Posts filed under ‘Education’
Your Portfolio’s Silent Killer
Shhh, if you listen closely enough, you may hear the sound of your portfolio disintegrating away due to the quiet killer…inflation. Inflation is especially worrisome with what we’ve seen happening with commodity prices and the drastic fiscal challenges our country faces. Quantitative Easing (read Flying to the Moon) has only added fuel to the inflation fear flames.
Whether you’re a conspiracy theorist who believes the government inflation data is cooked, or you are a Baby Boomer just looking to secure your retirement, it doesn’t take a genius to figure out that movies, pair of jeans, a tank of gas, concert tickets, or healthcare premiums are all going up in price (See also Bacon and Oreo Future).
Inflation starting to heat up. Source: IMF/Bloomberg via Financial Times
Companies are currently churning out quarterly results in volume and seeing the impact from commodity prices, whether you are McDonald’s Corp. (MCD) facing rising beef prices or luxury handbag maker Coach Inc. (COH) dealing with escalating leather costs, margins are getting crimped. Investors, especially those on fixed income streams, are experiencing the same pain as these corporations, but the problem is much worse. Unlike a market share leading company that can pass on price increases onto its customers, an investor with piles of cash, and low yielding CDs (Certificates of Deposit), and bonds runs the risk of getting eaten alive. Baby Boomers are beginning to reach retirement age in mass volume. Life spans are extending, and this demographic pool of individuals will become ever-large consumers of costlier and costlier healthcare services. If investments are not prudently managed, Baby Boomers will see their nest eggs evaporate, and be forced to work as Wal-Mart (WMT) greeters into their 80s…not that there’s anything wrong with that.
Every day investors are bombarded with a hundred different scary headlines on why the economy will collapse or the world will end. Most of these sensationalist scare tactics distort the truth and overstate reality. What is understated is what Charles Ellis (see Winning the Loser’s Game) calls a “corrosive power”:
“Over the long run, inflation is the major problem for investors, not the attention-getting daily or cyclical changes in securities prices that most investors fret about. The corrosive power of inflation is truly daunting: At 3 percent inflation – which most people accept as ‘normal’ – the purchasing power of your money is cut in half in 24 years. At 5 percent inflation, the purchasing power of your money is cut in half in less than 15 years – and cut in half again in 15 years to just one-quarter.”
In order to bolster his case, Ellis cites the following period:
“From 1977 to 1982, the inflation-adjusted Dow Jones Industrial Average took a five-year loss of 63 percent…In the 15 years from the late 1960s to the early 1980s the unweighted stock market, adjusted for inflation, plunged by about 80 percent. As a result, the decade of the 1970s was actually worse for investors than the decade of the 1930s.”
Solutions – How to Beat Inflation
Although the gold bugs would have you believe it, we are not resigned to live in a world with worthless money, which only has a useful purpose as toilet paper. There are ways to protect your portfolio, if you are properly invested. Here are some strategies to consider:
- TIPS (Treasury Inflation Protection Securities): These government-guaranteed tools are a useful way to protect yourself against rising inflation (see Drowning TIPS).
- Equities (including real estate): Bond issuers do not generally call up there investors and say, “You are such a great investor, so we have decided to increase your interest payments.” However, many publicly traded stocks do exactly that. Wal-Mart Stores (WMT) is an example of such a company that has increased its dividend for 37 consecutive years. As alluded to earlier, stocks are unique in that they allow inflationary pressures placed on operating profits to be relieved somewhat by the ability to pass on price increases to customers.
- Commodities: Whether you are talking about petroleum products, precious metals (those with a commercial purpose), or agricultural goods, commodities in general act as a great inflationary hedge. Another reason that commodities broadly perform better in an inflationary environment is because the U.S. dollar can often depreciate, which commonly increases the value of commodities.
- Short Duration Bonds: Rising rates are usually tied to escalating inflation, therefore investors would be best served by reducing maturity length and increasing coupon.
There are other ways of battling the inflation problem, but number one is saving and investing across a broadly diversified portfolio. If you want to secure and grow your nest egg, you need to use the silent power of compounding (see Penny Saved is Billion Earned) to combat the silent killer of inflation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, TIP, equities, commodities, and short duration bonds, 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.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. 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.
New Year’s Investing Resolutions
As we exit 2010 and enter 2011, many people go through the annual ritual of making personal New Year’s resolutions. Here is a list of go-to resolutions if you haven’t made one, or are having trouble coming up with one.
1) Lose weight
2) Spend More Time with Family & Friends
3) Quit Smoking
4) Quit Drinking
5) Enjoy Life More
6) Save Money & Get Out of Debt
7) Learn Something New
8) Help Others
9) Get Organized
10) Travel More
I have a few on the list above that I would like to work on, but when it comes to investing, there are a few other resolutions I am looking to make or maintain in 2011:
1) Don’t be a Hog. The last few years have produced excellent returns, but we all know that pigs get fat, and hogs get slaughtered. Cashing the register and banking some of my gains can be frustrating when positions charge higher, but sticking to a disciplined approach pays off handsomely in the long-run and helps navigate through the volatile times.
2) Follow Crash Litmus Test. Only buy what you would confidently purchase at lower prices. Sure, company or industry fundamentals can change over time, but for the vast majority of the time, companies and industries do not undergo paradigm shifts. Even though there are a 1,001 bombs that get launched daily, explaining why the world is coming to an end, I do my best to block out the useless noise and stick to the numbers and facts.
3) Remove Name Creep. It’s easy to fall in love with every new stock that walks by, but limiting the number requires a conviction discipline that pays off in the long run. Academic research and practical experience dictate diversification can be achieved without spreading yourself too thin. As Warren Buffett says, “I prefer to keep all my eggs in one basket and watch that basket closely.”
4) Tirelessly Turn Stones. I love my portfolio right now, but I know there are unique opportunities out there that can improve my results, if I take the time and make the effort.
5. Don’t Rush Into Tips. I’ve purchased or shorted securities recommended by respected investors, but it is important to do your own homework first. Even if these ideas work in the short-run, tips usually fall into loose hands and get punted at the worst times. Perform adequate due diligence to strengthen the roots of your thesis for volatile times.
6. Don’t Get Drunk on Story Stocks. There is never a shortage of great ideas, but many of them carry hefty price tags and have high expectations baked into future earnings growth estimates. Even if great stories exist in abundance, there is a shortage of great managers that can profit from great ideas. Associated high prices can however quickly turn a great story into a sad story – once excessively high expectations are not met, prices eventually will collapse.
7. Build Contingency Plan for Overconfidence. It’s important to have an exit strategy or contingency plan in place if things do not play out as planned. Overconfidence can be the pitfall for many investors, and this is not surprising when factoring in how highly people generally feel about themselves. Most believe they are better than average drivers, parents, and have superior intuition. This same overconfidence may not harm you in the real world, but in the financial markets, overconfidence can result in a woodshed beating. Confidence will not kill your portfolio, but arrogant confidence will.
8. Stick to Knitting. We all have our strengths and weaknesses. I do my best to stay away from my blind spots. As legendary baseball player Ted Williams discussed in his book The Science of Hitting, players are much better off by patiently waiting for the fat pitch in the sweet spot of the strike zone before swinging. Finding your sweet spot and not venturing out of your circle of competence is just as important in the investing world as it is in baseball hitting.
9. Trade Less. Trading is fun and exciting, but paying commissions on top of bid-ask spreads, impact costs, and other fees removes some of the enjoyment. Trading is a necessary evil to make profits, but requires the trader to be right twice – once on the sale, and another time on the purchase. Even if you are right on both sides of the trade, chances are the fees, taxes, commissions, and impact costs will remove most if not all of the profits.
10. Learn from Mistakes. Unfortunately, 2011 will be another year that I will not remain mistake-free. Conveniently forgetting investment mistakes is a great rationalization mechanism, but forever sweeping blunders under the rug without learning from them will not make you a better investor.
If you are able to set aside some of those Bonbons and pay off those credit card balances, then maybe you can join me and take on an investing resolution or two. Don’t worry, like all resolutions, you always have the option of making the resolution without following through!
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.
The Art of Weather Forecasting and Investing
Source: Photobucket
I’ve lived across the country and traveled around the world and have experienced everything from triple-digit desert heat to sub-zero wind chill. The financial markets experience the same variability over time.
Forecasting the weather is a lot like forecasting the stock market. In the short-run, volatility in patterns can be very difficult to predict, but if efforts are energized into analyzing long-term factors, trends can be identified.
For example, I live here in Southern California, and although weather is fairly homogenous, the variability can be significant on a day-to-day basis. I’m much more likely to be accurate in estimating the long-term climate than the forecast seven days from now. I’m not trying to rub salt in the wounds of those people freezing in Antarctica or the upper-Midwest, but forecasting a climate of 72 degrees, sunny, and blue skies is a good fall-back scenario if you are a television weatherman in Southern California.
Charles Ellis, author of the Winning the Loser’s Game – “WTLG” (see Investing Caffeine article #1 and article #2), highlights the weather analogy more convincingly:
“Weather is about the short run; climate is about the long run – and that makes all the difference. In choosing a climate in which to build a home, we would not be deflected by last week’s weather. Similarly, in choosing a long-term investment program, we don’t want to be deflected by temporary market conditions.”
Ellis adds:
“Like the weather, the average long-term experience in investing is never surprising, but the short-term experience is constantly surprising.”
In the financial markets the weather predicting principle applies to long-term economic forecasts as well. Predicting annual GDP growth can often be more accurate than the expected change in Dow Jones Industrial Index points tomorrow or the next day.
Economic Weathermen
As I outlined in Professional Guesses Probably Wrong, economists and strategists use several means of making their guesses.
- One method is to simply not make forecasts at all, but rather use some big words and current news to explain what currently is happening in the economy and financial markets.
- A second approach used by prognosticators is to constantly change forecasts. Consider a person making a weather forecast every minute…his/her forecast would be very accurate, but it would be changing constantly and not provide much more value than what an ordinary person could gather by looking out their own window.
- Thirdly, some use the “spaghetti approach” – throw enough scenarios out there against the wall and something is bound to stick – regardless of accuracy.
- Lastly, the “extend and pretend” method is often implemented. Forecasters make big bold economic predictions that garner lots of attention, but when the expectations don’t come true, the original forecast is either forgotten by investors or the original forecast just becomes extended further into the future.
Coin Flipping
If the weather analogy doesn’t work for you, how about a coin-flipping analogy? The short-term randomness surrounding the consecutive number of heads and tails may make no sense in the short-run, but will mean revert to an average over time. In other words, it is possible for someone to flip 10 consecutive “tails,” but in the long-run, the number of times a coin will land on “tails” will come close to averaging half of all coin tosses. The same dynamic is observed in the investment world. Often, short-term spikes or declines are short lived and return toward a mean average. IN WTLG, Ellis provides some more color on the topic:
“The manager whose favorable investment performance in the recent past appears to be ‘proving’ that he or she is a better manager is often – not always, but all too often – about to produce below-average results…A large part of the apparently superior performance was not due to superior skill that will continue to produce superior results but was instead due to that particular manager’s sector of the market temporarily enjoying above-average rates of return – or luck.”
Regardless of your interests in weather forecasting or coin-flipping, when it comes to investing you will be better served by following the long-term climate trends and probabilities. Otherwise, the performance outlook for your investment portfolio may be cloudy with a chance of thunderstorms.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.
Ellis on Battling Demons and Mr. Market
A lot of ground was covered in the first cut of my review on Charles Ellis’s book, Winning the Loser’s Game (“WTLG”). His book covers a broad spectrum of issues and reasons that help explain why so many amateurs and professional investors dramatically underperform broad market indexes and other forms of passive investing (such as index funds).
A major component of investor underperformance is tied to the internal or emotional aspects to investing. As I have written in the past, successful investing requires as much emotional art as it does mathematical science. Investing solely based on numbers is like a tennis player only able to compete with a backhand – you may hit a few good shots, but will end up losing in the long-run to the well-rounded players.
Ellis recognizes these core internal shortcomings and makes insightful observations throughout his book on how emotions can lead investors to lose. As George J.W. Goodman noted, “If you don’t know who you are, the stock market is an expensive place to find out.” Hopefully by examining more of Ellis’s investment nuggets, we can all become better investors, so let’s take a deeper dive.
Mischievous Mr. Market
Why is winning in the financial markets so difficult? Ellis devotes a considerable amount of time in WTLG talking about the crafty guy called “Mr. Market.” Here’s how Ellis describes the unique individual:
“Mr. Market is a mischievous but captivating fellow who persistently teases investors with gimmicks and tricks such as surprising earnings reports, startling dividend announcements, sudden surges of inflation, inspiring presidential announcements, grim reports of commodities prices, announcements of amazing new technologies, ugly bankruptcies, and even threats of war.”
Investors can easily get distracted by Mr. Market, and Ellis makes the point of why we are simple targets:
“Our internal demons and enemies are pride, fear, greed, exuberance, and anxiety. These are the buttons that Mr. Market most likes to push. If you have them, that rascal will find them. No wonder we are such easy prey for Mr. Market with all his attention-getting tricks.”
The market also has a way of lulling investors into complacency. Somehow, bull markets manage to make geniuses not only out of professionals and amateur investors, but also cab drivers and hair-dressers. Here is Ellis’s observation of how we tend to look at ourselves:
“We also think we are ‘above average’ as car drivers, as dancers, at telling jokes, at evaluating other people, as friends, as parents, and as investors. On average, we also believe our children are above average.”
This overconfidence and elevated self-assessment generally leads to excessive risk-taking and eventually hits arrogant investors over the head like a sledgehammer. Michael Mauboussin, Legg Mason Chief Investment Strategist and author of Think Twice, is a current thought leader in the field of behavioral finance that tackles many of these behavioral finance issues (read my earlier piece).
The Collateral Damage
As mentioned by Ellis in the previous WTLG article I wrote, “Eighty-five percent of investment managers have and will continue over the long term to underperform the overall market.” When emotions take over our actions, Mr. Market has a way of making investors make the worst decisions at the worst times. Ellis describes this phenomenon in more detail:
“The great risk to individual investors is not that the market can plummet, but that the investor may be frightened into liquidating his or her investments at or near the bottom and miss all the recovery, making the loss permanent. This happens to all too many investors in every terrible market drop.”
With the market about doubling from the early 2009 equity market lows, this devastating problem has become more evident. With volatility rearing its ugly head throughout 2008 and early 2009, investors bailed into low-yielding cash and Treasuries at the nastiest time. Now the stock market has catapulted upwards and those same investors now face significant interest rate risk and still are experiencing meager yields.
The Winning Formula
Ellis acknowledges the difficulty of winning at the investing game, but experience has shown him ways to combat the emotional demons. Number one…know thyself.
“’Know thyself’ is the cardinal rule in investing. The hardest work in investing is not intellectual; it’s emotional.”
Knowing thyself is easier said than done, but experience and mistakes are tremendous aids in becoming a better investor – especially if you are an investor who spends time studying the missteps and learns from them.
From a practical portfolio construction standpoint, how can investors combat their pesky emotions? Probably the best idea is to follow Ellis’s sage advice, which is to “sell down to the sleeping point. Don’t go outside your zone of competence because outside that zone you may get emotional, and being emotional is never good for your investing.”
Finding good investment ideas is just half the battle – fending off the demons and Mr. Market can be just as, if not more, challenging. Fortunately, Mr. Ellis has been kind enough to share his insights, allowing investors of all types to take this valuable investment advice to help win at a losing game.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.
Winning the Loser’s Game
Besides hanging out with family and friends, and stuffing my face with endless amounts of food, the other benefit of the holidays is the quality time I’m afforded to dive into a few books. While sinking into the couch in my bloated state, I had the pleasure of reading an incredible, investment classic by Charles Ellis, Winning the Loser’s Game – “WTLG” (click here to view other remarkable book I read [non-investment related]). To put my enthusiasm in perspective, WTLG has even achieved the elite and privileged distinction of making the distinguished “Recommended Reading” list of Investing Caffeine (located along the right-side of the page). Wow…now I know you must be really impressed.
The Man, The Myth, the Ellis
For those not familiar with Charley Ellis, he has a long, storied investment career. Not only has he authored 12 books, including compilations on Goldman Sachs (GS) and Capital Group, but his professional career dates back prior to 1972, when he founded institutional consulting firm Greenwich Associates. Besides earning a college degree from Yale University, and an MBA from Harvard Business School, he also garnered a PhD from New York University. Ellis also is a director at the Vanguard Group and served as Investment Committee chair at Yale University along investment great David Swensen (read also Super Swensen) from 1992 – 2008.
With this tremendous investment experience come tremendous insights. The original book, which was published in 1998, is already worth its weight in gold (even at $1,384 per ounce), but the fifth edition of WTLG is even more valuable because it has been updated with Ellis’s perspectives on the 2008-2009 financial crisis.
Because the breadth of topics covered is so vast and indispensable, I will break the WTLG review into a few parts for digestibility. I will start off with the these hand-picked nuggets:
Defining the “Loser’s Game”
Here is how Charles Ellis describes the investment “loser’s game”:
“For professional investors, “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.”
Underperformance by Active Managers
Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – read Darts, Monkeys & Pros. Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:
“The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.”
He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”
Exceptions to the Rule
Ellis’s bias towards passive management is clear because “over the long term 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” He does, however, acknowledge there is a minority of professionals that can beat the market by making fewer mistakes or taking advantage of others’ mistakes. Ellis advocates a slow approach to investing, which bases “decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating – producing bubbles.” This is the strategy and approach I aim to achieve.
Gaining an Unfair Competitive Advantage
According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:
1) Physical Approach: Beat others by carrying heavier brief cases and working longer hours.
2) Intellectual Approach: Outperform by thinking more deeply and further out in the future.
3) Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.
4) Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.
The Case for Stocks
Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:
“That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.”
Expanding on that point, Ellis points out the following:
“Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.”
While many people may feel stock investing is dead, but Ellis points out that equities should return more in the long-run:
“There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.”
The Power of Regression to the Mean
Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”
The Power of Compounding
For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).
Ellis throws in another compounding example:
“Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).”
The Lessons of History
As philosopher George Santayana stated – “Those who cannot remember the past are condemned to repeat it.” Details of every market are different, but as Ellis notes, “The major characteristics of markets are remarkably similar over time.”
Ellis appreciates the importance of history plays in analyzing the markets:
“The more you study market history, the better; the more you know about how securities markets have behaved in the past, the more you’ll understand their true nature and how they probably will behave in the future. Such an understanding enables us to live rationally with markets that would otherwise seem wholly irrational.”
Home Sweet International Home
Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:
“For Americans, this would mean about half our portfolios would be invested outside the United States.”
This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.
Beware the Broker
This is not new territory for me (see Financial Sharks, Fees/Exploitation, and Credential Shell Game), and Ellis warns investors on industry sales practices:
“Those oh so caring and helpful salespeople make their money by convincing you to change funds. Friendly as they may be, they may be no friend to your long-term investment success.”
Unlike a lot of other investing books, which cover a few aspects to investing, Winning the Loser’s Game covers a gamut of crucial investment lessons in a straightforward, understandable fashion. A lot of people play the investing game, but as Charles Ellis details, many more investors and speculators lose than win. For any investor, from amateur to professional, reading Ellis’s Winning the Loser’s Game and following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in GS, 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.
Investor Wake-Up Call
Source: Photobucket
The Pre Wake-Up Conversation
“Hey Milfred, did you see our brokerage statement? There must be a misprint. It says our portfolio of bonds is down.”
“Buford, how can that be, when our bond portfolio has been up for 30 consecutive years? I hear Jim Bernanke is trying to artificially inflate the economy by printing money and using it to buy bonds.”
“Sweetheart, you got it wrong…it’s Ben Jernanke.”
“Ohhh, yeah honey, you’re right. I never expected prices to go down after government bond yields were up almost 50% in a few months.”
“Sweetie, maybe we should give our broker a call?”
“Oh you mean Skip? I think he wants us to call him a financial consultant or financial advisor now…not a broker.”
“Well anyway, I just read the largest fund manager in the world, Bill Gross, is trying to convert his bond fund into a stock fund (read article). I can’t imagine why Mr. Gross would want to do that (see PIMCO article), but maybe Skip knows? You know, after Skip sold us that high commission annuity and Class-A mutual fund with that 6.25% load, he decided to take his wife, kids, parents, and in-laws to Tahiti for the holidays.”
“Oh I know, Skip is such a nice young man, and so thoughtful.”
“You’re right Pumpkin, I just wish we could hear from him more than once every two years.”
“That’s right Snookum, but at least we get to talk to him when he drops off the paperwork, and his secretary is sure nice.”
“What I really like about Skip is that he always makes so much common sense – he always tells us to buy investments that have already done really well like bonds and gold.”
“Exactly Buford. I just wonder how much longer it will take for stocks to become popular again, given the stock market is already up about 100% from the beginning of 2009? Perhaps with another +30% or so, maybe Skip will switch all our money out of bonds back into stocks?”
“What I love even more about Skip is that not only does he have us buy the popular investments, but he really protects us from buying the low-priced investments that are selling at bargain prices.”
“I hear you Muffin – come to think of it, maybe I should return that sweater I recently purchased at Marshall’s for 50% off – there may be an awful reason I do not know about.”
“Good idea Sweet Pea. The other thing I love about Skip is that he is so knowledgeable…he says the exact same thing I hear from those smart news people on TV. Good thing we have a reliable professional to protect our entire life savings.”
“You’re right as usual dear. He may only have a high school GED, but we’re lucky he has these fancy letters behind his name that I never heard of like PFS, AFC, and RFC… those must be some important credentials.”
“I feel better after our conversation. Maybe we’ll hear from Skip, and if not, I’m sure he’ll drop-off some paperwork for a new investment, if our portfolio goes down by another 10%.”
The Wake-Up Reality
I make some of these comments with tongue firmly in cheek, but the fact remains we live in a financial world with a structurally flawed system of loosely regulated, banks, brokerage firms, insurance companies, ratings agencies, hedge funds, mutual funds, and other financial institutions that continue to repeatedly place their interests ahead of clients. If the 2008-2009 financial crisis hasn’t taught you anything, then you should realize it behooves you to take control of your financial situation. At least ask tough questions that result in answers you can understand – not a lot of technical mumbo-jumbo that makes an advisor sound smart. Make life easier on yourself and have a blunt wake-up call conversation, otherwise grab a pen and get ready for Skip’s call – he’s about to come over with some more paperwork.
Related articles:
Beating off the Financial Sharks
Fees, Exploitation and Confusion Hammer Investors
Investment Credentials: The Letter Shell Game
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in TJX, or any 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.
Invisible Costs of Trading
Source: Photobucket
You can feel them, but you can’t see them. I’m talking about invisible trading costs. Although some single transaction trading costs can run as high as hundreds of dollars at the large brokerage firms, investors are generally aware of the bottom-basement commissions paid on trades executed at discount brokerage firms like Scottrade, TD Ameritrade (AMTD), E-Trade (ETFC), and Charles Schwab (SCHW) – generally less than $10 per trade. Unfortunately, these commissions are estimated to only account for 20% of total trading costs1. What most investors are unaware of are the host of invisible trading costs and expenses associated with active trading.
Here are some of the invisible costs:
Bid-Ask Spread: Besides the explicit commissions charged, traders must incur the implicit costs of the bid-ask spread. Let’s suppose you have a stock trading at $12.50 per share (ask price) and $12.25 per share (bid price). If you were to immediately buy one share for $12.50 (ask) and sell immediately for $12.25 (ask), then you would be -2% in the hole instantly – more than double the $7.95 commission paid on a $1,000 investment. Effectively, the investor would already be down about -3% the instant the small investment was made.
Impact Costs: The issue of impact costs is a bigger problem for larger institutional investors, although thinly traded stocks (those securities with relatively small trading volume) can even become expensive for retail investors. Suppose the same stock mentioned previously initially traded at $12.50 per share before you transacted, but reached $13.00 per share upon completion (with an average $12.75 price paid). The $.25 cent increase (average price minus initial price) translates into another -2% increase in the costs.
Taxes: It’s not what you make that matters, but rather what you keep that makes the difference. If you make a decent amount of money actively trading, but end up giving Uncle Sam more than potentially 40% of the gains, then your bank account may grow less than expected.
While my examples may shed some light on the costs of trading, an in-depth study using data from Morningstar and NYSE was conducted by three astute professors (Roger Edelen [University of California, Davis], Richard Evans [University of Virginia], and Gregory Kadlec [Virginia Polytechnic Institute]) showing that an average fund’s annual trading costs were estimated to be 1.44%, higher than an average fund’s overall expense ratio of 1.21%.
Unfortunately from an investor’s standpoint, as much as 30% of all trading costs can be attributed to money naturally pouring in and out of funds, due to fund share purchases and redemptions. Therefore, wildly popular or out-of-favor funds will have a detrimental impact on performance. I know firsthand the costs of managing a large fund, much like captaining a supertanker – you create a lot of waves and it can take a while to change directions. Smaller funds, however, can navigate trades more nimbly, much like a speedboat leaving behind smaller cost waves in its wake.
Style can also have an impact on trading costs. Value-based funds that sell into strength or buy into weakness can be considered liquidity providers, and therefore will experience lower trading costs. On the flip side, momentum strategies effectively pour gasoline on hot stocks purchases and pile on damaging sales to cratering losers.
Emotional Costs of Trading
More impactful, but more difficult to quantify, are the emotional trading costs of greed and fear (i.e., chasing extended winners out of greed and panicking out of losing positions due to fear). Constantly hounding winners and capitulating your losers may work in a few instances, but can lead to disastrous results in the long-run. Even if an investor is correct on the sale of a security, the investor must also be right on the subsequent buy transaction (no easy feat).
With that said, there are no hard and fast rules when buying/selling stocks. Buying a stock that has doubled or tripled in and of itself is not necessarily a bad idea, as long as you have credible assumptions and data to support adequate earnings/cash flow growth and/or multiple expansion. Consistent with that thought process, a plummeting stock is not reason enough to buy, and does not automatically mean the price will subsequently rebound. Reversion to the mean can be a powerful force in security selection, but you need a disciplined process to underpin those investment decisions.
Spiritual Savings
As I have stated in the past, investing is like a religion (read more Investing Religion). Most investors stubbornly believe their financial religion is the right way to make money. I personally believe there is more than one way to make money, just as I believe different religions can coexist to achieve their spiritual goals. Through academic research, and a lot of practical experience, my religion believes in the implementation of low-cost, tax efficient products and strategies used over longer-term time horizons. I use a blend of active and passive management that leverages my professional experience (see Sidoxia’s Fusion product), but I would fault nobody for pursuing a purely passive investment strategy. As John Bogle shows, and has proven with the financial success of his company Vanguard, passive investing by and large materially outperforms professional mutual fund managers (see Hammered Investors article).
Investing can be thrilling and exciting, but like a leaky faucet, the relatively small and apparently harmless list of trading costs have a way of collecting over the long-run before sinking long-term performance returns. Sure, there are some high-frequency traders that make a living by amassing a large sums of rebates for providing short-term liquidity, but for most investors, excessive exposure to invisible trading costs will lead to visible underperformance.
Read more about trading cost study here1
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Vanguard funds), but at the time of publishing SCM had no direct position in AMTD, ETFC, SCHW, Scottrade, 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.
Eggs or Oatmeal: Binging on Over-Analysis
I about chuckled my way out of my chair when ESPN reminded me of the absurd over-analysis that takes place in the sports world (I can’t wait for the 8 hour pre-game show before the upcoming Super Bowl) through a 30-second, football commercial. Typically when sports analysts get together, the most irrelevant issues are scrutinized under a microscope. After endless wasted amounts of time, the viewer is generally left with lots of worthless information about an immaterial topic. In this particular video, San Diego NFL quarterback Phillip Rivers innocently asks Sunday Countdown football analysts Chris Berman, Mike Ditka, Keyshawn Johnson, Tom Jackson, and Cris Carter whether they would like some eggs or oatmeal for breakfast?
Mayhem ensues while the analysts breakdown everything from the pros of frittatas and brats to the cons of cholesterol and sauerkraut. After listening to all the jaw flapping, Phillip Rivers is left dejected, banging his head against the kitchen refrigerator. It is funny, I feel much the same way as Phillip Rivers does when I’m presented with same overkill analysis found plastered over the financial media and blogosphere.
Analysis of Over-Analysis
Just as I mock the excess analysis occurring in the financial world, I will move ahead and assess this same over-thinking (that’s what we bloggers do). If this much analysis takes place when examining simple options such as eggs vs. oatmeal, or AFC vs. NFC, just imagine the endless debate that arises when discussing the merits of investing in a simple, diversified domestic equity mutual fund. Sounds simple on paper, but if I want to be intellectually honest, I first need to compare this one fund versus the thousands of other equity fund offerings, not to mention the thousands of other ETFs (Exchange Traded Funds), bond funds, lifecycle funds, annuities, index funds, private equity funds, hedge funds, and other basket-related investment vehicles.
Mutual funds are only part of the investment game. We haven’t even scratched the surface of individual securities, futures, options, currencies, CDs, real estate, mortgage backed securities, or other derivatives.
The investment menu is virtually endless (see TMI – Too Much Information), and new options are created every day – many of which are indecipherable to large swaths of investors (including professionals).
Sidoxia’s Questions of Engagement
Not all analysis is psychobabble, but separating the wheat from the manure can be difficult. Before engaging in the never-ending over-analysis taking place in the financial world, answer these three questions:
1.) “Do I Care?” If the latest advance-decline statistics on the NYSE don’t tickle your fancy, or the latest “breaking news” headline on monthly pending home sales doesn’t float your boat, then maybe it’s time to do something more important like…absolutely anything else.
2.) “Do I Understand?” If conversation drifts towards complex currency swaptions comparing the Thai Baht against the Brazilian Real, then perhaps it’s time to leave the room.
3.) “Is This New News?” Not sure if you heard, but there’s this new shiny metal called gold, and it’s the cure-all for inflation, deflation, and any-flation (hyperbole for those not able to translate my written word sarcasm). The point being, ask yourself if the information you receive is valuable and actionable. Typically the best investment ideas are not discussed 24/7 over every media venue, but rather in the boring footnotes of an unread annual report.
Investing in the Stock Market
For individual securities it’s best to stick to your circle of competence with companies and industries you understand – masters like Peter Lynch and Warren Buffett appreciate this philosophy. Once you find an investment opportunity you understand, you need a way of appraising the value and gauging a company’s growth trajectory. As Charlie Munger and Warren Buffett have described, “value and growth are two sides of the same coin.” Cigar-butt investing solely using value-based metrics is not enough. Even value jock Warren Buffet appreciates the merit of a good business with sustainable expansion prospects. As a matter of fact, some of Buffett’s best performing stocks are considered the greatest growth stocks of all-time. If you cannot assign a price (or range), then you are merely playing the speculation game. Speculation often comes in the form of stock tips (i.e.,stock broker or Jim Cramer) and day trading (see Momentum Investing and Technical Analysis).
We live in a world of endless information, and the analysis can often become overkill. So when overwhelmed with data, do yourself a favor by asking yourself the three questions of engagement – that way you will not miss the forest for the trees. As for stocks, stick with industries and companies you understand and develop a disciplined investment process by appraising both the growth and valuation components of the investment. If making these decisions are too difficult, perhaps you should stay in the kitchen and have Phillip Rivers whip you up some scrambled eggs or serve you a bowl of oatmeal.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in DIS, BRKA/B, 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.
Sentiment Cycle of Fear and Greed
Investing can be like a cross-country emotional roller-coaster ride to retirement. There are plenty of ups and downs, and plenty of unexpected twist and turns, but as long as investors stay the course, they will eventually reach their retirement objective. If not properly kept in check, however, emotions have the potential of sabotaging and/or delaying retirement objectives.
Barry Ritholtz at The Big Picture revisited the topic of sentiment cycles to hammer home the counterintuitive nature of successful investing (see also Doing the Opposite). As Ritholtz correctly points out in his chart, “euphoria” is actually the emotional “point of maximum financial risk,” and “despondency” is the “point of maximum financial opportunity.”
Source: The Big Picture with RED Sidoxia comments
In other words when the housing market was “euphoric” with demand in 2006, the financial risk was the highest, as millions of leveraged borrowers and homeowners painfully realized. Average investors suffered the reverse problem in early 2009 when “despondency” ruled the day and equity markets have marched upwards approximately +80% to +100%. Millions of investors bought real estate near the peak of the market and sold equities near the bottom of the market. Buying high and selling low is not a recipe for a retirement investment plan.
A more comedic representation of the sentiment cycle is provided below (CLICK TO ENLARGE). Laughable but spot on.
If investing was so simple, Jim Cramer would be among Forbes wealthiest top 10 and Lenny Dyskstra would have his private jet back (see story).
Where we are exactly on the sentiment cycle curve is debatable (my opinion is in RED on top chart), but if investors want to accelerate their path to financial success, they need to play the equity markets a lot more like a game of chess – anticipating future events not reacting to current ones. Too often, what appears as the obvious investment choice generates the worst long-term results. While on the investment rollercoaster, the choices that create the sweatiest palms are usually the best long-term decisions.
Read more about “Sentiment Cycles” from The Big Picture
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.
