes where it’s treated best, and the stock, bond, and currency vigilantes ensure that this is the case by selling the assets associated with deadbeat countries. Price declines eventually catch the attention of politicians (remember the TARP vote failure of 2008?).
Is This the Beginning of the Crash?!
What goes up, must come down…right? That is the pervading sentiment I continually bump into when I speak to people on the street. Strategist Ed Yardeni did a great job of visually capturing the last six years of the stock market (below), which highlights the most recent bear market and subsequent major corrections. Noticeably absent in 2013 is any major decline. So, while many investors have been bracing for a major crash over the last five years, that scenario hasn’t happened yet. The S&P chart shows we appear to be due for a more painful blue (or red) period of decline in the not-too-distant future, but that is not necessarily the case. One would need only to thumb through the history books from 1990-1997 to see that investors lived through massive gains while avoiding any -10% correction – stocks skyrocketed +233% in 2,553 days. I’m not calling for that scenario, but I am just pointing out we don’t necessarily always live through -10% corrections annually.
Source: Dr. Ed’s Blog
Even though we’ve begun to experience some turbulence after flying high in 2013, one should not panic. You may be better off watching the end of the airline movie before putting your head in between your legs in preparation for a nosedive.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Controlling the Investment Lizard Brain
“Normal fear protects us; abnormal fear paralyses us.”
– Martin Luther King, Jr.
Investing is challenging enough without bringing emotions into the equation. Unfortunately, humans are emotional, and as a result investors often place too much reliance on their feelings, rather than using objective information to drive rational decision making.
What causes investors to make irrational decisions? The short answer: our “amygdala.” Author and marketer Seth Godin calls this almond-shaped tissue in the middle of our head, at the end of the brain stem, the “lizard brain” (video below). Evolution created the amygdala’s instinctual survival flight response for lizards to avoid hungry hawks and humans to flee ferocious lions.
Over time, the threat of lions eating people in our modern lives has dramatically declined, but the human’s “lizard brain” is still running in full gear, worrying about other fear-inducing warnings like Iran, Syria, Obamacare, government shutdowns, taxes, Cyprus, sequestration, etc. (see Series of Unfortunate Events)
When the brain in functioning properly, the prefrontal cortex (the front part of the brain in charge of reasoning) is actively communicating with the amygdala. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check.
With this genetically programmed tendency of constantly fearing the next lion or stock market crash, how does one control their lizard brain from making sub-optimal, rash investment decisions? Well, the first thing you should do is turn off the TV. And by turning off the TV, I mean stop listening to talking head commentators, economists, strategists, analysts, neighbors, co-workers, blogger hacks, newsletter writers, journalists, and other investing “wannabes”. Sure, you could throw my name into the list of people to ignore if you wanted to, but the difference is, at least I have actually invested real money for over 20 years (see How I Managed $20,000,000,000.00), whereas the vast majority of those I listed have not. But don’t take my word for it…listen or read the words of other experienced investors Warren Buffett, Peter Lynch, Ron Baron, John Bogle, Phil Fisher, and other investment titans (see also Sidoxia Hall of Fame). These investment legends have successful long-term investment track records and they lived through wars, recessions, financial crises, and other calamities…and still managed to generate incredible returns.
Another famed investor, William O’Neil, summed this idea nicely by adding the following:
“Since the market tends to go in the opposite direction of what the majority of people think, I would say 95% of all these people you hear on TV shows are giving you their personal opinion. And personal opinions are almost always worthless … facts and markets are far more reliable.”
The Harmful Consequence of Brain on Pain
Besides forcing damaging decisions, another consequence of our lizard brain is its ability to distort reality. Behavioral economists Daniel Kahneman (Nobel Prize winner) and Amos Tversky through their research demonstrated the pain of $50 loss is more than twice as painful as the pleasure from $50 gain (see Pleasure/Pain Principle). Common sense would dictate our brains would treat equivalent scenarios in a proportional manner, but as the chart below shows, that is not the case:
Source: Investopedia
Kahneman adds to the decision-making relationship of the amygdala and prefrontal cortex by describing the concepts of instinctual and deliberative choices in his most recent book, Thinking Fast and Slow (see Decision Making on Freeways).
Optimizing Risk
Taking excessive risks in technology stocks in the 1990s or in housing in the mid-2000s was very damaging to many investors, but as we have seen, our lizard brains can cause investors to become overly risk averse. Over the last five years, many people have personally experienced the ill effects of unwarranted conservatism. Investment great Sir John Templeton summed up this risk by stating, “The only way to avoid mistakes is not to invest – which is the biggest mistake of all.”
Every person has a different perception and appetite for risk. The optimal amount of risk taken by any one investor should be driven by their unique liquidity needs and time horizon…not a perceived risk appetite. Typically risk appetites go up as markets peak, and conservatism reaches a fearful apex near market bottoms – the opposite tendency of rational decision making. Besides liquidity and time horizon, a focus on valuation coupled with diversification across asset class (stocks/bonds), geography (domestic/international), size (small/large), style (value/growth) is critical in controlling risk. If you can’t determine your personal, optimal risk profile, then find an experienced and knowledgeable investment advisor to assist you.
With the advent of the internet and mobile communication, our brains and amygdala continually get bombarded with fearful stimuli, leading to disastrous decision-making and damaging portfolio outcomes. Turning off the TV and selectively choosing the proper investment advice is paramount in keeping your amygdala in check. Your lizard brain may protect you from getting eaten by a lion, but falling prey to this structural brain flaw may eat your investment portfolio alive.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Can Good News be Good News?
There has been a lot of hyper-taper sensitivity of late, ever since Fed Chairman Ben Bernanke broached the subject of reducing the monthly $85 billion bond buying stimulus program during the spring. With a better than expected ADP jobs report on Wednesday and a weekly jobless claims figure on Thursday, everyone (myself) included was nervously bracing for hot November jobs number on Friday. Why fret about potentially good economic numbers? Firstly, as a money manager my primary job is to fret, and secondarily, stronger than forecasted job additions in November would likely feed the fear monster with inflation and taper alarm, thus resulting in a triple digit Dow decline and a 20 basis point spike in 10-year Treasury rates. Right?
Well, the triple digit Dow move indeed came to fruition…but in the wrong direction. Rather than cratering, the Dow exploded higher by +200 points above 16,000 once again. Any worry of a potential bond market thrashing fizzled out to a flattish whimper in the 10-year Treasury yield (to approximately 2.86%). You certainly should not extrapolate one data point or one day of trading as a guaranteed indicator of future price directions. But, in the coming weeks and months, if the economic recovery gains steam I will be paying attention to how the market reacts to an inevitable Fed tapering and likely rise in interest rates.
The Expectations Game
Interpreting the correlation between the tone of news and stock direction is a challenging endeavor for most (see Circular Conversations & Tweet), but stock prices going up on bad news has not a been a new phenomenon. Many will argue the economy has been limp and the news flow extremely weak since stock prices bottomed in early 2009 (i.e., Europe, Iran, Syria, deficits, debt downgrade, unemployment, government shutdown, sequestration, taxes, etc.), yet actual stock prices have chugged higher, nearly tripling in value. There is one word that reconciles the counterintuitive link between ugly news and handsome gains…EXPECTATIONS. When expectations in 2009 were rapidly shifting towards a Great Depression and/or Armageddon scenario, it didn’t take much to move stock prices higher. In fact, sluggish growth coupled with historically low interest rates were enough to catapult equity indices upwards – even after factoring in a dysfunctional, ineffectual political backdrop.
From a longer term economic cycle perspective, this recovery, as measured by job creation, has been the slowest since World War II (see Calculated Risk chart below). However, if you consider other major garden variety historical global banking crises, our crisis is not much different (see Oregon economic study).
While it’s true that stock prices can go up on bad news (and go down on good news), it is also possible for prices to go up on good news. Friday’s trading action after the jobs report is the proof of concept. As I’ve stated before, with the meteoric rise in stock prices, it’s my view the low hanging profitable fruit has been plucked, but there is still plenty of fruit on the trees (see Missing the Pre-Party). I am not the only person who shares this view.
Recently, legendary investor Warren Buffett had this to say about stocks (Source: Louis Navellier):
“I don’t have concerns about this market.” Buffet said stocks are “in a zone of reasonableness. Five years ago,” Buffett said, “I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced.” Today, “they’re definitely not way overpriced. They’re definitely not underpriced.” “If you live long enough,” Buffett said, “you’ll see a lot higher prices. I don’t know what stocks will do next week or next month or next year, but five or 10 years from now, they are very likely to be higher.”
However, up cycles eventually run their course. As stocks continue to go up on good news, ultimately they begin to go down on good news. Expectations in time tend to get too lofty, and the market begins to anticipate a downturn. Stock prices are continually incorporating information that reflects the direction of future earnings and cash flow prospects. Looking into the rearview mirror at historical results may have some value, but gazing through the windshield and anticipating what’s around the corner is more important.
Rather than getting caught up with the daily mental somersault exercises of interpreting what the tone of news headlines means to the stock market (see Sentiment Pendulum), it’s better to take a longer-term cyclical sentiment gauge. As you can see from the chart below, waiting for the bad news to end can mean missing half of the upward cycle. And the same principle applies to good news.
Bad news can be good news for stock prices, and good news can be bad for stock prices. With the spate of recent positive results (i.e., accelerating purchasing manager data, robust auto sales, improving GDP, better job growth, and more new-home sales), perhaps good news will be good news for stock prices?
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Investing: Coin Flip or Skill?
The Sidoxia Monthly Newsletter will be released in a few days (subscribe on right side of the page), so here is an Investing Caffeine classic to tide you over until then:
Everyone believes they are above-average drivers and most investors believe successful investing can be attributed to skill. Michael Mauboussin, author and Chief Investment Strategist at Legg Mason Capital Management, tackles the issue of how important a role luck plays in various professional activities, including investing (read previous IC article on Mauboussin) in his meaty 42-page thought piece, Untangling Skill and Luck.
Skill Litmus Test
Whenever someone becomes successful or a sports team wins, doubters often respond with the response, “Well, they are just lucky.” For some, the intangible factor of luck can be difficult to measure, but for Mauboussin, he has a simple litmus test to evaluate the level of skill and luck credited to a professional activity:
“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”
Mauboussin uses various sports and games as tools to explain the relative importance that skill (or lack thereof) plays in determining an outcome. At one extreme end of the spectrum you have a brain game like chess, in which a skillful chess pro could beat an amateur 1,000 times in a 1,000 matches. In the field of professional sports, at the other end of the spectrum, Mauboussin hammers home the relative significance luck contributes in professional baseball:
“In major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time.“
Here is a skill-luck continuum provided by Mauboussin:
Source: Legg Mason Capital Management
Streaks vs. Mean Reversion
Mr. Mauboussin spends a great deal of time exploring the implications of skill and luck in relation to streaks and mean reversion. In the streak department, Mauboussin uses Joe DiMaggio’s record 56-consecutive game hitting stretch. He acknowledges the presence of luck, but skill is a prerequisite:
“Not all skillful performers have streaks, but all long streaks of success are held by skillful performers.”
When detailing streaks, Mauboussin may also be defending his fellow Legg Mason colleague Bill Miller (see Revenge of the Dunce), who had an incredible 15 consecutive year of besting the S&P 500 index before mean reverting back to lousy human-like returns.
This is a nice transition into his discussion about mean reversion because Mauboussin basically states this reversion concept dominates activities laden with luck (as shown in the Skill-Luck Continuum chart above). Time will tell whether Miller’s streak was due to skill, if he can put together another streak, or whether his streak was merely a lucky fluke. Unlike the judicial world, investment managers are often treated as guilty until proven innocent. For now, Miller’s 1991-2005 streak is being treated as luck by many in the investment community, rather than skill.
Nobel-prize winner Paul Samuelson may believe differently since he concedes the existence of skillful investing:
“It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?”
Peter Lynch’s +29% annual return from 1977-1990 is another streak on which historians can chew (read more on Lynch). I, like Samuelson, will give Lynch the benefit of the doubt.
Creating a Skillful Analytical Edge
Unlike the process of mowing lawns, in which more applied work time generally equates to more lawns cut (i.e., more profits), the investment world doesn’t quite work that way. Many people could work all day, stare at their screen for 23 hours, trade off of useless information, and still earn lousy returns. When it comes to investing, more work does not necessarily produce better results. Mauboussin’s prescription is to create an analytical edge. Here is how he describes it:
“At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations.”
Thinking like a handicapper is imperative to win in this competitive game, and I specifically addressed this in my previous Vegas-Wall Street article. Steven Crist sums up this indispensable concept beautifully:
“There are no “good” or “bad” horses, just correctly or incorrectly priced ones.”
A disciplined, systematic approach will incorporate these ideas, however all good investors understand the good processes can lead to bad outcomes in the short-run. By continually learning from mistakes, and refining the process with a constant feedback loop, the investment process can only get better. On the other hand, schizophrenically reacting to an endless flood of ever-changing information, or fearfully chasing the leadership du jour will only lead to pain and sorrow. Fortunately for you, you have skillfully completed this article, meaning financial luck should now be on your side.
Read full Mauboussin article (Untangling Skill and Luck) here
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. Radio interviews included opinions of Wade Slome – not advice. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Sports, Stocks, & the Magic Quadrants
Picking stocks is a tricky game and so is sports betting. With the NFL and NCAA football seasons swinging into full gear, understanding the complexity of making money in the stock market can be explained in terms of professional sports-betting. Anybody who has traveled to Las Vegas and bet on a sporting event, understands that choosing a winner of a game simply is not enough…you also need to forecast how many points you think a certain team will win by (see also What Happens in Vegas, Stays on Wall Street). In the world of sports, winning/losing is measured by point spreads. In the world of stocks, winning/losing is measured by valuation (e.g., Price/Earnings ratios).
To make my point, here is a sports betting example from a handful years back:
Florida Gators vs. Charleston Southern Buccaneers (September 2009): Without knowing a lot about the powerhouse Southern Buccaneers squad from South Carolina, 99% of respondents, when asked before the game who would win, would unanimously select Florida – a consistently dominant, national franchise, powerhouse program. The question becomes a little trickier when participants are asked, “Will the Florida Gators win by more than 63 points?” Needless to say, although the Buccs kept it close in the first half, and only trailed by 42-3 at halftime, the Gators still managed to squeak by with a 62-3 victory. Worth noting, had you selected Florida, the overwhelming favorite, the 59 point margin of victory would have resulted in a losing wager (see picture below).
If investing and sports betting were easy, everybody would do it. The reason sports betting is so challenging is due to very intelligent statisticians and odds-makers that create very accurate point spreads. In the investing world, a broad swath of traders, market makers, speculators, investment bankers, and institutional/individual investors set equally efficient valuations.
The goal in investing is very similar to sports betting. Successful professionals in both industries are able to consistently identify inefficiencies and then exploit them. Inefficiencies occur for a bettor when point spreads are too high or low, while investors identify inefficient prices in the marketplace (undervalued or overvalued).
To illustrate my point, let’s take a look at Sidoxia’s “Magic Quadrant“:
A-B-Cs & 1-2-3s
What Sidoxia’s “Magic Quadrant” demonstrates is a framework for evaluating stocks. By devoting a short period of time reviewing the quadrants, it becomes apparent fairly quickly that Stock A is preferred over Stock B, which is preferred over Stock C, which is preferred over Stock D. In each comparison, the former is preferred over the latter because the earlier letters all have higher growth, and lower (cheaper) valuations. The same relative attractive relationships cannot be applied to stocks #1, #2, #3, and #4. Each successive numbered stock has higher growth, but in order to obtain that higher growth, investors must pay a higher valuation. In other words, Stock #1 has an extremely low valuation with low growth, while Stock #4 has high growth, but an investor must pay an extremely high valuation to own it.
While debating the efficiency of the stock market can escalate into a religious argument, I would argue the majority of stocks fall in the camp of #1, #2, #3, or #4. Or stated differently, you get what you pay for. For example, investors are paying a much higher valuation (~100x 2014 P/E) for Tesla Motors, Inc (TSLA) for its rapid electric car growth vs. paying a much lower valuation (~10x 2014 P/E) for Pitney Bowes Inc (PBI) for its mature mail equipment business.
The real opportunities occur for those investors capable of identifying companies in the upper-left quadrant (i.e., Stock A) and lower-right quadrant (i.e., Stock D). If the analysis is done correctly, investors will load up on the undervalued Stock A and aggressively short the expensive Stock D. Sidoxia has its own proprietary valuation model (Sidoxia Holy Grail Ranking – SHGR or a.k.a. “SUGAR”) designed specifically to identify these profitable opportunities.
The professions of investing and sports betting are extremely challenging, however establishing a framework like Sidoxia’s “Magic Quadrants” can help guide you to find inefficient and profitable investment opportunities.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in TSLA, PBI, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Most Hated Bull Market Ever
Life has been challenging for the bears over the last four years. For the first few years of the recovery (2009-2010) when stocks vaulted +50%, supposedly we were still in a secular bear market. Back then the rally was merely dismissed as a dead-cat bounce or a short-term cyclical rally, within a longer-term secular bear market. Then, after an additional +50% move the commentary switched to, “Well, we’re just in a long-term trading range. The stock market hasn’t done a thing in a decade.” With major indexes now hitting all-time record highs, the pessimists are backpedaling in full gear. Watching the gargantuan returns has made it more difficult for the bears to rationalize a tripling +225% move in the S&P 600 index (Small-Cap); a +214% move in the S&P 400 index (Mid-Cap); and a +154% in the S&P 500 index (Large-Cap) from the 2009 lows.
For the unfortunate souls who bunkered themselves into cash for an extended period, the return-destroying carnage has been crippling. Making matters worse, some of these same individuals chased a frothy over-priced gold market, which has recently plunged -30% from the peak.
Bonds have generally been an OK place to be as Europe imploded and domestic political gridlock both helped push interest rates to record-lows (e.g., tough to go lower than 0% on the Fed-Funds rate). But now, those fears have subsided, and the recent rate spike from Ben Bernanke’s “taper tantrum” has caused bond bulls to reassess their portfolios (see Fed Fatigue). Staring at the greater than -90% underperformance of bonds, relative to stocks over the last four years, has been a bitter pill to swallow for fervent bond believers. The record -$9.9 billion outflow from Mr. New Normal’s (Bill Gross) Pimco Total Return Fund in June (a 26-year record) is proof of this anxiety. But rather than chase an unrelenting stock market rally, stock haters and skeptics remain stubborn, choosing to place their bond sale proceeds into their favorite inflation-depreciating asset…cash.
Crash Diet at the Buffet
I’ve seen and studied many markets in my career, but the behavioral reactions to this most-hated bull market in my lifetime have been fascinating to watch. In many respects this reminds me of an investing buffet, where those participating in the nourishing market are enjoying the spoils of healthy returns, while the skeptical observers on the sidelines are on a crash diet, selecting from a stingy menu of bread and water. Sure, there is some over-eating, heartburn, and food coma experienced by those at the stock market table, but one can only live on bread and water for so long. The fear of losses has caused many to lose their investing appetite, especially with news of sequestration, slowing China, Middle East turmoil, rising interest rates, etc. Nevertheless, investors must realize a successful financial future is much more like an eating marathon than an eating sprint. Too many retirees, or those approaching retirement, are not responsibly handling their savings. As legendary basketball player and coach John Wooden stated, “Failing to prepare is preparing to fail.”
20 Years…NOT 20 Days
I will be the first to admit the market is ripe for a correction. You don’t have to believe me, just take a look at the S&P 500 index over the last four years. Despite the explosion to record-high stock prices, investors have had to endure two corrections averaging -20% and two other drops approximating -10%. Hindsight is 20-20, but at each of those fall-off periods, there were plenty of credible arguments being made on why we should go much lower. That didn’t happen – it actually was the opposite outcome.
For the vast majority of investing Americans, your investing time horizon should be closer to 20 years…not 20 days. People that understand this reality realize they are not smart enough to consistently outwit the market (see Market Timing Treadmill). If you were that successful at this endeavor, you would be sitting on your private, personal island with a coconut, umbrella drink.
Successful long-term investors like Warren Buffett recognize investors should “buy fear, and sell greed.” So while this most hated bull market remains fully in place, I will follow Buffett’s advice comfortably sit at the stock market buffet, enjoying the superior long-term returns put on my plate. Crash dieters are welcome to join the buffet, but by the time they finally sit down at the stock market table, I will probably have left to the restroom.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including IJR, and IJH, but at the time of publishing, SCM had no direct position in BRKA/B, Pimco Total Return Fund, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Confessions of a Bond Hater
Source: stock.xchng
Hi my name is Wade, and I’m a bond hater. Generally, the first step in addressing any type of personal problem is admitting you actually have a problem. While I am not proud of being a bond hater, I have been called many worse things during my life. But as we have learned from the George Zimmerman / Trayvon Martin case, not every situation is clear-cut, whether we are talking about social issues or bond investing. For starters, let me be clear to everyone, including all my detractors, that I do not hate all bonds. In fact, my Sidoxia clients own many types of fixed income securities. What I do hate however are low yielding, long duration bonds.
Duration…huh? Most people understand what “low yielding” means, when it comes to bonds (i.e., low interest, low coupon, low return, etc.), but when the word duration is uttered, the conversation is usually accompanied by a blank stare. The word “duration” may sound like a fancy word, but in reality it is a fairly simple concept. Essentially, high-duration bonds are those fixed income securities with the highest sensitivity to changes in interest rates, meaning these bonds will go down most in price as interest rates rise.
When it comes to equity markets, many investors understand the concept of high beta stocks, which can be used to further explain duration. There are many complicated definitions for beta, but the basic principle explains why high-beta stock prices generally go up the most during bull markets, and go down the most during bear markets. In plain terms, high beta equals high octane.
If we switch the subject back to bonds, long duration equals high octane too. Or stated differently, long duration bond prices generally go down the most during bear markets and go up the most during bull markets. For years, grasping the risk of a bond bear market caused by rising rates has been difficult for many investors to comprehend, especially after witnessing a three-decade long Federal Funds tailwind taking the rates from about 20% to about 0% (see Fed Fatigue Setting In).
The recent interest rate spike that coincided with the Federal Reserve’s Ben Bernanke’s comments on QE3 bond purchase tapering has caught the attention of bond addicts. Nobody knows for certain whether this short-term bond price decline is the start of an extended bear market in bonds, but mathematics would dictate that there is only really one direction for interest rates to go…and that is up. It is true that rates could remain low for an indefinite period of time, but neither scenario of flat to down rates is a great outcome for bond holders.
Fixes to Fixed-Income Failings
Even though I may be a “bond hater” of low yield, high duration bonds, currently I still understand the critical importance and necessity of a fixed income portfolio for not only retirees, but also for the diversification benefits needed by a broader set of investors. So how does a bond hater reconcile investing in bonds? Easy. Rather than focusing on lower yielding, longer duration bonds, I invest more client assets in shorter duration and/or higher yielding bonds. If you harbor similar beliefs as I do, and believe there will be an upward bias to the trajectory of long-term interest rates, then there are two routes to go. Investors can either get compensated with a higher yield to counter the increased interest rate risk, and/or they can shorten duration of bond holdings to minimize capital losses.
Worth noting, there is an alternative strategy for low yielding, long duration bond lovers. In order to minimize interest rate risk, these bond lovers may accept sub-optimal yields and hold bonds to maturity. This strategy may be associated with short-term price volatility, but if the bond issuer does not default, at least the bond investor will get the full principal at maturity to help relieve the pain of meager yields.
Now that you’ve survived all this bond babbling, let me cut to the chase and explain a few ways Sidoxia is taking advantage of the recent interest rate volatility for our clients:
Floating Rate Bonds: Duration of these bonds is by definition low, or near zero, because as interest rates rise, coupons/interest payments are advantageously reset for investors at higher rates. So if interest rates jump from 2% to 3%, the investor will receive +50% higher periodic payments.
Inflation Protection Bonds: These bonds come in long and short duration flavors, but if interest rates/inflation rise higher than expected, investors will be compensated with higher periodic coupons and principal payments.
Shorter Duration: One definition of duration is the weighted average of time until a bond’s fixed cash flows are received. A way of shortening the duration of your bond portfolio is through the purchase of shorter maturity bonds (e.g., buying 3-year bonds rather than 30-year bonds).
High Yield Bonds: Investing in the high yield bond category is not limited to domestic junk bond purchases, but higher yields can also be earned by investing in international and/or emerging market bonds.
Investment Grade Corporate Bonds: Similar to high yield bonds, investment grade bonds offer the potential of capital appreciation via credit improvement. For instance, credit rating upgrades can provide gains to help offset price declines caused by rising interest rates.
Despite my bond hater status, the recent taper tantrum and interest rate spike, highlight some advantages bonds have over stocks. Even though prices declined, bonds by and large still have lower volatility than stocks; provide a steady stream of income; and provide diversification benefits.
To the extent investors have, or should have, a longer-term time horizon, I still am advocating a stock bias to client portfolios, subject to each investor’s risk tolerance. For example, an older retired couple with a conservative target allocation of 20%/80% (equity/fixed income) may consider a 25% – 30% allocation. A shift in this direction may still meet the retirees’ income needs (especially if dividend-paying stocks are incorporated), while simultaneously acknowledging the inflation and interest rate risks impacting bond positions. It’s important to realize one size doesn’t fit all.
Higher Volatility, Higher Reward
Frequent readers of Investing Caffeine have known about my bond hating tendencies for quite some time (see my 2009 article Treasury Bubble has not Burst…Yet), but the bond baby shouldn’t be thrown out with the bath water. For those investors who thought bonds were as safe as CDs, the recent -6% drop in the iShares Aggregate Bond Index (AGG) didn’t feel comfortable for most. Although I am still an enthusiastic stock cheerleader (less so as valuation multiples expand), there has been a cost for the gargantuan outperformance of stocks since March of ’09. While stocks have outperformed bonds (S&P vs. AGG) by more than +140%, equity investors have had to endure two -10% corrections and two -20% corrections (e.g.,Flash Crash, Debt Ceiling Debate, European Financial Crisis, and Sequestration/Elections). If investors want to earn higher long-term equity returns, this desire will translate into more volatility than bonds…and more Tums.
I may still be a bond hater, and the general public remains firm stock haters, but at some point in the multi-year future, I will not be surprised to hear myself say, “Hi my name is Wade, and I am addicted to bonds.” In the mean time, Sidoxia will continue to optimize its client bond portfolios for a rising interest rate environment, while also investing in attractive equity securities and ETFs. There’s nothing to hate about that.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including floating rate bonds/loan funds, inflation-protection funds, corporate bond ETF, high-yield bond ETFs, and other bond ETFs, but at the time of publishing, SCM had no direct position in AGG or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Information Choking Your Money & Mood to Misery
Source: Photobucket
On a daily basis, I make my way into the office before the market opening bell, preparing myself to gorge on a massive heaping of news stories and headlines. But scarfing down tons of tweets and hundreds of headlines is not enough. Magazines, newspapers, conference calls, blogs, presentations, conferences, interviews, television clips, and software lists are but just a few additional aspects to my steady diet of information. Like shopping down each and every aisle of the grocery store, an annoying tendency I admittedly commit, there are plenty of healthy and unhealthy items to choose from. The key is identifying the items that are the best for your financial health. After carrying out this gluttonous information-stuffing business for more than twenty years, I’ve gotten much better at separating the data wheat from information chaff. This is critical in avoiding heartburn for my Sidoxia clients and me.
One might ask, “What harmless headline or innocent anecdote could possibly cause harmful financial indigestion?” I don’t know about you, but in recent months, gobbling down these following headlines without discretion can lead to a serious case of acid reflux:
- “Stocks Tumble as Bernanke Discusses Tapering” – USA Today
- “China’s Economy is Freezing Up. How Freaked Out Should We Be?” – Washington Post
- ” ‘Suffocating in the Streets’: Chemical Weapons Attack Reported in Syria” – NBC News
- “Europe’s Zombie Banks – Blight of the Living Dead” – The Economist
- “Threats from Extremists as Egypt Slides into Turmoil” – The Times
- “Japan Market Plunge Sparks Global Sell-Off” – Los Angeles Times
I think you get the idea. No wonder investors collectively are acting like a deer in headlights, resulting in declining stock market participation – a 15-year low (see Investing Caffeine’s DMV Economy)
In the world of competitive eating, the execution of improper consumption technique can lead to a so-called “reversal of fortune,” as can be experienced by the last video on my Investing Caffeine article, Baseball and Hot Dogs. Disciplined processes are needed to prevent such an event when devouring excessive amounts of information. This is a timely topic as Joey Chestnut recently set a new world record by eating 69 hot dogs in 10 minutes.
While digesting the avalanche of daily data is quite complex, understanding the harmful consequences of doing so is quite simple. Carl Richards, a contributor writer to the The New York Times and Morningstar Advisor does a great job of outlining the detrimental impact of information consumption on investors’ wealth and happiness through minimalist charts found at BehaviorGap.com.
Here is my co-mingled version of Richards’ work:
As Mark Twain said, “If you don’t read the newspaper, you are uninformed. If you do read the newspaper, you are misinformed.” It’s perfectly fine to remain current with major economic, political, and worldly events, but the consequences to overreacting to the ever-changing news flow can be disastrous to your financial and personal well-being. Managing your life savings can be stressful and if not managed correctly will damage your financial goals.
If you do not have the time, interest, or self-control to digest the massive buffet of endless information, do yourself a favor and find an experienced and trusted advisor that can assist you with the Heimlich maneuver, so you don’t choke on the infinite amount of data.
See also (Investing Caffeine: Age of Information Overload)
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and CMCSA, but at the time of publishing, SCM had no direct position in GCI, WPO, NYT, MORN or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
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