Free Money Finance

The Portrait of the Perfect Investor

The following is excerpted with permission of the publisher John Wiley & Sons, Inc. from The Big Win: Learning from the Legends to Become a More Successful Investor by Stephen L. Weiss. Copyright (c) 2012 by Stephen L. Weiss. 

The book profiles various investors, their strategies, and what has made them successful. This excerpt summarizes the author's conclusions as to what makes a great investor and I thought FMF readers would appreciate reading it.

So what are the common threads running through each of these personalities? What makes them so successful at what they do? And is it possible for someone to replicate these traits and processes with the goal of becoming a better investor? The obviousness of all this makes it almost too simplistic to catalog but, never one to pass up a fat pitch, I am going to proceed with a numbered list.

1.  No emotion. Not one of the successful investors I know, and I know many in addition to those chronicled herein, expresses any emotion about the markets. Cool, calm, and levelheaded, they are confident in their strategy and process. In fact, they see the bright side of dislocation — opportunity. They do not get caught up in euphoria and chase stocks or markets, nor do they sell at bottoms because they panicked or were taken by surprise.

2.  No ego. There are many big egos in this business and I have seen ego destroy a fund more often than I have seen it work in its favor. No one in this book had any evidence of ego. Self-confidence, yes, but ego, no. They all recognize that they can be wrong at times.

3.  Long-term investors. Who really makes money actively trading? Not these people; they have too much money to whip around effectively. And, they profess to not being smart enough to trade the market. Very, very few traders are smart—or lucky—enough to consistently make money trading in and out of positions, particularly with the way the markets have evolved. It takes time for an investment thesis to mature, particularly if you are a value investor and usually early to a story.

4.  Discipline. Disciplined risk management and a disciplined investment strategy that they never veer from, ever. Style drift is one of the most popular ways to lose money.

5.  Thorough research process. They all have it: the real estate investors, the equity investors, the commodity investors. Diligent, thorough, and disciplined (that word again). They do not buy anything they don’t know and will not even look at what does not fit into their style.

6.  Passion and work ethic. With unseen opponents and unexpected pitfalls, investing is too tough an endeavor to pursue unless you have passion. Despite the length of time they have been investing and the long days they still put in and the incredible wealth they have all built, they all work extremely hard. Taubman has stepped away from the day-to-day of the company he founded, although he is still the largest shareholder. Instead he has channeled his work ethic to other pursuits, charitable pursuits, working just as hard to find a cure for cancer as he did to build malls and wealth through investments.

7.  Drive.  They all want to be the best  and devote whatever effort it takes to get there.  They all have enough money, so wealth is not the motivator except for what it can do for their families and philanthropically. Moreover, it is the challenge of doing well against the markets, of figuring them out and coming out ahead; of being engaged and having a focus.

Drive. Passion. Process. Equanimity. Discipline. Humility. These are the commonalities between all those profiled in this book and the qualities that make for a great—and legendary—investor.

Your Money or Your Life, Become a Great Investor

Today we're going to cover the final step, step #9, from Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence: Revised and Updated for the 21st Century.

Last time in this series we discussed the Crossover Point, the point where your monthly investment income becomes more than your monthly expenses. Since your money earns enough to cover all your costs (without you working), at this point you are financially independent. Today we're going to build on this thinking with step #9.

The book summarizes step #9 as follows:

Become knowledgeable and sophisticated about long-term income-producing investments and manage your finances for a consistent income sufficient to [cover] your needs over the long term.

This chapter details various investing issues you might expect it to: return, safety, inflation, risk, and so on. But it does this in ONE chapter. As you might imagine, it gives very simplistic and general advice. I can't see anyone reading this and having a viable investment strategy. I wouldn't really expect this any way since the book is more of a "lifestyle finance" book IMO than an investing book, but to even try and cover a complex subject like investing in such a short space (and in a Pollyanna way in many cases) seems a bit careless to me.

That said, their point is valid: if you have the assets to generate enough income to cover your expenses, you better spend some time learning how to make the most of them. Otherwise you may not have them that long.

I'm the last person to say that investing advice needs to be long-winded and complicated. But to me they miss the basics of what it takes to be a successful investor. Then again, they are investing mostly for income and I am not (at least not at this point in my life.)

Even with that said, you'd be much better off reading "Income Investing for Dummies" (if such a book exists) or something similar than trying to develop an investment strategy off of this chapter. There simply isn't that much "meat" in it.

How I Feel About the Book

After several posts on this book you're probably guessing that I'm not in love with it. You would be correct. That said, there are some thoughts that I do like including the following:

• You give up your life to get money. You trade an hour here and an hour there for pay so that your family can survive/thrive. Let's not forget that we're trading hours of life for money when we work.


• Tracking every cent you spend is a good exercise. Maybe not forever, but if you do it for 30 days or so it will be quite insightful. You will certainly learn things about your money and your spending that will totally surprise you.


• Not letting your lifestyle creep up is a key part of financial success. And if you really want to ramp up your money performance, take it to a whole new level and look for places you can cut spending.


• At the same time, look for ways to increase your income. By cutting expenses (or at least keeping them from growing too much) while also growing your income, you'll be increasing your gap -- the difference between revenue and expenses. And this is the fundamental step for anyone wanting to grow their net worth.


• I LOVE the Crossover Point concept. It's the heart of what many of us are trying to accomplishment (as I wrote about in The Safest Retirement). If you can get to the point where your money makes enough to cover your expenses, you are certainly financially independent.

However, there are some negatives to this book for me including:

• The "life energy" talk is a bit esoteric and long-winded for me. I get it, we all trade time for money. But do we need to go on and on about it for four chapters?


• The book is for beginners -- people that know relatively little about managing money. This is a positive if you fit into this group, but for me it was a bit like reading "See Jane run" over and over again.


• The book was high on ideas, but low on practical suggestions. The concepts were often good, but I felt there were not very many thoughts on how to put them into practice. Not to say that there weren't any, but I would have preferred a less theoretical and more practical book.


• The investing section was dreadful, maybe even harmful. Ugh.

Overall, my main impression was that the book was "ok", but nothing special. If I had started reading it from ground zero -- not thinking it was one of the best personal finance books ever (since so many people have said this online) -- maybe I would have thought better of it. But since my expectations were so high, I couldn't help but be disappointed.

Now that you have had the chance to read my thoughts on the entire book, what do you think? Do you like this book? Why or why not? I'm very interested in reading your comments below.

Update: If you want to read this entire series, go here and then follow the links from one post to the next.

2012 Gone-Fishing Portfolio

The following is a guest post from Marotta Wealth Management.

A gone-fishing portfolio has a limited number of investments with a balanced asset allocation that should do well with dampened volatility. Its primary appeal is simplicity. As a secondary virtue, it avoids the worst mistakes of the financial services industry. This year I limited myself to 12 investment vehicles.

Asset allocation begins by selecting the top six asset categories. A good starting point is an age-appropriate allocation. We use as our example a couple both born in 1972 and turning 40 this year. The most popular names of that era were Michael and Jennifer. Their age-appropriate allocation will be 3% short money, 5.8% U.S. bonds, 5.8% foreign bonds, 32.2% U.S. stocks, 36.2% foreign stocks and 17.0% hard asset stocks. (Click to enlarge chart.)

Short money matures in less than two years. Often simply kept in the money market, it can be tapped for emergencies during the accumulation phase or used as a pool for spending during the distribution phase. Michael and Jennifer will put 3% in short money.

Last year I chose a single exchange-traded fund (ETF) representing the entire bond market. This year I suggest two holdings as the best prospects for U.S. bonds and foreign bonds, respectively. PIMCO Total Return (PTTDX/PTTRX) looks for yield wherever it may be on the yield curve. PIMCO Emerging Markets Bond (PEMDX/PEBIX) has a 4.72% yield. Michael and Jennifer will invest 5.8% in each.

In the next few columns, I will explain why these two bond funds are appropriate choices for each category and why I chose mutual funds this year instead of ETFs.

U.S. debt and deficit is enormous. We sit squarely in what investment author Bill Gross calls the ring of fire. We are also burdening businesses with needless regulation and steep tax increases that will continue to stunt economic growth. On the brighter side, the United States is still mostly free according to the Heritage Foundation's Index of Economic Freedom. For these reasons, we recommend investing more in foreign stocks in countries with less debt and deficit than the United States but still investing here.

We normally suggest tilting small and value to boost returns. But this year the projected price-to-earning ratios favor a large blend. Therefore we advise mostly investing according to the S&P 500. We recommend splitting your U.S. stock allocation 80% in the Vanguard S&P 500 ETF (VOO) and 20% in the Vanguard Information Technology ETF (VGT). For Michael and Jennifer that would mean 25.8% in VOO and 6.4% in VGT.

The United States shines when it comes to technology, less burdened under government regulation than financials, energy or now health care. Although it has high volatility, technology also has historically high returns. About 20% of the S&P 500 is already in information technology, so our allocation will put 36.2% of your U.S. stock holdings there. For Michael and Jennifer, 2.3% of their total portfolio will be in Apple stock, the highest concentration in their portfolio.

I would use half of the 12 investment options in foreign stocks. Tilting foreign and toward very specific countries may be the best investment advice for 2012. Avoiding countries low in economic freedom and high in debt and deficit may be critical to experience good investment returns.

Last year I included options for ETFs that represented the MSCI EAFE Index of developed countries before recommending specific countries. The EAFE index stands for Europe, Australia and the Far East. Australia is positive, but the Far East is mostly Japan, a country with the highest ratio of debt to gross domestic product. Most of Europe is also firmly in the ring of fire with high debts and deficits. For every dollar invested in the EAFE index, 61 cents is allocated in these countries. Therefore I recommend investing only in specific developed countries.

First I would put 15% of your foreign stocks in these countries high in economic freedom and low in debt and deficit: Hong Kong (EWH), Singapore (EWS), Australia (EWA) and Switzerland (EWL). I would allocate another 10% in Canada (EWC), lower than the others because of its rising debt. These are all ETFs by fund company iShares.

These five countries have the top rankings in the 2012 Heritage Foundation's Index of economic freedom. They all have low debt and deficit. All five countries have better financial investments than the United States. Australia and Canada have better investments for materials. Canada has better energy investments. Switzerland has better consumer staples and health care investments. These countries are the best places where your investments will be free to grow unhindered by the drag of big government.

Finally, I would allocate the last 30% of our couple's foreign stock allocation to Vanguard emerging markets (VWO). Unlike America and Great Britain's century of invention and innovation, emerging countries today can develop quickly.

All Brazil has to do is to send their children to one of our schools for four years. After returning home, they can buy parts for a factory on the global market and be ready to compete with us in a matter of months. All they need is the capital to get started. That's exactly what your investment provides.

Michael and Jennifer would invest 5.4% in EWH, EWS, EWA and EWL. They would invest 3.6% in EWC and 11.0% in VWO, emerging markets that can be extremely volatile but also very profitable.

The last asset class, hard asset stocks, includes companies that own and produce an underlying natural resource. Examples include oil, natural gas, precious metals (particularly gold and silver); base metals such as copper and nickel; real estate investment trusts (REITs); and other resources such as diamonds, coal and lumber.

Do not equate investing in hard asset stocks with investing directly in commodities. Buying gold bullion or a gold futures contract is a direct investment in raw commodities or their volatility. Buying a gold mining company, in contrast, is a hard asset stock investment.

For 60% of your hard asset allocation, we recommend the iShares S&P North American Natural Resources Index ETF (IGE). This index tracks hard asset stocks in North America. It consists of 62% energy and 15% metals and mining. The largest holding in this fund is Exxon Mobil (XOM), the second largest holding in the S&P 500. Given these two ETFs, Michael and Jennifer will have 1.6% of their investments in XOM.

For the other 40% of your hard asset allocation, we recommend the Vanguard Real Estate Investment Trust ETF (VNQ). This fund invests in all aspects of the U.S. real estate market from commercial to residential. REITs are a very small percentage of IGE or the S&P 500. A specific allocation to this sector provides an additional diversified hedge against inflation.

Michael and Jennifer will put 10.2% in IGE and 6.8% in VNQ. These two investments provide an additional allocation to U.S. stocks, tilting the entire portfolio back toward domestic investments. The total tilt will end up 55% U.S. stocks and 45% foreign stocks. Michael and Jennifer's average gross expense ratio would be only 0.31%. (Click to enlarge chart.)

A gone-fishing portfolio is appropriate for limited amounts of money, especially during the accumulation phase. When investors have significant holdings or approach retirement, I recommend seeking professional comprehensive financial planning from a fee-only fiduciary.

Using Dynamic Asset Allocation to Boost Returns

The following is a guest post from Marotta Wealth Management.

In the last several columns, I have described the investment science that supports dynamic asset allocation. Think of static asset allocation as where to set your sails and dynamic asset allocation as a way to keep your balance as your boat glides and sometimes bounces through the waves.

A static asset allocation, not the same as a buy-and-hold strategy, already has a dynamic component. Buy and hold sets an asset allocation and then allows the portfolio to drift. The portfolio generally moves in a more aggressive direction, increasingly overweighting whatever has done well. It's certainly a better strategy than jumping out of the markets after a drop and waiting to jump back in after a rally. But it isn't the optimum strategy.

Asset allocation is a buy-and-rebalance strategy. Portfolio rebalancing boosts returns. And thanks to a rebalancing bonus, this strategy produces portfolios with either higher returns or lower volatility. By looking at the mean return and standard deviation of an asset class, you can gauge its distance from the efficient frontier. The correlation of an asset class to other asset categories determines the optimum ratios of those two indexes in your portfolio.

We used a ratio of excess return to standard deviation called the Sharpe ratio to measure the efficiency of each asset category. Then we used a proportionally weighted allocation based on the square of each Sharpe ratio to create a portfolio asset allocation. I humbly call this the Marotta allocation method.

Previously we've looked at the Shiller price-to-earnings (P/E) ratio. We took the current price and divided by the average inflation-adjusted earnings from the previous 10 years. This measurement is also known as the cyclically adjusted P/E ratio, or the Cape ratio, abbreviated as P/E 10.

The Shiller P/E ratio helps determine the expected forward-looking return of an investment or index, not if you should be in or out of the markets. Another measurement is the forward-looking P/E ratio. It uses projected earnings for the next 12 months.

The projected P/E ratio can help us decide where to invest. If one index's projected P/E ratio implies it is relatively cheap and another that it is relatively expensive, overweighting the inexpensive index should boost investment returns.

For example, take the projected P/E for the Russell 2000 small cap divided by the projected P/E ratio for the Russell 1000 large cap. This ratio of P/E ratios averages about 1.033. Small cap has a slightly higher P/E ratio because people are willing to pay a little more for a small-cap stock. Although the mean ratio of P/E ratios is close to 1, the standard deviation is 0.122. One standard deviation is a good measurement to use. When the ratio is as high as 1.155, the market is signaling that small cap is relatively expensive and large cap relatively cheap. An allocation tilted more toward large cap should do better. And when the ratio is as low as 0.911, one standard deviation, the market is signaling that small cap is relatively cheap and should outperform in the coming months. Tilting dynamically between asset categories can boost returns even more than asset allocation.

Let's look at four concrete examples for the U.S. stock allocation of our gone-fishing portfolio. Our first two examples represent the extreme indexes of large-cap and small-cap value. First we put everything in the S&P 500. Then we put everything in the Russell 2000 Value. Our third asset allocation is a static one with two thirds in the S&P 500 and one third in the Russell 2000 Value. Normally an allocation that tilts toward small and value will have higher returns. (click chart to enlarge)



The final asset allocation is done dynamically. One third is put into the S&P 500. The remaining two thirds is divided between the S&P 500 and the Russell 2000 Value. Normally the allocation is split evenly. This results in the same allocation as the static asset allocation with two thirds in the S&P 500 and one third in the Russell 2000 Value. This normal allocation occurs when the ratio of the projected P/E ratios is at the mean of 1.033.

But as the ratio of the Russell 2000 projected P/E to the Russell 1000 projected P/E rises, this dynamic allocation will tilt more toward the cheaper large cap. At 1.155, one standard deviation higher, the dynamic allocation will be all toward the S&P 500. And as the ratio drops to 0.911, one standard deviation lower, it will approach the dynamic allocation being entirely in the Russell 2000 Value. Because one third is always in the S&P 500, this results in two thirds in the Russell 2000 Value.

We looked at the mean monthly return and standard deviation of these four portfolios from 1979 through 2011. The S&P 500's monthly return was 0.97% versus the Russell 2000 Value's 1.13%. Annualized, that's the difference between 12.33% and 14.45%. (click chart to enlarge)


The Static 2:1 asset allocation boosts returns by approximately the one-third higher returns of the Russell 2000 Value allocation. The only benefit of asset allocation is that this 0.70% annualized higher return (13.03%) could be gained without any additional increase in standard deviation.

Amazingly, over this time period the dynamic allocation boosts returns another 1.19% over the static allocation, even though the average asset allocation was no different. The dynamic asset allocation has an annualized return of 14.22%, although the monthly standard deviation was no more than the S&P 500. (click chart to enlarge)

Boosting annualized returns by static and then dynamic asset allocation 1.89% without adding monthly standard deviation, you can reap the benefit of careful portfolio construction and dynamic changes based on the ratio of projected P/E ratios. (click chart to enlarge)



We've been using the U.S. stock portion of our portfolio to illustrate how static portfolio construction using the Marotta allocation method gives us a starting target. Then a ratio of projected P/E ratios can be added to offer a dynamic component and boost returns even more. In our typical portfolios, the percentage allocated to a U.S. style box is usually less than a quarter of the total portfolio. But this same methodology can be used with any noncorrelated asset categories to provide a dynamic allocation model.

The Shiller Ten-Year P/E Ratio

The following is a guest post from Marotta Wealth Management.

A common measurement given on financial sites for a stock, index or fund is the price-to-earnings ratio, or P/E ratio.

The P/E ratio is the market price per share divided by the annual earnings per share. For example, if a stock is trading at $15 per share and the company has earnings of $1 per share, the stock would have a P/E ratio of 15. If you bought a share for $15, during the next 15 years you would get your money back in earnings and still own the share of stock.

Although the P/E ratio of the S&P 500 varies widely over time, it averages about 15. Getting $1 for every $15 you have invested equals a return of around 6.67%. This is about the average return over inflation of the stock market.

Your investment appreciates in two ways. First, the value of the company appreciates by inflation, which generally has averaged about 4.5%. Second, the company has earnings that bring an additional 6.7% return. Sometimes a portion of these earnings is paid out in dividends. Other times the earnings are reinvested to grow the value of the company by opening more stores or buying other companies. Regardless of how the earnings are used, the total return in dollars is around 11.2%, about 6.7% over inflation.

Although both the P and E are defined in "per share" terms, the ratio is often calculated for the company as a whole. Total capitalization is price times the number of outstanding shares. And total earnings is earnings per share times the number of shares. Hence the P/E ratio is the total capitalization of the company divided by its total earnings.

Several different numbers can be called the P/E ratio. For example, the trailing P/E uses the earnings for the most recent 12 months. This is the most common measurement, often abbreviated P/E ttm, which stands for "trailing twelve months."

An alternative measurement excludes some of the onetime accounting measurements such as large write-offs that can cause a reduction in net earnings. But sometimes these write-offs should be factored into a company's profitability.

For companies with accelerating earnings growth, investors are willing to pay a high P/E ratio for the stock because they expect the earnings E to be higher in the future. As a result, another P/E measurement uses forward-looking earnings or estimated earnings based on the consensus of analyst-projected earnings over the next 12 months. But analysts are often wildly more optimistic than justified by subsequent operations.

At its core, all investing is paying for an earnings stream. When U.S. treasuries are paying high interest rates, people are not as willing to put money at risk in the markets for an equivalent return. At this point P/E ratios fall until stocks are attractive enough in their expected return. And when interest rates of treasuries are extremely low, P/E ratios can rise because there is no other investment offering an attractive expected return.

There are problems using any of these P/E measurements. Sometimes during recessions a company's earnings can be zero or negative over several quarters. When the trailing 12 months of earnings approaches zero, the P/E ttm approaches infinity. This divide-by-zero error often happens when the stock is about to recover.

A high P/E ratio is normally a sign that P price has become higher than it should. But using trailing 12 months of earnings masks movements in price within the divide-by-zero error. Investors are smart enough to know that zero earnings accompanied by a modest drop in price makes the stock attractive to buy on the assumption that earnings will recover. A P/E ttm measurement, however, will still look terrible.

The difficulty with the common ways of measuring P/E ratios is that we want to measure past earnings even when earnings virtually disappear for a few quarters. What we would really like to measure are the changes in price P that cause a company with a good long-term track record to look relatively cheap. Economist Robert Shiller created just such a measurement.

The Shiller P/E ratio is computed by taking the current price and dividing by the average inflation-adjusted earnings from the previous 10 years. This measurement is also known as the cyclically adjusted PE ratio (CAPE ratio), or P/E 10.

Using 10 years of earnings allows movements in price to play their important role in market cycles. After price has fallen but before earnings have recovered is the best time to invest. The ttm P/E ratio will still look bad, but the P/E 10 will be signaling a buy. Similarly, when the markets are doing well and the last year of earnings make it look like P/E ttm ratios are attractive, the P/E 10 will be signaling you to consider trimming stocks that now look expensive.

In his book "Irrational Exuberance," Shiller shows that P/E 10 is correlated to the subsequent 20-year annualized return after inflation. A low P/E bodes well for the next 20 years of investing, whereas a higher P/E 10 suggests a lower expected return.


(Click image to enlarge)

But even if the P/E 10 suggests a lower expected return, it is still appropriate to be invested in the markets. Even a lower expected return is usually sufficient to justify staying invested. Jumping in and out of the markets is not a good investment strategy.

Additionally, the expected return is a 20-year expected return. You cannot justify jumping in and out of the markets based on a 20-year expected return. And finally, average P/E ratios drift based on several factors that have not been modeled in a well-defined system or formula.

The P/E 10 can suggest the proximity of specific indexes or investments to the forward-looking efficient frontier. If P/E 10 is relatively low for an index or investment, it suggests it is closer to the efficient frontier and overweighting it may boost returns going forward. But if P/E is at historical highs, underweighting or lightening up on that particular index investment may lower volatility or downside risk. You can also use the relative ratio between two P/E 10 ratios to suggest that one asset class may be overvalued while another may be inexpensive.

The movements suggested by this approach are small and gradual. This is a much different approach than stock picking or market timing. Indexing is based on the idea that fees matter, whereas this strategy is based on the idea that price matters. And when price gets ahead of what is justified by the past 10 years of inflation-adjusted earnings, then perhaps the exuberance is excessive.

Style Boxes and the Efficient Frontier

The following is a guest post from Marotta Wealth Management. Click any images below to enlarge them.

Over the past few weeks we've been examining the investment science behind asset allocation. We learned that risk generally follows return. We learned that tilting small and value can boost returns. And we learned that blending investments near the efficient frontier can make even more efficient portfolios.

In our fall conference at Dimensional Funds, Eugene Fama presented the U.S. market returns from 1927 through 2010. He broke them down into 25 style boxes, each representing two deciles of size and value measurements. Style boxes were made popular by Morningstar as a visual representation of size and valuation. Morningstar divides each axis in thirds, but the data we looked at divided each axis in fifths to make a 5 by 5 grid. Each style box from micro-cap value to mega-cap growth had a computation of its monthly mean return and standard deviation to locate it on the efficient frontier.

If the capital asset pricing model (CAPM) represented the entire formula for risk and return, each of the 25 points would be along the efficient frontier in a relatively straight line. But this is not the case. Only 8 of the points were so obviously efficient that no other point had a higher return with a lower standard deviation. Three additional points were nearly as efficient so only one other data point was more efficient.

Given a longer time period, the efficiency of each box would possibly become more apparent, but this does not seem to be the case. At least four boxes do not appear to be anywhere next the efficient frontier because they have high volatility and low returns. There also seems to be a pattern of efficiency curving from large-cap blend down through mid-cap value to small-cap value.

As I have explained previously, not everything is on the efficient frontier. In this case, it appears as though small-cap growth has higher volatility and lower returns than every other category. This situation is both as unusual as it is unexplainable.
It does not appear to be an initial public offering (IPO) effect. Most IPOs are trading below their initial valuation two years after the company goes public. Many of them fall into the small-cap growth category. But even after accounting for these, the category still has higher volatility and lower returns.

In the Fama-French three-factor model, the value factor has a greater effect than the size factor. This is because of the poor performance of small growth. Whatever the reason, reducing your allocation to small-cap growth, on average, should boost your returns and lower your volatility.

In the investing world the Sharpe ratio, named for Nobel prizewinning economist William Sharpe, measures efficiency. It is the amount of excess return above the risk-free rate divided by the standard deviation. I used the equivalent of 3.5% annually for the risk-free rate and computed Sharpe ratios for each style box. This produced Sharpe ratios ranging from 0.046 through 0.217. I also translated the 5-by-5 grid to the more familiar Morningstar 3-by-3 grid.

Sharpe ratios suggest where you should be investing your money. But they do not specify a corresponding asset allocation. We could use efficient frontier calculations. Over any specific time period, however, that might eliminate entirely decent investments that are just slightly off the efficient frontier.

Picking and choosing to invest in specific asset classes comes with a cost. And one of the important principles of efficient investing is that costs matter. Total stock market indexes come with very low expense ratios. Any investment that picks and chooses from among smaller asset classes has to justify returns exceptional enough to overcome higher expense ratios. A better investment strategy allows investments off the efficient frontier. But it underweights them by some ratio of their distance from the efficient frontier.

I made up my own algorithm for computing an asset allocation from a collection of Sharpe ratios. Much of investing wisdom is simple rules of thumb to help you make relatively smart decisions quickly, easily and accurately. It is not hubris to use such methods to approximate a precise decision in an imprecise world. In fact, that's the very way we got the Sharpe ratio. Perhaps in the future this methodology will be called the "Marotta allocation method."

The method involves first squaring the Sharpe ratio of each asset category. A small Sharpe ratio such as the 0.046 of micro-cap growth becomes an even smaller 0.002. The larger 0.217 Sharpe ratio of mid-cap value is not reduced as much and ends up as 0.047.

From the resulting numbers I created an allocation where each category gets a proportional allocation of the 100% total. Where the micro-cap growth starts as 21% of the size of mid-cap value, after squaring the Sharpe ratios, ends up as less than 5%. Squaring makes the small allocations tiny.

So the Marotta allocation method is a proportionally weighted allocation based on the square of each Sharpe ratio. Squaring the Sharpe ratio drastically reduces asset categories in proportion to their distance from the efficient frontier.

For the traditional Morningstar style boxes, this translates to investing only 3.31% in small-cap growth while allocating 18.31% to mid-cap value. And it means 47.82% on the value side and only 15.40% in growth. It also implies 37.84% in mid-cap and only 28.11% in large cap. These asset allocations may seem to tilt more toward the small and value side than many investors are familiar with. Historically, however, this allocation would produce better risk-adjusted returns.

This allocation is relatively easy to approximate with a simple portfolio of low-cost exchange-traded funds. Invest 20% in Vanguard S&P 500 (VOO), 10% in Vanguard S&P 500 Value Index ETF (VOOV), 30% in Vanguard Mid-Cap Value ETF (VOE), 20% in Vanguard Small Cap Value ETF (VBR) and 20% in iShares Russell 2000 Value Index (IWN). This allocation produces a very efficient portfolio for an expense ratio of only 0.19%.

Although this is an excellent static asset allocation, in the next post we will learn how to add a dynamic component to boost returns even more.

Asset Allocation and the Efficient Frontier

The following is a guest post from Marotta Wealth Management. 

Crafting portfolio asset allocations is a combination of art and engineering. Just as a blending of colors can produce cerulean, so a blending of indexes produces a unique shade of risk and return. And these blended portfolios can be better than any of their components.

Many investors don't appreciate asset allocation or understand intuitively how a diversified portfolio can exceed the sum of its parts. After all, the capital asset pricing model (CAPM) suggests that return follows risk, and therefore you can't increase return and reduce risk at the same time. But CAPM is just a straight-line projection. And at the efficient frontier, the math produces nothing but curves.

The efficiency of an investment is measured by the greatest return for the lowest volatility. Blending a portfolio allocation can make it even more efficient by either boosting returns or lowering volatility.

To understand the math behind blended returns, let's start with a simple case of two investment choices and two years. Investment A goes up 30% the first year and 0% the second year. Investment B goes up 0% the first year and 30% the second year. If you invest in either A or B, you get a 30% return over two years. Your average volatility is 15%.

It seems no matter how you mix these two investments, you can't get more than a 30% return over two years. But you can. And you can lower your volatility as well.

Imagine a blended portfolio of half invested in A and half invested in B. The first year you would experience a 15% return, and the second year a 15% return. Your volatility would be 0%. Lower volatility means a more efficient portfolio.

You would have both lower volatility and higher returns. Compounding returns would produce a total return over the two years of 32.5%. You experience a higher return because after half of your portfolio invested in A grows by 30% the first year, you rebalance your portfolio. So half of the growth from investment A is rebalanced and put into investment B. Half the growth would experience another 30% growth the second year when investment B did better. Thus your total return for the two years would be 32.5%.

Most investors are surprised that by creating a blended portfolio and rebalancing regularly, you can both lower volatility and boost returns. But this is the math behind modern portfolio theory (MPT) developed in the 1950s by Harry Markowitz.

MTP requires knowing the average return and standard deviation of returns for each investment component. This situates each component on the risk-return grid. To look at the effects of blending these two investments together, MPT also entails knowing how much they move in sync with one another. This measurement is called the correlation coefficient. Two asset categories that move completely together have a correlation of +1.0. If they move completely opposite, their correlation is -1.0.

The lower the correlation, the greater the benefit of blending two different indexes in a portfolio. Asset allocation means dividing your portfolio into components that do not move completely in sync with one another to reduce total portfolio volatility. There is also a rebalancing that is a function of low correlation and high volatility.



We use historical correlation measurements to help define what qualifies as an asset class and what is simply a sector or subsector. If historical correlations are low enough, we separate two indexes into different asset classes. Otherwise they are just sectors or subsectors within an asset class.
Once you know the average return, the standard deviation of each index and the correlation coefficient between each pair of indexes, the rest is math. The difficulty is that these measurements vary every year and every decade. Long-term averages are useful guidelines, but there are no guarantees.

If long-term measurements put an index just off the efficient frontier, it should not be eliminated entirely. We consider an investment close to the efficient frontier equivalent to one that historically was clearly there. Perhaps the next decade will be its turn to shine.

Most of the time portfolio gains from rebalancing are small at about 1.6% annually. But there are historical periods, especially choppy volatility ones, when the rebalancing bonus is significant enough to bend the mix of a blended portfolio well above either component by itself.



Placing asset categories on the efficient frontier requires knowing their historical average return and standard deviation. These numbers vary depending on the period of time being measured. If you measure risk and return during a time period in which one asset category did poorly, that category will not appear on the efficient frontier. However, if it happened to do well with little volatility during the time measured, it might dominate portfolio construction.

The math is only as good as the assumptions. And the assumptions can only be measured exactly by looking backward at historical returns. But past performance is no guarantee of future returns, which is why portfolio construction is part engineering and part art. There are assumptions to be made. Engineering can suggest elegant answers or art can be crafted with engineering precision, but nothing is guaranteed.

The efficient frontier is the blending of all possible components into portfolios with the highest possible return and the lowest possible volatility. Diversification means you always have something to complain about. But it also allows investors to craft allocations that are along the efficient frontier, getting the most return for the least volatility.

The Efficient Frontier

The following is a guest post from Marotta Wealth Management.

The capital asset pricing model (CAPM) approximates return as a linear function of beta. Beta is a measurement of how much an investment fluctuates in sync with the markets. For a stable bond, beta might be zero. The markets as a whole have a beta of 1.0. Volatile technology stocks might have an even higher beta.

The efficient frontier measures all investments on a scale of risk and return. Risk is commonly placed on the x-axis, and return is placed on the y-axis. Risk is the volatility of an investment as measured by standard deviation. And return is the average return over the same time period. This is similar to the CAPM, but with standard deviation standing in for beta.

The risk and return components of the efficient frontier are computed for a specific time period, usually one year. These are the volatility and return measurements with which investors are most familiar. Investments with a high standard deviation over one year have a lower standard deviation when measured over longer periods. Shorter time periods produce higher measurements of volatility.

Consider the year starting in October 2008. The S&P 500 went from 1,166.36 to 1,057.08, down 9%. For the year, losing 9% seems like a relatively reasonable loss. But the roller-coaster ride bottomed out at 682.55 before recovering. Had you asked investors if they were willing to lose 42% and then from that point gain 55% (as measured from the new low), they might have balked at the volatility.

This is why time horizon matters. There is a reversion to the mean return, but it requires a long enough investment period to revert. Volatility in the long term is much less of an issue than it is in the short term.

The efficient frontier is composed of investments with the highest return and the lowest volatility. The most efficient investments are those such that no other investment has a higher return for the same amount of standard deviation. Or there is no investment with a lower standard deviation for the same expected return.

Many investments fail the most basic criteria even when considering their efficiency. It takes decades of data to determine a strategy's expected return and eliminate random luck. Loyalty to any track record less than half a century should be held lightly. For example, there will always be mutual fund advisors with incredible 10-year track records. Statistically, this is the inevitable result of random chance. It doesn't matter that such a fund manager has a system any more than if thousands of penny flippers had systems. Statistics would still produce a lucky penny.

Investments must be publicly priced and traded to measure volatility accurately. Private equity investments may appear stable, but that is only because you aren't trying to sell them every day and seeing how little or how much you can get for it. Hidden volatility is still volatility.

Any investment that doesn't trend upward is not an investment. It has a zero or negative expected return. These are not investments. They are speculations. All futures or options are bets against the party on the other side of the contract. Such speculations are zero-sum exchanges. And because they have zero expected return, they are inferior to the rate of risk-free return. Therefore, they are not on the efficient frontier.

Finally, many investments are so laden with fees and expenses as to diminish their returns without dampening their volatility. The efficiency of these can be measured, but it will be found wanting. Such investments fall in the lower right quadrant of high volatility and low standard deviation. The correct allocation to inefficient investments is zero percent. Diversification does not mean to invest in inefficient investments. Your goal should be to invest somewhere along the efficient frontier.

The efficient frontier is a continuum of portfolios made up of investments along the upper left edge. Each point on this line represents a potential portfolio that can be built from allocations of the most efficient assets. Most efficient in this case means getting the best possible return for a given amount of volatility.

The efficient frontier is a mathematical construction that can be computed given any finite set of investment options. Only two pieces of information are needed for each investment: average return and standard deviation. These position the investment on the graph and determine if it will be part of the efficient frontier.

The efficient frontier generally tracks the straight line of CAPM, except that it is a curve and asymptotically reaches a point of diminishing returns. Beyond this point additional volatility does not provide any significant additional average return. This limit is generally set by the best performing asset that exists beyond which additional risk can't get a better average return.

Among stocks in the United States, microcap value stocks might have the highest average returns but also the highest volatility. Next might be small-cap value and then mid-cap value. On the low end of volatility would be the aggregate bond index and 30-day Treasury bills.

The efficient frontier is approximated by connecting the dots of all the most efficient investments, but different mixes of investments can produce even more efficient portfolios. To add to this blending effect, one more piece of information is needed: the correlation between each pair of investment options. Next week we will look at how a blended portfolio of asset allocation produces even higher returns.

Why Experts are so Wrong

The following is an excerpt from Jackass Investing: Don't do it. Profit from it.. It's a book that takes "conventional knowledge" on investing and argues that it's a myth.

A truly telling study conducted by Philip Tetlock, a research psychologist at Stanford University, helps to answer this question. The study looked at 82,361 predictions made by 284 experts (pundits).

Tetlock asked the pundits to rate the probability of three potential outcomes for each prediction they felt qualified to make. In the case of an economic expert, he may ask, for example, whether the economy was likely to:

• remain at the same level of growth
• grow faster
• grow slower

What he found was that the experts could literally have been beaten by dart-throwing monkeys. The experts’ predictions were worse than if they had randomly selected the outcome.

And it gets worse. Tetlock asked similar questions to those who were not experts. The experts scored no better than did this non-expert group. Their massive level of knowledge relative to the non-experts did nothing to improve their predictive capabilities. Tetlock wasn’t the first to discover this. In one earlier study from the 1960s, researchers asked college counselors to predict the grades high school students would achieve as college freshman. The counselors were provided with test scores, grades and the results of personality tests. They were also permitted to interview the students. Their results were compared to those derived from a formula based solely on test scores and grades. The outcome was that the counselors were beat by the formula.

An even earlier study from the 1950s involved the results of tests used to diagnose brain damage in patients. This data was presented to a group of clinical psychologists and their secretaries. The result of the study revealed that the psychologists’ diagnoses were no better than the secretaries’.

The fact is that people over-think and quickly form biases based on limited information. Once that bias is formed, substantial effort is employed in supporting it, regardless of whether it is right or wrong. People really hate to be wrong.

Rats!

Right before Christmas, in 2009, my wife was searching for the perfect surprise gift for our three boys. She ended up buying three “Dumbo” rats from the local pet store. (The name “Dumbo” refers to the rats’ big ears, not their intelligence.) While we were told by the salesperson that the rats were smart and could be trained, no one on earth would ever assume that a rat could outsmart a human in any given situation. But in the basic understanding of probability, without-a-doubt a mandatory skill for achieving any measure of success in money management, rats seem to be able to outperform people. Here’s an example that Tetlock witnessed at Yale University 30 years before he published the results from his pundits study.

In this particular Yale study, a rat was placed in a T-shaped maze. The researchers placed food in the left part of the “T” 60% of the time and in the right part 40% of the time. Students were asked to predict on which side of the “T” the food would appear each time. The rat, of course, was left to find the food on his own. The students weren’t told that there would be a bias to one side. But it was the rat who eventually figured out that the food was more likely to appear on the left side than the right and, as a result, almost always went to the left first, scoring roughly 60%. In contrast, the students scored only 52%!  In trying to outsmart the placement of the food, the students seemed to be looking for patterns that clearly didn’t exist and, as a result, were outsmarted by the rat.

This is a common human behavior. We try to outsmart the system (or the market) looking for patterns that don’t exist – desperate to “beat the system.” When that desire is combined with our need to be ‘”right” and our easily established biases, we can become dumber than a rodent. Experts – pundits and advisors – surprisingly enough, are (in most cases) humans too.

This leads us to a third significant discovery made by Tetlock: the more often an expert appears on TV or other media, the worse his or her batting average. Think about that.

The experts who are most often touted, and who reach the most disciples, are shown to be the most often wrong.

This is not surprising. Experts exist to provide the media with a steady flow of content and, more importantly, entertainment. Their purpose is not to provide you with useful, profit-making information. Furthermore, if an expert has staked his reputation on a prediction announced to millions of fans re-peatedly on television, across the Internet, over the radio, and in print, it will be very difficult for him to have a change of mind – even if the evidence overwhelmingly indicates he is wrong. At that point he is locked in to his bias.

If there was ever a reason to avoid expert opinions, this is it.

“One small step for a man. One giant leap for mankind.”

July 20, 1969 was a huge day for me. As a young boy on a fam¬ily vacation, I remember sitting in my grandparents’ living room in Ohio watching the grainy, small-screen television images of the first humans walking on the Moon. I had always been a space buff. I still vividly recall being totally enamored with the Mercury missions and the hero/astronauts who flew them, Alan Sheppard, John Glenn, Scott Carpenter, Gus Grissom, Wally Schirra, Gordon Cooper, and Deke Slayton. Starting with the Apollo program, I had made scrap books for all the flights and my brother and I even rigged up a tape re¬corder to the television to record virtually every telecast of every flight. I still have the tapes today.

The Apollo flights were dramatic from the start. Tragedy struck the U.S. space program for the first time when, in January 1967, the Apollo 1 fire killed Gus Grissom, Ed White and Roger Chaffee during a training accident on the pad at Kennedy Space Center. But the resilience of the U.S. space program was impressive. Less than two years later, Frank Borman, James Lovell and Bill Anders orbited the Moon in Apollo 8. Their Christmas Eve telecast, where they read the first 10 verses from the book of Genesis, was the most watched television program ever up to that time.

NASA had worked hard to earn their newly acclaimed suc-cess. The U.S. space program was an endeavor of immense proportion. More than 400,000 people had been working on the program over a 10-year period leading up to the lunar land-ings.  Finally, after this decade of patient, steady advancement in space flight technology, punctuated by triumphs and catastro-phe, Neil Armstrong and Buzz Aldrin climbed down the ladder of the lunar module to stamp the first human footprint on the moon. …Or did they?

I’ve made up my mind – don’t confuse me with the facts

An otherwise rational guy I know is absolutely convinced that the Apollo moon landings were fake. He’s positive that NASA never reached the Moon. He’s not alone. Depending on where you live, between 6% and 28% of your neighbors side with him. These are the results of polls taken over the past 20 years in places ranging from the U.S.A. to Russia. In a 2009 poll conducted by the British Engineering & Technology magazine, 25% of Britons stated they did not believe humans had ever walked on the Moon.

These people cite numerous pieces of evidence in support of their claim that the Moon landings were a hoax. All of these have been re¬futed numerous times by qualified experts, but the “hoax” proponents continue to thrive. And it doesn’t take much to gain new converts to their cause. In 2001, public skepticism of the validity of the Moon landings increased from 6% to 20% after Fox Television aired a TV show titled Conspiracy Theory: Did We Land on the Moon? In 2000, 28% of Russians polled stated that they did not believe that Americans walked on the Moon.

Despite the solid evidence refuting these hoax charges, de-spite the significant weight of evidence supporting the validity of the Moon landings, despite the enormous implausibility that the 400,000 people who worked in the U.S. space program and the 24 astronauts who went to the Moon, including 12 who walked on its surface, could join together in an elaborate conspiracy to defraud the rest of the world’s population – and keep it quiet – millions of people still believe the Moon landings were a hoax.

People have an enormous capability for ignoring the facts and believing what they have already made up their minds to believe. This capability seems to also hold true with their choices of how to manage their money.

Compounding the problem

Everyone has a bias, which is formed through a combination of research, learned reasoning and intuition. Each bias will be reinforced when you seek out experts, as you will welcome new information that supports your bias and dismiss information that conflicts with your view.

A major problem with following expert advice is that it compounds an individual’s bias.

People form their biases and then only welcome the views of those experts who hold the same biases. And those experts in turn dismiss new information that doesn’t fit in with what they already believe. As a result, people quickly reach a tipping point where their minds are set and they are locked in to their view.

Another friend of mine is a gold bug. She devours any in-formation that supports her view that gold is going up in price. The fact that gold has risen in price for much of the past 10 years only supports her belief in the truth behind this information and the experts who are presenting it to her. But that doesn’t make the information correct. And it certainly doesn’t mean that the result of that information will be higher gold prices going forward. But it does provide her comfort in pursuing her goal of owning a significant amount of gold.

When people get locked in to a view and only consume information that supports their view, they are no longer engaged in the pursuit of profits, but the pursuit of entertainment. All of the studies described above indicate that my friend’s fascination with gold and her acceptance of expert opinion that supports her view will lead to a loss of money. But following “expert” advice becomes a drug. It’s hard to stop. The best advice is not to start.

Buy When There’s Blood in the Street (And Why Buffett is a Market Timer)

The following is an excerpt from Jackass Investing: Don't do it. Profit from it. It's a book that takes "conventional knowledge" on investing and argues that it's a myth.

Perhaps one of the most famous anecdotes related to market timing can be attributed to Baron Rothschild. In July 1870, Napoleon III, the nephew of Napoleon Bonaparte, threw France into a war with Prussia. The result was a disastrous for France. In September 1870 the Prussian army began the siege of Paris.  After a massive bombardment of the city, on January 28, 1871, Paris surrendered and a new provisional government was formed. During the siege however, hundreds of thousands of Parisians became armed members of a citizen’s militia known as the “National Guard,” which held 400 cannons on the Butte Montmartre. The new government viewed this as a threat and ordered its own troops to seize the cannons. But instead, the government troops rebelled against the order and effectively joined forces with the National Guard. Fearfully, the govern-ment members fled to Versailles, leaving the Central Committee of the National Guard as the only effective government in Paris. In keeping with its democratic ideals, the Central Committee arranged for elections for a “Commune,” which took place on March 26th.

Soon thereafter however, government forces returned from Versailles and besieged the city. Their forces, enlarged by French POWs released by Prussia, pushed back the National Guard. The siege reached its climax during “La Semaine Sanglante,” or “The Bloody Week,” in May 1871, when as many as 30,000 people were reportedly executed or killed in fighting. It was at that time that a young man, who had just received a large inheritance, called on the great banking firm of Rothschild to ask their advice on how best to invest his fortune. Here’s a recounting of the story as published in a 1917 edition of The Gas Record:

In 1871 when the Commune in Paris was at its height and the streets were red with blood, a young man called on the great banking firm of Rothschild to ask advice about a large fortune to which he had become heir. The head of the house told him to buy French Government Securities. “What: buy securities when the streets of Paris are running with blood!” was the young man’s surprised exclamation. Baron Rothschild is re¬ported to have said: “My young friend, that is the very reason that today you can buy securities for 50% of their face value.”

This led to the oft-quoted adage “Buy when there’s blood in the street.” Investment opportunities are presented to you at exactly the time you are least emotionally prepared to accept them. That is precisely why they exist.

Fortunately, investment opportunities do not require actual blood to be spilled. Far less dramatic opportunities are pre¬sented every day. And the world’s greatest investors, in fact “The World’s Greatest Investor,” regularly employs market timing.

“The World’s Greatest Investor” (also known as The Oracle of Omaha)

“The World’s Greatest Investor” (the phrase often used when referring to Warren Buffet), is a market timer. Buffet’s company, Berkshire Hathaway, held $47 billion dollars, a full 28% of its market capitalization, in cash at the U.S. stock market peak in the fall of 2007.  This was the most cash ever held by Berkshire Hathaway and turned out to have been a great time to have been in cash, as stock prices fell by more than 50% over the ensuing 18 months. Rather than increasing his stock positions at unattractive prices he engaged in market timing by making the decision to hold a large cash position.

Conversely, as stocks began to collapse during the financial crisis of 2008, Buffet began to buy. First he picked up a distressed position in both Goldman Sachs  and General Electric.  In late 2009 he capped off his buying spree with a purchase of the remaining shares in Burlington Northern Santa Fe railroad that he didn’t already own. At a price of $44 billion, this was, by far, the largest purchase Buffet’s company had ever made.

Buffet knows and uses what you learned in Myth #1 – Stocks Provide an Intrinsic Return – short-term stock prices are driven primarily by people following their emotional weather vane. When they are depressed about corporate prospects, as they were during the 2008 financial crisis, they drive the prices of stocks straight down.

Warren Buffet is a “value investor” only because people, through their knee-jerk buying and selling patterns, consistently provide him with the perfect opportunity to be one.

Perversely, the recognition of this short-term behavior leads to Buffet’s reputation as a long-term investor. Once he’s made his opportunistic purchase, Buffet holds many of his stock posi-tions for long periods of time. He is capturing the benefit of corporate growth, which dominates stock prices over long periods of time. He is hand-picking individual stocks. Not the market. He is interested in reaping the benefits of selecting strong, well-managed companies and being rewarded in higher stock prices for their individual corporate performance.

Stocks aren’t the only financial instrument Warren Buffet market times. As Mr. Buffet succinctly describes in his 2007 letter to shareholders of Berkshire,

The U.S. dollar weakened further in 2007 against major currencies, and it’s no mystery why: Americans are a lot more excited about buying products made elsewhere than the rest of the world is about buying products made in the U.S. Inevitably, that causes America to ship about $2 billion of IOUs and assets daily to the rest of the world. And over time, that puts pressure on the dollar.

And a few paragraphs later he describes a long position he entered into in the Brazilian currency, the “real,” as a way to time the direction of the U.S. dollar:

At Berkshire we held only one direct currency position during 2007. That was in – hold your breath – the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodi¬cally withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth. But any Brazilian who followed this apparently prudent course would have lost half his net worth over the past five years. Here’s the year-by-year record (indexed) of the real versus the dollar from the end of 2002 to year-end 2007: 100; 122; 133; 152; 166; 199. Every year the real went up and the dollar fell. Moreover, during much of this period the Brazilian govern¬ment was actually holding down the value of the real and supporting our currency by buying dollars in the market.

Not only does Mr. Buffet reveal that he is a market timer, but that he is timing a currency which as a market has proven to be the antithesis of buy-and-hold. As he acknowledges, “during the past century five versions of Brazilian currency have, in effect, turned into confetti.” As discussed in Myth #1 – Stocks Provide an Intrinsic Return, and clearly understood by Mr. Buffet, the past performance of a market is virtually irrelevant when considering whether to buy or sell it today. All that mat-ters is whether the return drivers for that market today warrant a buy or sell decision.

“Sure,” you say. “It’s easy for The World’s Greatest Investor to successfully time the market. That’s why he’s The World’s Greatest Investor. But what about me?” The answer is: you can – precisely because most people can’t.

It appears that people are hard-wired for investment failure. Because of that it is easier for financial professionals to instruct their clients to buy-and-hold rather than attempt to time the market, simply because most people will time the market incorrectly. But you don’t have to be one of those people. You can exploit their behavior.

Value: The Third Factor of Investing

The following is a guest post from Marotta Asset Management. It's a continuation of their first factor (CAPM) and second factor (size) posts.

A stock's valuation is the final factor of the Fama-French three-factor model of investment returns.

A stock's valuation is measured on a continuum from "value" to "growth." In broad strokes, value stocks are cheap and growth stocks are expensive. But there are compelling reasons why an investor might be willing to pay more for a growth stock than a value stock.

Consider a local utility company whose stock is selling for $10 a share. The price has not changed much in the past 20 years. The company only services a specific geographic area that is not experiencing population growth. It has also had consistent earnings each year and paid the entire amount to shareholders at $1 per share.

This company has a price per earnings (P/E) ratio of 10. If you were to buy a share of this company, it would take 10 years to get paid back in earnings. After a decade you would have been paid back the price of your purchase and still own your share of stock. This type of stock is considered a value stock.

In contrast, consider a technology startup company that has shown meteoric growth in the past three years. Annual company earnings were $0.25. Then they doubled to $0.50, and now they are $1 per share. The business has just entered into several synergistic deals with other companies that should vastly increase its market penetration. Expectations are for the earnings to continue to double for the next three years.

Investors might rightly decide that the growing technology company is worth more than the static regional utility. If earnings grow to $2, then $4 and then $8, this technology company might be worth $80 a share instead of just $10. If so, the current P/E ratio of this stock would be 80. This type of stock is considered a growth stock.

The P/E ratio is one common measurement used to place stocks on the value to growth continuum. Low P/E ratios are value and high P/E ratios are growth. When computing P/E ratios, the price (P) is easy to compute. Price is the share price on the stock market exchange throughout the day. Calculating earnings, however, is a little more difficult.

Some measurements use the past four quarters of earnings, which is often called the trailing P/E ratio. A projected or forward P/E uses the analyst consensus of the next four quarters' worth of earnings. For companies whose earnings are in flux, these two numbers can be very different.

Additionally, during hard economic times a company's earnings can decrease significantly or even disappear entirely. When earnings go to zero or turn negative, the P/E ratio ceases to make sense.

For these reasons a more common way to place a stock on the value-to-growth scale is the price-to-book ratio. Book value is the value shareholders would theoretically receive if a company was liquidated and all of its assets sold. Using book value ensures that you have some positive number and you won't be dividing by zero.

Many other metrics are used to analyze the value or growth attributes of a stock. These include price per cash flow, cash flow growth, price per sales, sales growth, book value growth and dividend yield. Each metric is simply trying to measure a future return on your investment.

Value and growth stocks react differently to new information. If the local utility company has some additional capital projects one year and only manages to pay $0.80 in dividends, it might not even change the stock's price. Value stocks are more resilient in flat or down markets. Not so with growth stocks.

If the technology startup's earnings grow from $1.00 to $1.80 the next year, the stock's price might tumble 27% from $80 per share down to $58 a share. The company's phenomenal track record of growth would be broken, and a more realistic valuation would be given to the company on account of lowered expectations.

Investors would wonder if instead of doubling earnings from $1 to $2 to $4 to $8, the company might only experience an 80% growth each year. That would mean earnings would grow from $1 to $1.80 to $3.24 to $5.83. As a result the stock might immediately drop 27% from $80 per share down to $58 per share.

Many investors find it baffling that a company could grow their earnings by 80% and the stock would drop 27% as a result. But everything is based on the expectation that the company would grow by 100% each year for the next three years. That expectation was already factored into the share price.

On average, value beats growth. The analysis that Eugene Fama presented during our conference last fall analyzed returns of the U.S. markets from 1927 through 2010. Rather than the price-to-book ratio, he used the book-to-price ratio. Because price is the market price, this is commonly called the book-to-market (BtM) ratio. When the BtM is high, a stock is a value stock. And when it is low, a stock is a growth stock.

Fama analyzed each decile from the lowest 10% of the BtM growth stocks through the highest 10% of the value stocks. The results were remarkable.

The average return of the lowest BtM decile was 10.99%, and the highest decile was 17.32%. There was a continuum such that except for a few, each more valuable decile showed a higher average return. The average return for the top 30% value was 16.30%, a full 4.80% higher than the bottom 30% growth's 11.50%. The neutral 40% in the middle averaged 12.91%.

Most major indexes are split between the value half and the growth half. The S&P 500 has an S&P 500 value and an S&P 500 growth. Similarly, the Russell 1000 Large Cap and the Russell 2000 Small Cap have subindexes for the value and growth side of each.

In my own analysis I measured the returns of the Russell 1000 Value against the Russell 1000 Growth from 1979 through the end of February 2012. During that period, large-cap value returned 13.27% versus growth's 12.47%, a premium of 0.80%.

The difference in small cap was much greater. The Russell 2000 Small Cap Value returned 15.07% versus Small Cap Growth's 12.44% for a premium of 2.63%.

In future articles we will explore how the value premium is higher for small cap than it is for large cap. The landscape of investment returns gets more complex with just the two dimensions of size and value. We begin to see that expected returns do not fit our simple linear formula. Rather they follow a curve.

Adding size and value as factors in our capital asset pricing model shows us certain truths about the markets. Many people follow the Dow and invest like the S&P 500, but tilting small and value provides a better return on average. And while large-cap growth technology companies got all the headlines and captured everyone's attention during the last half of the 1990s, there is quiet money to be made by growing rich slowly with value stocks.

The Downside of Buy-and-Hold

The following is an excerpt from Jackass Investing: Don't do it. Profit from it. It's a book that takes "conventional knowledge" on investing and argues that it's a myth.

We can see that if a person had held stocks over the 111 year pe-riod ending December 31, 2010 and reinvested all dividends, they would have achieved a return of 9.5% before inflation. But the average person’s life expectancy is in the range of 80 years. If you consider that the last 15 or so of those years are the pe¬riod when they will be spending their savings, then that leaves about 45 years to accumulate and invest their earnings (from the ages of 20 to 65). So when considering implementing buy-and-hold as an investment strategy, the first important question to ask yourself is “what length of time should I plan on holding the position?” The answer is “probably much longer than most people can wait.”

Figure 5 illustrates the real (inflation-adjusted) growth in an initial $100 placed into a basket of U.S. stock at the start of 1900, assuming dividends are spent and not reinvested. That will undoubtedly rock the world of people who have been told, as long as they’ve been alive, that stocks work best in the long-run. The most interesting observation here is that it took until 1950 before the value of the initial $100 exceeded and stayed above that $100 value.

Growth of $100 Placed into U.S. Stocks in 1990: Real Returns – Without Dividends

 
Figure 5 (Click to enlarge)

That means that for more than 50 years any person who placed $100 into a broad basket of U.S. stocks, and who did not reinvest his or her dividends, would have suffered a loss, al-lowing for inflation. That really does give new meaning to the term “long run.”

Perhaps most troubling though is the following fact:

All of the real stock market returns earned over the past 110 years can be attributed to just an 18 year period – the great bull market that began in August 1982 and ended in August 2000. Without those years the real, inflation-adjusted return of stocks, without reinvesting dividends, was negative.

This points out the greatest risk of the buy-and-hold strat-egy, which is that stock market returns are extremely “lumpy.”

Secular bulls and bears

Let’s look at real returns without reinvesting dividends. Over the past 111 years, the U.S. stock market experienced four secular bear markets and three confirmed secular bull markets (it is not yet clear whether we are still in the bear market that began in 2000 or have entered into the fourth bull market). Each bear market averaged just less than ten years from the prior peak to the bear market low and suffered an average loss of 68%. On average it took the market 14 years to recover from each loss and the market continued to rise for another six years subsequent to recovering the ground lost in the bear market. This means that for 82 years the market was either in a bear market or recovering from one. It spent 27 years breaking into new high ground.

These figures aren’t as bad as they first appear. First, they are the “real” return from stocks. So this is what your money would have grown to, even after reducing its value for inflation. Second, these figures represent only gains from the rise in stock prices and do not include the benefit of reinvesting dividends. Unfortunately though, a lot of people do not reinvest their earned dividends, or as was the case of the growth stock market of the late 1990s, do not put money into high dividend stocks. As a result they miss out on what, over time, becomes the greatest source for potential stock market returns…dividends. Finally, for people who hold stocks, recovering from a bear market is still good, it means that money is being made (although if they were also invested during the bear market they are merely recovering past losses). So the fact that, on average, 14 years was spent recovering from each bear market still means that the market was going up. If you were astute enough to miss the bear, every year of recovery would have put you into new high ground. Figure 6 lists the secular bull and bear markets since 1900.

Secular Bull and Bear Markets 1900 - 2010


Figure 6 (Click to enlarge)

The average person can easily examine stock market history and feel confident that he or she would have the discipline and perseverance to hold through significant declines of this magnitude. But over the past decade, the investing public has proven otherwise. An average secular bear market length of ten years requires a person to sustain a vigilant, faith-like adherence to the policy of buy-and-hold.

Figure 7 overlays the market P/E ratio at the time of each se¬cular peak and trough. What is obvious from the chart is that the P/E ratio (the price people were willing to pay for earnings) peaked at each market peak and bottomed out at each market trough. What is also evident from the chart is that each of the prior three secular bear markets bottomed with the P/E ratio settling in the single digits. At the market bottom in March 2009 the P/E dropped only to as low as 13.

Growth of $100 Overlaid with P/E Ratio

Figure 7 (Click to enlarge)

What does this information mean to a person committed to buy-and-hold? It means that if their timeframe is less than 20 years, they may be taking on the significant risk that their money in stocks will be worth less at the end of that period than at the beginning. And, as we learned in Myth #1 – Stocks Provide an Intrinsic Return, their returns over that period are more dependent on the whims of other people as reflected in the P/E ratio than on the performance of the stocks of the individual companies in which they place their money.

Interestingly, bear markets are not caused solely as a re-sult of economic contraction, but are instead driven pri-marily as a re¬sult of changes in the multiple that people are willing to pay to own stocks.

Now – why buy-and-hold is wrong

So much for history. Now I will explain why all of that is meaningless.

First, virtually every part of buy-and-hold data was created with the benefit of hindsight. I’ve often joked how much fun investing would be if we could invest in the “Hindsight Fund,” where we decide today where we would have placed our money last week or last year and then get the credit for that. That’s what all the buy-and-hold studies are. Of course, every study is based on retrospective analysis, which may have little to no bearing on real-time action or reaction. Announcing what would have or could have happened, after the fact, with any particular market pick is simply a basis for mildly interesting conversation. It is not a revelation. It is simply an observation.

In 1900 there were more than 100 recognized countries, or sovereign nations, existing across the globe. And, according to Steven T. Brown, William N. Goetzmann and Stephen A. Ross  in “Survival,” “there is historical evidence of at least thirty-six (stock) exchanges extant at the beginning of the (20th) century.”

How many reports have you seen issued extolling the bene-fits of buying-and-holding stocks for the past century in The Netherlands, Germany, Belgium, Hungary, Argentina, Egypt, Denmark, Hong Kong, Turkey, Portugal, Spain, Mexico, Russia, Brazil, Chile, Korea, Japan, Austria and Poland? The answer? …None. And that’s for one simple reason. All of those countries had stock exchanges at the beginning of the 1900s and all of them provided opportunities for people to buy stock for the long run, but all of them suffered major interruptions in their activity due to nationalizations or war. None of them out-performed the returns a person would have made if, instead, they had put their money into U.S. stocks. In fact, out of the remaining countries that did not suffer interruptions in their trading, the inflation-adjusted stock market performance of only three of them, South Africa, Australia and Sweden, out-performed the United States.  Investing in stocks in the U.S., South Africa, Australia and Sweden beat all those other countries during the 20th century.

Here’s why: The baseline conditions in those other countries changed, sometimes multiple times, during the 20th century. Many people were wiped out or had the money they placed in those markets substantially destroyed. In fact, as stated by Brown, Goetzmann and Ross in “Survival,” “more than half (of the markets that existed in 1900) suffered at least one major hiatus in trading.” The reason there aren’t a multitude of books using historical performance to promote the buy-and-hold strategy in all those other countries is because it didn’t work in those countries. Or at least it didn’t work as well in those countries as it did in the U.S. The focus on the out-performing U.S. market is called selection bias. It is sufficiently damaging, all by itself, to be the reason not to rely on buy-and-hold as a strategy.

Think about that. All the studies showing the value of buy-ing-and-holding U.S. stocks have one thing in common; they all had the benefit of hindsight. It did pay to buy stocks in the U.S. in 1900, when the U.S. was an emerging economy, and hold on as stocks rose in price over the past 111 years. But that’s not a good reason to buy stocks today. Baseline conditions change. The conditions which existed in the U.S. in 1990 are different from those which exist today. Merely relying on historical repetition is not a sufficient return driver.

Active versus Passive Fund Management

The following is excerpted with permission of the publisher John Wiley & Sons, Inc. from The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails by Steven M. Sears. Copyright (c) 2012 by Steven M. Sears. 

The discipline of constantly questioning how your money is managed applies to all areas of your financial life. A healthy skepticism will serve you well, especially when picking funds or ETFs. Most investors with account balances under $100,000 should probably only buy ETFs or mutual funds that charge low management fees. If you must choose actively managed mutual funds, look at more than one year’s performance. Compare fund fees. At minimum, see how the fund fared over five years. Ideally, review a fund’s performance over its entire lifecycle. If the fund changed managers, look at how each manager performed. A lot of changes might indicate trouble at the fund. It is probably a good idea to initially avoid mutual fund rankings like Morningstar’s star system. Do the work yourself. Develop your own opinion, and then compare it to Morningstar or other companies that rate funds.

The idea of owning indexes or ETFs that track the market is scary for many investors. Indexes rise and fall with the market. Actively managed funds have someone at the helm who hopefully buys low and sells high. Yet, some two-thirds of all mutual fund managers fail to beat their benchmarks.

Standard & Poor’s put the question to the test. The company found that 71.9 percent of actively managed, large-capitalization mutual funds failed to outperform the S&P 500 from 2004 to 2008. The number was even higher for the S&P MidCap 400; 79.1 percent of mid-capitalization funds failed to outperform the Index. The number was even more dramatic for small-capitalization mutual funds; 85.5 percent of those funds failed to beat the S&P SmallCap 600 Index. Fixed income and international funds had similar performance. The results were similar in the 1999 to 2003 market cycle.

“The belief that bear markets favor active management is a myth,” wrote Srikant Dash and Rosanne Pane, Standard & Poor’s analysts in an April 2009 report that compared S&P indexes versus active funds scored in April 2009.

Standard & Poor’s has a vested interest in shaping perceptions about index funds and actively managed funds. The company makes loads of money licensing its indexes to mutual funds and other financial groups. But the Massachusetts Pension Reserves Investment Management Board does is not similarly conflicted. The fund has a simple mandate: increasing returns on the almost $47 billion under management.

In August 2008, in the midst of the credit crisis, the pension fund fired five active-fund managers for poor performance. Money was taken from Legg Mason, Gardner Lewis, NWQ Investment, Mazama Capital, and Ariel Capital and invested in a Russell 3000 Index and a variety of hedge funds.

“We’ve been managing money here for 24 years and our approach utilizing traditional long-only equity managers has not added value over that span,” according to Michael Travaglini, who at the time was the pension’s executive director.

The pension fund’s decision attracted little attention off Wall Street. Dennis Gartman, publisher of the influential Gartman Letter, read by top hedge funds and banks, felt compelled to alert his subscribers to the decision’s importance. He wrote:

“We strongly suggest that long-only equity managers read, and reread and re-read again Mr. Travaglini’s comment for we fear that this is the death knell for the long-only stock fund manager. His/her age has passed. The era of paying managers to be long of the equity market only, and to recompense them and to applaud them for relative performance is dying,” Gartman wrote. “Money, in the future, will pay only for performance beyond a very small fixed fee, and it will be quite happy to pay well for excess performance. At the same time, it will be swift in culling those managers who do not perform positively.”

Indeed, Travaglini explained his funds decision by saying the pension fund wanted to create a structure that “consistently added value”— and that is precisely the key issue that all investors must remember when dealing with stockbrokers and mutual funds.

Death by a Thousand Fees

The following is excerpted with permission of the publisher John Wiley & Sons, Inc. from The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails by Steven M. Sears. Copyright (c) 2012 by Steven M. Sears. 

Finding a good stockbroker, or reliable mutual fund, entails luck and considerable effort. But there is one critical part of the investment process that is easy to control and that will immediately increase investment returns: fees.

Fees can prove to be the difference between a comfortable retirement, or not. The issue is significant in a low-return environment such as has existed in the United States for more than a decade, and which some pundits believe could exist for a decade longer as the nation, and world, struggles to emerge from the credit crisis. If a stock portfolio annually advances 5 percent, and an investor pays 1 percent in fees, they are giving away 20 percent of their return. No one thinks that way—but they should.

It is not realistic to expect financial products will be free of fees or transaction costs. There is a cost in running banks, exchanges, and even in organizing and selling mutual funds, and operating a stockbrokerage office. Stockbrokers deserve to be paid for their time. But it is important to be realistic about fees. Fees can influence decisions that stockbrokers make for clients.

If you are a self-directed investor, and make your own decisions, and do your own research, online discount stockbrokerage firms that charge low fees are irresistible. Vanguard’s low-cost index funds and exchange-traded funds (EFTs) are hard to ignore. But most people inevitably turn to, or are recruited by, stockbrokers who work for firms such as Merrill Lynch, Wells Fargo, or UBS.

The president of a brokerage firm, who has asked to remain anonymous for reasons that will soon be apparent, says investors must determine if their stockbroker works from left to right, or right to left. That quizzical phrase is how the stockbrokerage chief thinks about stockbrokers and customers. A stockbroker who works from the left to the right first considers how much fee income he will earn off the customer. Fees then determine what products are sold to the customer.

A stockbroker who works right to left focuses on making the right decisions for customers. Telltale signs that a stockbroker cares more about themselves than their clients are recommendations to invest in mutual funds that charge high management fees, or that have high sales commissions, known as loads. Expensive stock commissions are another sign, especially if the stockbroker frequently recommends buying and selling stocks. Frequent trading can be a sign that your stockbroker is “churning” your account to generate sales commissions. That is a red flag. Something is always wrong if your stockbroker earns more money managing your account than you earn through your investments.

Most people spend their financial lives stuck between the underperformance of mutual funds and the overpromising of stockbrokers. Most people enter the market by first buying mutual funds. The familiarity with mutual funds leads them to climb the risk ladder into stocks, and maybe even options. When they have saved enough money, they usually seek—or are sought by—stockbrokers. Having a stockbroker is a rite of passage for many people. When you have enough money, you have a stockbroker. If people are very lucky, they find a good, honest stockbroker who will treat them, and their money, as if it was their own in the best sense of the phrase. If they are unlucky, or have average luck, they meet stockbrokers who treat the clients’ money like their own in the worst sense of the phrase.

The brokerage firm president knows this. He is torn between overseeing the firm and working as a stockbroker. He believes he could make more money managing clients’ accounts, because investors are desperate to work with honest stockbrokers who work right to left. He says too many stockbrokers think about their own interests over the interests of clients.

Stockbrokers generate fees for their banks, and for themselves, based on the size of their “books.” The book is Wall Street lingo that describes a stockbroker’s assets under management (AUM). The more money a stockbroker “manages,” the more money the stockbroker makes. Most investors pay their stockbrokerage firm a 1 percent annual management fee. The stockbroker shares some percentage of that 1 percent fee with his or her employer. A 1 percent fee may not seem like a lot, but it represents $1 million for every $100 million that a stockbroker manages. It’s hard to say what the average stockbroker earns, but a stockbroker with a decent sized book could make $300,000 to $400,000 each year. The best stockbrokers make more, and they are worth every dime, plus their weight in gold.

If you have access to the top stockbrokers, and top banks, you get the best of all possible worlds. If you have a small account, and just have a few hundred thousand dollars, very few stockbrokers will take the time to work with you. They won’t make enough money. The median account size, according to industry sources, is about $88,000. An account that small maybe merits an annual, hour-long meeting.

The size of the book is an asset for brokers. Books are bought and sold. Sometimes by other brokers. Sometimes by other brokerage firms. Every seven years, some stockbrokers switch firms because they can sell their books and get a big check.

If a stockbroker brings a “book” to a new firm and stays seven years, it is common to get a check for three-times revenue. If a stockbroker has a $450,000 income and generates $1 million a year in commissions or fee-income, that stockbroker can get a $3 million check by moving to a new firm. That’s a big enough number, especially when kids are going to college, weddings need to be paid for, or retirement looms.

Fees are not as salubrious to the financial health of investors. Over time, mutual fund fees, for example, devour investor returns.

According to Vanguard, an important mutual fund company, minimizing costs are critical to long-term investment success. This is a counterintuitive point because many people equate high prices with quality. That logic does not always work in the financial industry. Sometimes, high fees are charged simply because they can, and because the people paying the fees do not understand what they are doing. David F. Swensen, the well-regarded chief of Yale’s pension fund, is a sharp critic of the mutual fund industry. He believes individual investors should own index funds, and avoid actively managed funds that charge higher fees. “Instead of pursuing ephemeral promises of marketbetting
strategies, individuals benefit from adopting the ironclad reality of market- mimicking portfolios managed by not-for-profit investment organizations,” Swensen says.1 He believes the mutual fund industry exploits investors. He thinks the U.S. government should intervene.

Vanguard mutual funds, which satisfies Swensen’s dictum, notes that there are five main factors that determine investment returns: dividends/ interest income; operating costs; transaction costs; and taxes.2 Of those five factors, operating costs are the only ones that are fairly predictable. Those costs cover fees paid to the fund manager and administrative, recordkeeping, and reporting costs.

Vanguard cites a February 2002 study performed by the Financial Research Corporation that shows that expense ratios are the most reliable predictor of future performance. Expense ratios overshadowed past investment performance and Morningstar ratings. Vanguard, which specializes in low-cost mutual funds, has a website tool that shows how much money investors lose because of mutual fund fees. A $250,000 mutual fund investment in a Vanguard fund whose average expense ratio is 0.21 percent, and which rose 8 percent annually, saves investors a significant amount of money compared to a mutual fund that charges a 1.15 percent fee. Over 20 years, investors saved $192,675 if they picked the fund with lower fees.

The difference is even more dramatic over 30 years. A $200,000 investment split between two identical mutual funds that earned 8 percent annually respectively, but that charged different expenses ratios proves the point. An investor would earn $242,079 more by investing in Fund A that charged an expense ratio of 0.2 percent, compared to Fund B’s 1.19 percent expense ratio.3 The double insult for investors is that most mutual funds fail to beat their performance benchmarks. For every Dan Rice at Blackrock who continually beats the market, most fail to keep pace. This means investors often pay top dollar for substandard performance. This is a tricky area. Mutual fund companies often market their hot funds. Many investors chase after those hot mutual funds. The irony is that this year’s hot funds are often next year’s duds. This is because the funds tend to attract so much money that managers have a tough time investing the same way as before—or it means the managers just got lucky. But most mutual fund companies—and therefore most investors—focus on one-year market performance—and not enough on low costs and long-term investment results.

An August 2010 study performed by Morningstar confirms Vanguard’s assertion that expense ratios are a “primary test” in fund selection. Russel Kinnel, the analyst who performed the study, found that fees are the most dependable predictor of performance. When picking funds, he recommends focusing on funds in the cheapest, or two cheapest, quintiles.

“In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance,” Kinnel found. “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”4

For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35 percent versus 2.02 percent for the most expensive quintile over the ensuing fi ve years. The gap was similar in other categories, including municipal bonds and taxable bond funds.

Just as dividends are an historically important—and often overlooked— part of the profits investors earn when buying stocks, fees are an important reason why investors often do not earn as much money as implied by the return of certain mutual funds or even entire swatches of the stock market as measured by the Standard & Poor’s 500 Index.

As an exercise, compare your mutual fund’s performance to similar ETFs. ETFs are like mutual funds except they trade on the stock exchange. ETF fees are typically much lower than mutual funds. ETFs are not always superior to mutual funds. Someone who makes small investments each month is probably better off with mutual funds. But someone who has a chunk of cash and is investing in a sector, or even the broad stock market, should consider ETFs—or low-cost index funds. If your mutual fund manager cannot consistently beat a benchmark index, or similar ETF, there is no reason to own the mutual fund. Why pay top dollar for substandard performance?

Size: The Second Factor of Investing

The following is a guest post from Marotta Wealth Management.

In this series we are looking at the Fama-French three-factor model of investment returns. Any model of investment returns tries to predict an investment's returns and volatility by factors that can be measured in advance of investing.

The first factor, beta, taught us that the riskier, more volatile stocks on average have better returns. These same stocks, however, lose more value when the market is declining. We also learned there is no such thing as a safe investment that pays market rates of return.

The second factor of investing is size as measured by a stock's total capitalization. A stock's capitalization is found by multiplying the current share price times all the outstanding shares of stock. In other words, what would it cost to buy all the outstanding shares of stock at the current share price? This is called the total capitalization of a stock.

Today, large cap generally means stocks with a total capitalization of $10 billion. Mid-cap is between $2 billion and $10 billion. And small cap is less than $2 billion in total capitalization. Sometimes investors also categorize mega-cap stocks as those over $100 billion and micro-cap as those under $300 million. Those below $50 million have been called nano-cap.

These absolute dollar amounts have gradually increased as the total U.S. market capitalization has grown. The analysis that Eugene Fama presented during our conference last fall analyzed returns of the U.S. markets from 1927 through 2010. He analyzed each decile from the largest 10% of the market through the smallest micro-cap. The results were remarkable.

The average return of the largest decile was 10.90%, and the smallest decile was 21.26%. There was a continuum such that each smaller decile showed a higher average return. The average return for the smallest half of the market was 17.24%, a full 3.92% higher than the larger half's 13.32%.
Large-cap indexes include the S&P 500 (which is only approximately the 500 largest companies) and the Russell 1000 (which is only approximately the 1000 largest companies). The Dow is also a large-cap index, composed of just 30 large-cap stocks.

The only common small-cap index is the Russell 2000, which is approximately the 2000 stocks after the Russell 1000 largest companies. For the purposes of talking about index returns in this article, I am simply calling the Russell 1000 "large cap" and the Russell 2000 "small cap."

In my own analysis I measured the returns of the Russell 1000 large cap against the Russell 2000 small cap from 1979 through the end of February 2012. During that time period, small cap returned 13.79% versus large cap's 12.94%, a premium of only 0.85%. This is partly due to the last half of the 1990s where large-cap stocks beat small-cap stocks.

But since the 1990s, small-cap stocks have again performed better. In fact, ending February 29, 2012, the Russell 2000 small-cap stocks have an annual return over the past 10 years of 7.00% versus only 4.63% for the Russell 1000 large-cap stocks.

There are many explanations why small firms tend to outperform large firms. First, their share price is more volatile. They have a higher standard deviation that often moves in sync with the markets producing a higher beta. Thus a portion of their excess return is explained by the first factor, beta.
Second, it is easier to double the revenue on a small startup company than it is to double the revenue on a large company. The outperformance of small-cap stocks depends on those few companies with exceptional growth. And the smaller the company, the greater the chance of doubling revenue growth.

Small companies are more likely to pay no or smaller dividends. Large cap is currently paying a 1.77% yield while small cap is only paying 1.27%. This is partly because smaller companies need to use the income to grow, whereas larger companies often have nothing better to do with earnings than return them to the shareholders.

The stock of smaller companies are more thinly traded. This means that a single investor can move the stock markets higher by buying and lower by selling. This is part of what makes small-cap stocks more volatile. Part of the excess return of small caps is dampened by the costs of getting in and out of the market moving the market.

When buying or selling small-cap individual stocks, it is important to put in limit orders so a purchase of a given number of shares does not move the market upward and you do not spend more than you had intended. Similarly, using a limit order when selling ensures that you get a fair value for the shares you are offering.

The conclusion from this study suggests that over time small cap will outperform large cap even after factoring out measurements of volatility. In future columns we will look at other factors of investing as well as indicators that suggest times to tilt even more small or back toward large cap.

CAPM: The First Factor of Investing

The following is a guest post from Marotta Wealth Management.

A group of our advisors attended a conference this past fall sponsored by Dimensional Fund Advisors. In his talk, "Risk Dimensions of the Market," Eugene F. Fama reviewed the latest data on the Fama-French three-factor model for investment returns.

Modeling investment returns seeks to find an equation to predict your expected returns as much as possible. The simplest equation for the markets would be "Return equals 11.71%." This has been the average return from 1927 through 2010, the zero factor model. Put your money in the market, and you will get, on average, 11.71% annually.

The one-factor model, called the capital asset pricing model (CAPM), was developed in the early 1960s. William Sharpe, Harry Markowitz and Merton Miller won the Nobel Prize in economics for this work. CAPM adds a single factor to the equation: risk as measured by standard deviation.

CAPM claims that the riskier the stock, the greater its expected return. Historical analysis provides evidence of how much. The CAPM formula says that the 11.71% returns of the market are actually a risk-free return of 3.67% plus a premium of 8.04% that investors require to take the risks in an inherently volatile stock market.

CAPM goes on to state that although the average premium for investing in the market is 8.04%, the premium is higher on more volatile stocks and lower on less volatile stocks. In other words, investors demand and receive a higher expected return for more volatile stocks. The sensitivity of a stock to market volatility is called "beta."

The beta of a stock measures the likely movement of a specific investment against the actual movement of the market. If the x-axis is the movement of the market and the y-axis is the movement of a specific investment, a line can be graphed of the average for all the movements of the market and the corresponding movements of a specific investment. The formula for the expected return of an investment is the risk-free return plus the stock's beta times the risk premium.

For example, a stock with a beta of 2.0 will go up twice the market premium when the stock market goes up. But it will go down twice as much when the market goes down. Because the market generally trends upward, this stock has a higher expected return. A stock with a beta of only 0.5 will be less volatile but also have a lower expected return.

Individual stocks do not follow these trends exactly. They are only aggregate trends. The more heavily diversified you are and the longer you are invested in the markets, the more your experience will coincide with market averages. But the general idea that systematic risk and average return go together is the important lesson for investing.

Three caveats to note. Systematic risk is undiversifiable market risk. Many investment schemes involve specific risks that can and should be avoided. Also, typically the market is measured by the S&P 500, which ignores the fact that this index only represents a portion of the investable markets. Finally, your experience of market returns is diminished by the fees and expenses of your investment vehicles. Hidden costs are often a significant drag on your specific portfolio investments.

There is no such thing as a safe investment that pays market rates of return. Safe investments average 3.67% annually. If you want the other 8.04%, you must be willing to put your money at risk. You can and should be prudent, but there is no guarantee that you will get all your money back. The general principle is that risk follows return.

CAPM is the one-factor model for investment returns. In future articles we will add two more factors that help explain more of the variance of specific investments against general market returns. In the meantime, we learn from CAPM that the markets are inherently volatile but also very profitable. Historically, the market has paid a premium for risk. And although we cannot avoid systemic risk, we can steer clear of specific risks and high fees and expenses.

Index Funds Win Big

Here's a piece from Moneyland that says index funds win by a landslide. The summary:

Index mutual funds trounced actively managed mutual funds last year by the widest margin in 15 years, once again raising the confounding question: Why do so many individuals gravitate to actively managed funds when they are a proven loser?

Among large-cap fund managers, 79% trailed the return of the S&P 500, says fund tracker Morningstar.

Of course, this is just for one year. A look at another year will show index funds not doing as well. That said, index funds do better on average in most years:

Sadly, these results aren’t all that unusual. More than half of active managers underperform their benchmark year after year. According to the latest S&P Index Versus Active (SPIVA) scorecard: “Over the past three years, which can be characterized by volatile market conditions, 64% of actively managed large-cap funds were outperformed by the S&P 500; 75% of mid-cap funds were outperformed by the S&P MidCap 400; and 63% of the small-cap funds were outperformed by the S&P SmallCap 600.”

The piece then gets to what makes index funds such attractive investments:

The odds of winning are greatly enhanced through lower costs. That’s where index funds enjoy an advantage. According to Money magazine, annual expenses of actively managed funds average 1.3% of assets while index fund expenses average just .69% of assets. Meanwhile, some of the best-known S&P 500 index funds charge less than .2%. In that case, a large-cap manager must beat the market by more than a full percentage point to merely equal the return of the index.

This is a HUGE difference!!!!! Let's look at this info a bit closer:

• "Annual expenses of actively managed funds average 1.3% of assets". Yikes! As an index fund investor, 1.3% seems like a GIGANTIC number.


• "While index fund expenses average just .69% of assets." Perhaps this is the average, but still way too high IMO.


• "Some of the best-known S&P 500 index funds charge less than 0.2%." Pretty good, but we can do better (as I'll show in a minute.)


• "A large-cap manager must beat the market by more than a full percentage point to merely equal the return of the index." Think 1% isn't a big deal? Try plugging in a 6% return instead of a 7% return in any retirement calculator and see just how big a deal 1% is.

Here are the main three index funds I use and their annual expense ratios:

• Vanguard Total Stock Market Index Admiral (VTSAX) -- 0.07% expense ratio


• Vanguard Total Bond Market Index Admiral (VBTLX) -- 0.11% expense ratio


• Vanguard Total International Stock Index Admiral (VTIAX) -- 0.20% expense ratio

As you can see, all have very, very low expenses. And over a 40-year investment horizon (like for retirement), even fractions of a percentage can add up.

The one thing the article gets wrong is the following:

One explanation for the continuing reliance on active management is the lure of being better than average, which by definition is the fate of all indexers.

This is kind of correct and kind of not. If they are referring to the total (or gross) return, then they are correct. But if they are talking about the net (after expenses) return, they are not (FYI, I explained the difference in The Beauty of Index Funds.) That's just the point -- and that's why we see numbers like we do at the top where, post expenses, index funds beat the vast majority of actively managed funds.

Of course there are those that CAN beat the averages on a regular basis. But just because they can doesn't mean most people can. If you don't believe me, check out the details behind why I invest like I do.

Turn Your Tax Refund Into a Solid Investment

The following is a guest post from Jon Stein, Founder & CEO of Betterment.

The factual, “figures” side of money, often has us confused. We can crunch the numbers and figure out the best way to build wealth, but it doesn’t make financial success a certainty. This is because there’s a profoundly psychological element to managing money, and human instincts are often irrational.

The fact is that Americans are struggling to manage their finances: in a recent Gallup poll, 66% of people ranked not having enough money for retirement as their top financial concern. At the same time, people aren't taking the necessary steps to save the amount needed for retirement: according to a survey conducted by the Employee Benefit Research Institute, 46% of American workers have less than $10,000 saved for retirement.

How did it come to this?

Let’s take a look at why, when it comes to money, humans don’t do what we should.

Windfall Gains

Take, for example, an unexpectedly large tax return. How does your brain make sense of this gain? Do you make the most of it and boost your investments? Or do you view it as "free" money to be enjoyed? Chances are it’s the latter…

Mental Accounting

According to Dan Ariely, Professor of Behavioral Economics and Author of “Predictably Irrational”, we allocate money to different categories and don’t see them as interchangeable. A study by Ariely shows that when contemplating the purchase of a $15 pen, the majority of people said they would drive to another store 15 minutes away to save $7 – but they would not make that same effort for a $1,015 suit. The amount saved and time involved are the same, but people make very different choices.

Make the Most of Windfalls

It’s a natural tendency to view unexpected financial gains as a bonus. That money hasn’t been allocated to anything, so why not splurge? But think of the boost that extra income could bring to helping you achieve your goals.

According to the Wall Street Journal, thinking of your goals in real world terms helps you get there faster. Adding $2,000 to a generic “investment” might not seem so appealing, but now imagine that you’re putting that towards a trip to Rome or a down payment on your dream home. It should become easier to find the motivation to stick to the plan.

Studies have shown that when humans are able to picture older versions of themselves, it's easier to save for the future. Think of the activities that you enjoy doing now -- traveling, dining, spending time with friends -- and think of retirement savings as a way to guarantee you can keep doing these things forever.

It Can Be Done

Regular readers of FMF’s blog will be familiar with his story of how he paid off his entire debt – including his mortgage. Each windfall gain – a pay raise, bonuses, income from a side business, and even gifts – went towards paying down the mortgage.

Regular contributions – no matter how small – will make a difference in your progress. Saving a million dollars towards retirement might sound intimidating, but with regular deposits and boosts from your windfall gains, it becomes that much more achievable.

So, when your big tax return comes in, how will you put it to work?

The Key to Great Investment Returns

Here's a piece from Smart Money that profiles what they call 401k Millionaires -- people who have managed to save $1 million or more in their 401ks.

The piece gets to the heart of what differentiates the 401k Millionaires (which is only 0.2% of all savers) versus the average 401k investor that has a balance of $60,000. They don't have higher incomes and they aren't some kind of investing geniuses. Here's what makes them wealthy:

The one characteristic that differentiates the winners from the non-winners here is contribution rate -- a high percentage of those million-dollar savers had constant participation and high contribution rates.

In other words, they invested as much as they could for a long period of time. Wow, I wish I had thought of that. ;-)

Seriously, this is the path that I have followed. Year after year I have maxed out my 401k and saved in other forms as well. I've invested these savings in index funds. and watched them grow. I plan to stick with this method to "get rich slowly" over time.

So far, it's working. My net worth is to the point where I will be able to retire well before age 65 (whether I want to or not is another question.) You can do the same. Wherever you are in your finances, you can be waaaaaay better off in 20 years if you start saving and investing now and keep it up (increasing your savings rate along the way) for a couple decades.

I feel like I'm preaching now. ;-)

Anyone else out there who has done the same? Please share your story with the rest of us.

Are Dividend Stocks Good Investments?

Here's a piece from the Wall Street Journal that can be summarized as follows:

• Bonds (and other forms of income-generating investments) are yielding very low rates. Duh!


• As a result, Americans are plowing a ton of money in high-dividend stocks and mutual funds.


• While doing this can result in a better yield for those needing income, it also comes with extra risks (mainly, the underlying assets can lost their value.)

In other words, a dividend-paying stock isn't the same thing as a bond -- in many different ways.

Given the above, the WSJ suggest four tips for investing in high-dividend stocks and mutual funds as follows:

• Diversify your income sources. To limit stock-related risk and boost income, plan to get income from a mix of bonds, as well as dividend-paying stocks.


• Own some stocks just for growth. Most investors—even those who already have entered retirement—need the capital appreciation that stocks can generate to reduce the risk of outliving their assets.


• Be mindful of fund costs.


• Be sure you're comfortable with overseas exposure. One classic strategy for income-oriented investors—and the funds that cater to them—has been to blend U.S. stocks with European stocks, since the latter historically have had higher yields.

These seem like pretty common sense tips to me. Of course you would never want to put all your eggs in one basket -- especially one that's low on growth, expensive, and subject to either default or large drops.

But what if you found a group of stocks that had lots of room for appreciation, were relatively safe, and had high yields? Something like maybe the Dogs of the Dow?

For those of you not familiar with the Dogs strategy, here's the (edited a bit) take from Wikipedia:

The Dogs of the Dow is an investment strategy popularized by Michael B. O'Higgins, in 1991 which proposes that an investor annually select for investment the ten Dow Jones Industrial Average stocks whose dividend is the highest fraction of their price.

Proponents of the Dogs of the Dow strategy argue that blue chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with high dividend relative to price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low yield companies. Under this model, an investor annually reinvesting in high-yield companies should out-perform the overall market.

The logic behind this is that a high dividend yield suggests both that the stock is oversold and that management believes in its company's prospects and is willing to back that up by paying out a relatively high dividend. Investors are thereby hoping to benefit from both above average stock price gains as well as a relatively high quarterly dividend.

In other words, on January 1 you buy the top 10 Dow stocks with the highest yield. You hold them for a year and rebalance (sell those off the next year's list and buy new ones on the list) each January 1. Supposedly, this will net you a better TOTAL (appreciation plus dividends) return. Whether or not this actually happens is up for debate.

And in case you were wondering, here are the Dogs for 2012:

• AT&T
• Verizon
• Merck
• Pfizer
• GE
• DuPont
• Johnson and Johnson
• Intel
• Procter and Gamble
• Kraft

The highest of these yields 5.82% and the lowest yields 3.1% (as of the beginning of the year), well better than you can do with many other income-producing assets PLUS these stocks are "supposed to" appreciate. Whether or not they actually do/will is again up for debate.

I must admit that this strategy would tempt me if I needed income (like during retirement.) But I'd have to do a lot more research (and develop an overall investing plan) before I decided whether or not to jump in with the Dogs.

We know that one FMF guest poster hates dividend investing, what about you? What's your take on investing in high-dividend stocks/mutual funds and/or the Dogs of the Dow strategy?

The Absolutely Last Chance for a Massive Roth Conversion

The following is a guest post from Marotta Wealth Management.

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This will be your last opportunity to safeguard your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2012, the Bush tax cuts will expire and tax rates will go up across the board. Even the 10% bracket will rise to 15%. There will once again be a marriage penalty on two-income families. A phaseout of itemized deductions and personal exemptions will return. The child tax credit will drop to half. The death tax will return at 55%. The capital gains tax will rise from 15% to 20%. Tax on dividends will increase from 15% to 39.6%.

And these are just the first wave of tax increases for 2013. Obamacare rolls out additional taxes through 2014. Taxes will be higher, but the country will still be in financial trouble. Like a merchant in danger of going bankrupt, the government is trying to raise prices to stay solvent. Cutting overhead, nearly always the solution, isn't even being considered.

It is time to take as much of your business elsewhere as you can before these rate hikes come into effect. Mercifully the government has provided a way for you to get a massive amount of your net worth out from under the growing tax burden. It is time to drive a Brink's truck through the legal loophole of Roth conversions this year. For those of you unwilling to take advantage of this opportunity, the road to serfdom is the default.

If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

There are many reasons to do a Roth conversion this year. Each of them is a new tax burden being laid on the most productive members of society. Moving your money to a Roth IRA is putting your money in the only vehicle where it will never be taxed again.

Traditional IRAs get you a tax deduction now, and you can delay paying taxes until after your investment has grown. With a Roth IRA there is no tax deduction when you deposit the money. But the investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate will be higher when you withdraw the money than it was when you contributed.

In a Roth conversion you transfer your investment from your traditional IRA account into a Roth account. You pay tax on the value of what you transferred. The amount you can convert is unlimited. If you have traditional IRAs worth millions of dollars, you can increase your income this year by millions of dollars. If you are already in the top tax bracket, the conversion will not increase your marginal tax rate.

If you execute a Roth conversion now, you can change your mind later. If you decide the conversion wasn't worth it, you can move the money from the Roth account back to your traditional IRA account in a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.

If you convert this year, you can always recharacterize the conversion next year and undo it. But if you fail to convert this year, you miss forever being able to realize the income under the Bush tax cuts.

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

You are a good candidate for a Roth conversion in 2010 if you have the following characteristics. You have an AGI more than $100,000, so you are being targeted for future taxes. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and higher tax preparation fees.

Even thought this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

I published similar advice in 2010 when it looked like that would be the last year for conversions under the Bush tax cuts. Congress unexpectedly extended the lower rates for another two years. Those who have taken advantage of those two years have moved as much of their money as possible to Roth accounts and saved a tremendous burden of future tax hikes. Now that extension is expiring, and this time there probably won't be another extension.

Freedom Investing 2012

The following is a guest post from Marotta Wealth Management.

I've been discussing foreign freedom investing for a decade now. In the spring of 2010, I used the term "Ring-of-Fire" to describe countries with a high debt and deficit and suggested avoiding them. A year later, I revisited that advice and counseled investors to continue tilting toward specific countries. Now at year end, I will review how freedom investing fared in 2011 and in the decade since 2002.

The Heritage Foundation has released its 2012 Index of Economic Freedom. Since 1994, the Heritage Foundation Index of Economic Freedom has used a systematic empirical measurement of economic freedom to evaluate countries worldwide. The index clearly shows that economic freedom and higher rates of long-term economic growth go together. Investors can use the study to select countries for their foreign stock allocation.

The foundation defines economic freedom as "the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

This year's changes were discouraging. Paul A. Gigot, the Wall Street Journal editorial page editor, wrote in the foreword to this year's report, "The financial panic and Great Recession have sent the march of freedom in reverse, and the policy responses to both events have done little to arrest the retreat." If all that Keynesian spending really did any good, you would expect countries that increased government spending to have better returns as a result. But they did not.

I took 14 of the developed countries with the largest investable markets and compared their current economic freedom score with their returns over the past 1, 3, 5 and 10 years. Only five of these countries are ranked in the free category: Hong Kong, Singapore, Australia, New Zealand and Switzerland. Canada moved from free to mostly free this year. Two years ago the United States fell out as well.

The nations in my analysis included 16 different developed countries representing 85% of the world's investable markets and 98% of the developed countries. Freedom scores ranged from #1 in freedom Hong Kong at 89.9 to #92 ranked mostly unfree Italy at 58.8.

The spread of freedom scores among these countries was more than 30 points. And the trend line for the last year showed an average extra return of 0.36% per freedom point. The 3-year, 5-year and 10-year trend lines between freedom and investment return were similar or better. Over the past decade, countries with freedom have experienced annual investments returns 6% above the EAFE index and 10% above countries like Italy.

This correlation is not accidental. As Italy's government spending has increased, so has its corruption. Big government is not the answer to corruption. It is largely the cause. And excessive government spending does not encourage the private sector. It competes with the private sector.

A country's economic freedom score is based on 50 measurements. They fall under these 10 categories: property rights, freedom from corruption, fiscal freedom, government spending, business freedom, labor freedom, monetary freedom, trade freedom, investment freedom and financial freedom.

The sovereign debt problems of the United States and the European Union affect several of these freedom scores. Nevertheless, we think it is important to look at a country’s debt and deficit as well. Some countries actually follow Keynesian advice and have built up a reserve fund specifically for the lean years of recession. Others simply use his ideas as an excuse to spend even more in the lean year than their normal irresponsibility.

We believe this is one of the times when your asset allocation should tilt foreign and overweight the handful of countries with high economic freedom. Although many economists acknowledge that freedom matters, few investment strategies take advantage of this fact.

Tricky Tactics by Mutual Funds

We've talked a lot about index fund investing and, specifically, how they beat most actively managed funds over a long period of time once costs are deducted from returns. As well as they do, Wise Bread thinks index funds probably beat more actively managed funds than is generally accepted because of some tricky tactics by those other funds. Their summary:

Most funds try to compare themselves to the S&P 500, but many of them cite the performance of the index itself instead of the performance of the index plus the dividend that the 500 companies in the S&P 500 distribute. The current yield on the S&P 500 is around 2%, which means that your fund (or your own stocks) better be outperforming it by more than 2% for it to be worth your while.

Here's my take on this:

• Some mutual funds probably do try to compare themselves to index funds without dividends to give themselves an unfair advantage.


• I would guess (assume) that most reputable rating sites would take total return into account (which would include dividends) when they do their comparisons.


• I'm not so sure that many mainstream media journalists would be smart enough to add in dividends.


• Even if this issue is widespread (which I'm not sure it is), index funds STILL beat the vast majority of actively managed funds over time once all costs are deducted from gross returns.

Anyone have an informed opinion on how commonplace the "not including dividends" comparison is?

Your Portfolio Needs Rebalancing

The following is a guest post from Marotta Wealth Management.

Most investors do not have a balanced portfolio. They look for investments with little to no risk that still provide great rates of return. And by chasing this elusive chimera they miss the easy money they could make from having a good asset allocation in the first place and rebalancing it periodically.

To have a balanced portfolio, you must know your asset categories and what percentage of your portfolio to put in each one. Without such a plan, your portfolio is automatically out of balance.

It is like trying to coach football without knowing the purpose of the various positions on the team. So you send in three quarterbacks, two halfbacks, four wide receivers and a couple of field goal kickers. All too late you realize you have no one in your offensive line to block.

Many investors try to pick a few specific companies in the hope that these companies will do well. This risks picking too many famous quarterbacks. Any position over 15% of your portfolio significantly increases its volatility without increasing the average return. It is best not to put all your eggs in one basket. But again, that makes it critical to know what constitutes a basket. Here are four ways to make sure your portfolio is well diversified.

First, look at what percentage of your investments you put in each country. Putting all of your investments in the United States could be just as risky as putting them all in Greece. Countries are divided into developed countries, emerging markets and those even less developed, sometimes call frontier markets. Countries can also be divided by those with a high sovereign debt and deficit and those with better financial affairs. Countries have also been ranked in 10 categories of economic freedom.

Stocks can also be divided by company size. Larger companies are often less volatile, but smaller companies can provide higher returns. Company size is categorized by their capitalization, calculated by taking the current share price and multiplying it by the total number of shares outstanding. In other words, what would it cost to buy the entire company at the current share price?

Companies with a capitalization greater than $10 billion are considered large cap. Companies smaller than $2 billion are considered small cap. Between those two numbers is the midcap category. Companies over $100 billion are sometimes called mega-cap. And companies smaller than $300 million are often called micro-cap.

Third, stocks can be divided on a scale of value to growth. Value stocks have a high book-to-market value. They are priced reasonably in relation to the company's assets. Value stocks often have a low price-to-earnings (P/E) ratio. These are all indicators that the company is a good buy when considering its intrinsic value or its current stream of earnings or dividends.

Growth stocks are not as reasonable. They have a low book-to-market value. Often they have little or no earnings and usually pay lower dividends if they pay them at all. Growth stocks are overpriced because the market is anticipating that the companies will have exceptional growth. They may not look like a good deal on account of recent earnings, but often earnings are growing at 40% or more every year. A few years of exponential growth often gets priced into growth stocks.

The higher prices for growth stocks are reasonable if they experience a few years of 40% earnings growth. But if one year only delivers 35% growth with a lowered expectation, the stock price can drop dramatically. Growth stocks have a higher P/E ratio because they expect earnings to continue to grow. Diversifying across the spectrum of value and growth stocks can help balance your portfolio's volatility or boost your expected return.

Finally, stocks can be grouped by sector of the economy and industry. Morningstar divides the economy into three sectors and eleven subsectors. Sector rotation tracks nine different categories that tend to do better than average at different times of the business cycle. Value Line uses over 100 industry categories. The industry classification benchmark classifies every stock by industry, supersector, sector and subsector.

Your portfolios can be out of balance based on any of these groupings. Most of us are prone to invest in what we know. Experience with one type of investment makes you more likely to pick similar investments. You may have all U.S. large-cap stocks, the most common out-of-balance portfolio. These are the companies that everyone is familiar with.

A portfolio of Apple, IBM, Google, Microsoft, Oracle, Qualcomm, Amazon.com, Intel and Verizon is unbalanced in multiple ways. They are all U.S. stocks. They are all mega-cap. They are all growth stocks. And they are all in the information/technology industry.

These are all categories that are easily diversified. In fact, you can get the entire world stock market roughly in its current allocation simply by buying two exchange-traded funds (ETFs). The first is Vanguard Total Stock Market ETF (VTI). It contains over 3,000 stocks representing more than 99.5% of the capitalization of the U.S. equity markets.

An investment in VTI is about 71% in large cap, 20% in midcap, and 9% in small cap. It is roughly half value and half growth. And its largest sector is 19% in information technology. These mimic the ratios in the U.S. stock market. And the cost of owning this ETF is extremely low with an expense ratio of only 0.07%. If you wanted to invest according to the world's stock allocation, you would put 44% of your money in this fund.

With your remaining money you would invest in the Vanguard Total International Stock ETF (VXUS). This fund has about 6,700 holdings from 44 different countries. It represents 98% of the world's non-U.S. markets. Europe is about 43%, Japan 15%, Canada 9% and emerging markets 23%. It also has a low expense ratio of 0.20%.

With these two funds you would own the world's stock market in exactly the proportions of global capitalization--all for the low average expense ratio of 0.14%. Any investment philosophy that deviates from this asset allocation should have a good reason to do so. Limiting your investment to 100 or so stocks in a typical mutual fund and paying a 1.2% expense ratio in the process is often a losing proposition. There are reasons to tilt your asset allocation, but the stock-picking expertise of a mutual fund manager is rarely one of them.

Not every categorization is worth diversifying. Only diversify your portfolio across the spectrum of the best investments. Investors make a mistake when they spread their money across whole life insurance, annuities, hedge funds, private placements and other investments with high fees, lockup periods, illiquidity and no public pricing. Many investment products are not on the efficient frontier of investment choices. Avoid them altogether.

Save Yourself a Boatload of Money by Buying the Right Index Fund

I've noted a couple times that not all index funds are the same (see Not All Index Funds Are the Same and Index Funds: Not All Equal.) The way that index funds tracking the same index are not the same is in their fees. And those fees can add up to some big money over an investing lifetime.

Moneyland recently pointed out this fact with the following story:

You’re headed to a picnic and need some ice for the cooler. At the store you see two equal-sized bags of cubes, but they are priced differently. You buy the cheaper one, right? Ice is ice.

Well, the same can be said of stock index funds. Those designed to mimic a certain benchmark, like the S&P 500, are all pretty much alike. Yet they are priced differently—and people routinely choose the ones that cost the most.

So, why do people end up paying more for the same thing? Because they don't understand what to look for. Instead of looking at expenses, they looked at results. And results from different time periods of all things (which aren't comparable). The details:

Researchers asked individuals to allocate $10,000 choosing from four actual S&P 500 index funds that had been in existence for different lengths of time and had different expense ratios. Almost no one focused on annual fund costs, which for an S&P 500 index fund may range from as little as 0.18% of assets to 2% of assets or more. In the survey, subjects almost all chose funds that charged more than 1% of assets.

Almost everyone focused on historical returns. In the study, most looked at returns since fund inception, and because the funds had launched at different times these were meaningless figures that often led investors to the funds with the highest fees.

Paying more than you need to for anything is a bad deal, but when it's on something that's of high value (like when you have $250,000 in your retirement account) and it's over a long period of time (say 40 years or so) it's an especially harmful money move. Here's Moneyland's take on the issue:

If you have $100,000 in an index fund that charges 1.2%, your annual cost is $1,200. But you could chop that cost to $200 with a like fund that charges just 0.2%.

Is that a big deal? Well, yes. You’d save $1,000 a year, which if reinvested in the fund, which compounds quarterly and has average annual gains of 8%, translates into an additional $124,000 over 30 years (and a total of nearly $1.3 million)—just because you understood to focus on the expense ratio.

One simple decision (buy the less expensive option) and you have $124k more. Pretty good deal, huh?

As you know, I like index funds and I use them for almost all of my investments. I focus on three key Vanguard funds (though I have a couple others) and invest in Admiral shares to keep costs as low as possible. Here are the most recent details on my key funds:

• Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX); Expense ratio: 0.07% (94% lower than the average expense ratio of funds with similar holdings.)


• Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX); Expense ratio: 0.11% -- (88% lower than the average expense ratio of funds with similar holdings.)


• Vanguard Total International Stock Index Fund Admiral Shares (VTIAX); Expense ratio: 0.20%     (85% lower than the average expense ratio of funds with similar holdings.)

It's painful to think that the AVERAGE total stock market fund is 94% higher than the Vanguard one. Just imagine what the high-priced funds of the same type charge. They are ripping people off big-time!

If you're reading this, you may want to check the expense ratio on your index funds and if they are too high, look for an alternative. Doing so may save you an extra $100k...

Investing Mostly in Bonds Means a Lower Lifestyle in Retirement

The following is a guest post from Marotta Wealth Management.

Everyone worries about running out of money in retirement. Few people feel secure about government spending and Social Security. Even fewer retirees are confident about the future returns of the stock market.

In the midst of this turmoil, especially after this past summer's sharp drop, many investors wonder if they should put all of their investments into something safe and avoid the markets altogether. What people perceive as secure varies and includes bonds, cash, gold bullion or immediate annuities.

Recent history has proven that safe investments generally don't produce decent returns. For example, bonds get downgraded, and even entire countries default. Cash is currently paying close to zero. Gold bullion lost 69% of its value over a 21-year slide for a consistent annualized loss of 5.5% ending in 2001.

Safe withdrawal rates in retirement are mathematical attempts to determine what percentage of your portfolio you can spend in a given year. That amount is increased by inflation each year. In other words, what is the maximum standard of living you can maintain for the rest of your life and not run out of money before you die?

In financial planning, a good chance means at least an 80% likelihood of staying solvent. Any failure rate less than 20% is considered acceptable. If you aimed for a 100% success rate, your spending rate would approach zero. Financial systems are not well behaved statistically. They are often subject to events that are multiple standard deviations away from the norm. That's why I always describe the markets as inherently volatile. In mathematical terms, market events are not Gaussian; they are subject to power laws. That is, rather than a predictable bell curve of results, they have lumpy tails or more wild returns than you would normally expect.

Government pensions could fail. The markets could drop precipitously. The Treasury could default. Tax rates could double. We could experience hyperinflation. These unexpected occurrences, often called "black swan" events, mean it is nearly impossible to achieve a 100% success rate in retirement.

Multiple studies have tried to compute the safe withdrawal rate at age 65. The original studies suggested 4% was overly safe and 5% was too much. Planners later argued these conclusions were either too aggressive or too conservative. The original allocation was 50% stocks and 50% bonds. Subsequent studies show a better success rate with 75% stocks and 25% bonds. Most studies rebalanced back to a constant asset allocation. But some research suggests that adjusting the asset allocation to gradually grow more conservative provides a higher success rate. Others set the safe withdrawal rate and then blindly increase it by inflation. In the real world, however, people adjust their spending depending on good or bad years in the markets.

Our safe withdrawal rate assumes an age-appropriate asset allocation, starting at age 65 with about 75% stocks and 25% bonds. Normally such a portfolio would average 5.6% over inflation. But the stock market can have wild returns for a decade. We can only count on getting returns that average 3% over inflation, close to the average return of a bond portfolio. The glide path for our top-level asset allocation starts with 75% stocks, but by age 96 the portfolio is completely in bonds. We also recommend making annual adjustments to your safe spending rate rather than blindly increasing your withdrawal rate by inflation regardless of what happened the previous year in the markets.

Given this methodology and investments strategy, our safe withdrawal rate at age 65 is 4.36%. Thus for a $1 million portfolio, the annual safe withdrawal rate is $43,600.

We use projections for average portfolio returns to last until age 100 to ensure an 80% success rate at the average life expectancy. Then we run a Monte Carlo simulation to ensure that 80% success rate. Sometimes clients ask us not to use age 100 so they can safely spend more money. We do not oblige. A 50-50 chance of having money through age 100 provides only an 80% success rate through the end of your life. Our analysis gives you the freedom to spend as much money as you safely can in retirement.

But our safe withdrawal rate is only appropriate if your asset allocation strategy was also designed to maximize success. It should not be used with other investment strategies.

For example, if you put most of your money in more stable fixed-income investments, the odds of averaging 3% over inflation are much less likely. With a bond portfolio, you only have an 80% chance of keeping up with inflation. And simply keeping up with inflation means a much lower withdrawal rate.

A portfolio with an 80% chance of keeping up with inflation has a safe withdrawal rate at age 65 of only 2.78%. At age 65 you have 36 years through your 100th year. With this withdrawal rate you have a 50-50 chance of making it through age 100 and an 80% chance of not running out of money before you die.

Keeping all of your investments in stable bonds might look like an attractive option during volatile markets. But spending only 2.78% of your portfolio at age 65 certainly is not. With 75% of your investments in equities, you can spend $43,600 of a $1 million portfolio. If you keep everything in bonds, you can spend $27,800, less than 64% of your budget otherwise.

A bond portfolio at least keeps up with inflation. Other investments will not. Cash, gold bullion and real estate with no income may not. Keeping your money in cash is probably one of the riskiest strategies. The biggest concern in retirement normally is inflation. And the biggest danger is a black swan event for inflation.

In recent years inflation has averaged 5%, partly because of the double-digit inflation of the 1970s. Official inflation numbers were recently skewed downward because in 1997 the government changed the way it calculates inflation. Assuming an average 5% inflation, safe withdrawal rates for a portfolio invested in cash-like investments is only 1.04% at age 65.

So instead of being able to spend $43,600 of a $1 million portfolio, you would only be able to spend $10,400 at age 65. Spending less than a quarter of your lifestyle is not worth running to cash every time the markets drop. In fact, given market volatility, turning to cash when the markets drop will likely lock in losses at the lowest point.

The markets are inherently volatile. What you must give up in your lifestyle to avoid market volatility is not worth it for most retirees. Make sure your portfolio asset allocation is set appropriately and well diversified across all six asset categories. And then moderate your spending each year in accordance with the safe percentages for your age. Having an appropriate asset allocation matters for what you can safely spend in retirement.

Dividend Investing is Not the Perfect Solution for Yield

The following is a guest post from Barbara Friedberg, MBA, MS, editor-in-chief of Barbara Friedberg Personal Finance, where she writes to show you how to build wealth.

This current low interest rate environment has created a lack of opportunities for investors looking for yield. With Bankrate quoting a 1.15% return on a 1 year certificate of deposit and a lofty 2.25% yield for the 5 year CD, investors are clamoring for yield. This historically low interest rate environment has led the yield starved masses to look towards dividend paying stocks as a method of bulking up their returns.

This article is not going to be another of those “dividends are wonderful” pieces. In fact, I’d like to share a dividend investing horror stories with you so that you understand the down side to this popular trend. Keep in mind, I have invested through the late 1990’s and into the dot com bubble of the early 2000’s when dividends were slammed and capital gains were king. Any one talking about “yield” was considered a fool when stocks were growing 15-30% annually!

So, what happened?

Finance 101

Being a university finance professor, I can’t help myself when it comes to market history. So excuse me if I step on my podium for a moment. Markets are cyclical!! Business cycles and trends come and go. In fact, let’s look at the annual dividend yield** (dividend/price) of the S & P 500 during the first year of each decade since 1881:

Data courtesy Standard & Poor’s and Robert Shiller.

As of November, 2011, the dividend yield of the S & P 500 index is 1.99%. There are some stocks paying much higher dividends than that. One would think that all you have to do is buy a high yielding stock and watch the dividends roll in. After all, the average yield will only go up, and the current yield of 1.99% is much closer to the historical low of 1.11% in August, 2000 than it is to the high yield of 13.84% in June, 1932.

Dividends are Only One Piece of the Return Puzzle

When you buy a stock, your expectation is the dividend will stay steady or rise and the stock price will also increase. That way, the total return will be positive. What happens when this does not occur?

Stocks are historically volatile. That volatility, measured by their standard deviation, means their prices go up and down. Investors don’t worry when the stock prices go up, that type of volatility is okay. But, when the prices go down, well, it doesn’t matter how great the dividend is if the stock price is half of the amount you paid!

Nokia

Nokia was one of those incredibly popular stocks. They were at the forefront of cell phones and on a growth tear for many years. Their popularity was confirmed by the market granting them a lofty price earnings multiple of 59 in 2001. Who wouldn’t want to own a great stock with the largest cell phone market share in the world?

Consequently, being a value investor, I watched this stock for many years waiting for the PE ratio to fall into a more normal range. Fast forward to 2005 and 2006; At that time, Nokia still had a great product and a large market share, but their PE ratio fell from the stratosphere to the mid teens. I purchased many shares over those two years at reasonable prices ranging from the low $20s on up to a few shares at $30. Add the reasonable PE ratio to an awesome growth rate of over 25%  in earnings from 2005 to 2006. I couldn’t lose!

In November, 2011, Nokia shares are trading at $6.75. For those without your calculators, that is a lot less than $20-$30 dollars per share. What good is a high dividend if the market landscape changes, and the company stock price falls?

The Takeaway

Nokia was over taken by the higher margin smart phones. Those phones grew rapidly in popularity and Nokia was slow to adopt. Now, the company is playing catch up and partnering with Microsoft to gain a presence in the smart phone landscape. Meanwhile, they continue to lose market share. It is uncertain whether Nokia will ever regain its market dominance.

As this story illustrates, there’s more to investing than finding a great yield. You must research the growth drivers of the company, the competitive landscape, and be vigilant in monitoring your shares. A great dividend is no reward if the share prices tank. This was definitely a net loss situation.

Today, with a 6.75% yield, Nokia may be a better value. But a stock is never a good value if the company does not prosper!

Is My House an Investment?

The following is a guest post from Marotta Wealth Management.

Just because something costs a lot doesn't mean it is an investment. An investment is something that pays you money.

For most families the largest purchase they make will be their house. It is crucial to understand how to consider real estate holdings in every aspect of wealth management, from asset allocation to retirement planning.

An investment is something that pays you money. Therefore the house you and your family live in is not an investment. Neither is the vacation home you rent occasionally. Nor that piece of land next to your house you bought to preserve your view. It is human nature to justify a purchase by calling it an "investment," but if it doesn't pay you money, it shouldn't be treated as an investment in financial planning.

Historically, equities appreciate at a rate of about 6.5% above inflation. If inflation has historically been 4.5%, equities average about 11%. Equities include stocks, stock mutual funds and stock exchange-traded funds (ETFs). Your portfolio should be invested mostly in equity investments to appreciate at a rate greater than inflation.

Fixed income is more stable, but averages interest payments of 3% over inflation. If inflation averages 4.5%, fixed-income investments average 7.5%. Fixed income includes bonds, bond mutual funds and bond ETFs.

Real estate as an investment falls somewhere between stocks and bonds. On average commercial real estate produces a real return of about 4.9% over inflation. If inflation averages 4.5%, commercial real estate averages 9.4%.

Commercial real estate as property with no income does not appreciate at the rate of inflation. It actually depreciates against inflation by about 1% a year. Fortunately, it should produce 5.9% in profit to overcome this depreciation and produce a real return of about 4.9% over inflation.

Handling commercial real estate privately requires more work. If your commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

These historical averages provide benchmarks as a way to judge the investment worthiness of a particular piece of property. If you own a $300,000 rental home, you should expect to average at least $3,000 each year in repairs and upkeep. One year it might be lower only to have major bills the next. Your benchmark is a real return of 4.1%. After repairs and all other expenses, you should have a profit of $12,300, or 4.1% of your investment. That means you have to have a profit of at least $15,300 (5.1%) or more for your investment to pay you the appropriate amount.

Real estate that pays you appropriately can be considered an investment for the purposes of wealth management. But you need to run it like an investment and track your return after all of your expenses.

This analysis helps explain why property that you do not rent is not an investment. Every $100,000 of equity put into property that lies fallow costs you $1,000 in expenses just to keep up with inflation. And although keeping up with inflation is good, without the 4.1% income there is no way your $100,000 investment will grow to have the increased purchasing power of $273,000.

In financial planning, therefore, we consider fallow property as simply keeping up with inflation and holding its purchasing power. In reality it deteriorates about 1% a year, but we assume your costs of upkeep are factored into your standard of living expenses. Whenever you decide to sell fallow property, that money can be invested either in bonds earning 3% more than inflation or stocks earning 6.5% more than inflation.

A family's home, however, is not even worth that much. Some couples sell a large expensive home, purchase a smaller house and invest the difference. Many believe they will, but when the time comes, their downsized house is so much nicer that little is left over to invest.

Additionally, for many couples the value in their home is used as equity toward an assisted living arrangement. The larger their home, the more expensive the retirement community they buy into. For these and other reasons, we usually do not assume that the equity in a family's home will be available during retirement.

To reiterate, just because something costs a lot doesn't mean it is an investment. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on noninvestments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

What Happened This Summer?

The following is a guest post from Marotta Wealth Management.

This summer many things that should do better over a long-term investment strategy did not. This situation is not unusual for one quarter's worth of time. Such a result only makes reversion to the mean much more likely in the coming quarters.

Previously I've likened investing to playing chess in slow motion: you make a move and then see six months later if it was a good one. Six months is a good time frame, but your investment strategy should be geared for the long term. In this column I am looking at a relatively short-term movement during just the third quarter from June 30 through September 30, 2011.

The returns I am using here are those for specific exchange-traded funds (ETFs), usually iShares, rather than abstract index numbers. I'm using the adjusted close from the Yahoo! Finance site. These numbers are close to the official index numbers, but they are off by the tracking error of the ETF and by the fact that dividends are not counted as being reinvested. I refer to the symbol of the specific ETF in parentheses.

During the second quarter, the S&P 500 (IVV) was down 13.7%. Down months usually invert the basic wisdom of investing. Categories that do better when the markets are up generally drop more when the markets are down. So by maximizing returns for the long term, investors may see their portfolios drop more during a down quarter.

Small cap generally does better than large cap. But this quarter the iShares Russell 2000 Small cap (IWM) was down 21.8%. Value generally beats growth. But iShares Russell 3000 Value (IWW) was down 16.6%, whereas Growth (IWZ) was only down 13.9%.

Foreign stocks generally do better than U.S. stocks. This quarter the iShares EAFE foreign index ETF (EFA) was down 20.6%, and Emerging Markets (EEM) was down 26.2%. North American Hard Asset stocks (IGE) was down 23.1%. All of these returns were significantly worse than the S&P 500.

As my love of games grew, I learned to play party bridge with my mother and would substitute for a member of her bridge club as needed. I did not enjoy the random chance of the deal. There was no score for how well you played, only a score for how well the card fell. It wasn't until I started playing duplicate bridge in my early 20s that I began to love the game.

In duplicate bridge, players compete against multiple partners playing the same hand repeatedly. You might bid and make a small slam and lose because everyone else playing the hand bid and made a grand slam. Or you might be set two tricks doubled and win because everyone else playing your hand let their opponents win the game. As a result, duplicate bridge pushes you to learn how to play the best hand you are dealt.

As a bridge player, you always play the odds. If there is a 60% chance the queen is on your left and you need to finesse, you finesse on the left. You are making the right move even if it turns out that this time the queen is on your right. Playing the odds is always right even when it happens to be wrong this time.

The same principles apply to investing. Staying invested during the summer months, on average, is better than jumping out of the markets every summer. This is true even though the summer months have a smaller average return than November through April. In this regard, investing this summer was not a mistake. It was just unfortunate.

I reserve the term "mistake" for decisions you should have known not to make before investing. For times when the market drops, that is not a mistake. It is just unfortunate. It is a mistake to be invested in annuities with high fees and years of withdrawal penalties. It is unfortunate when tilting small and value, which usually pays off, does not do so for a quarter.

Asset allocation means always having something to complain about. For the past decade it was the S&P 500 that underperformed. This quarter with the S&P 500 down only 13.7% was better, relatively speaking, than many of the other asset classes.

It is instructive to look at the breakdown among foreign countries. The iShares EAFE Index (EFA) was down 20.6%. Japan, an underperformer for years, was only down 9.3% for the quarter. The European Monetary Unit (EZU) was down 29.6%. Germany, one of the best countries in the European Union, took the worst hit and was down 32.1%. Investors reset German stocks in light of the need of the country to bail out Greece and potentially Italy as well. Italy was down 32.5%. European Financials were also down 32.1%.

The six countries with the highest economic freedom according to the Heritage Foundation's study (Hong Kong, Singapore, Australia, New Zealand, Switzerland and Canada) fared better and only averaged down 19.1%.

At least part of the movement in the markets was due to the changing values of currencies. The U.S. Dollar Index strengthened 5.3% during the quarter, first dropping and then sharply strengthening. The Aggregate Bond Index (AGG) was up 4.0%. The euro, in contrast, dropped 7.1%. Precious metals were similarly choppy. Gold rose 8.13% during the quarter while silver dropped 14.6%.

Investing this summer was unfortunate but not a mistake. It is always a good time to have a balanced portfolio. And you shouldn't let a summer quarter's correction ruin a brilliant long-term investment philosophy.

Saving More Beats a Higher Yield

CNN Money addresses a question from a reader about how to best grow his retirement savings. CNN covers a variety of issues in their response, but they focus in on which is the better option -- saving more or having a higher return rate. Their thoughts:

If you could do just one thing to improve your outlook, what would it be? Save more or earn more?

You can't, of course, say you'd prefer an 8% annual return instead of 6% and turn a dial higher to get it. The investing world doesn't work that way. So to try to earn more you have to invest more aggressively.

In this example, both increasing your savings rate from 10% to 12% and shifting to a more growth-oriented portfolio that's 80% stocks and 20% bonds -- an appropriate mix for a 35-year-old -- will boost your chances of retirement success. But saving more has a larger effect than earning a higher return would.

Notice the last sentence. Sooooooo true. In fact, I've noted this a few times here on Free Money Finance. My key thoughts can be seen in the post The Best Way to Maximize Your Investment Return. The summary: saving more for a longer period of time is the best way to increase the value of your investments. And good news goes along with that: it's easier to increase your savings and save longer than it is to increase your return rate (as CNN notes).

That said, why not do all three (save as long as you can, save and much as you can, and get a good return)? You should do all three. Here's what CNN says about it:

In the real world you're not limited to one move. You can bump up the amount you save and improve a sub par investing strategy. Do both those things -- which, ideally, you would -- and you can feel even more confident about achieving a secure retirement.

Here's what I'm doing to grow my investments as much as possible:

• I'm saving/investing as much as I can each year in a variety of ways.


• I'm doing all I can to maximize my return rate by investing in index funds in the lowest cost alternatives I can find.


• I'm going to postpone withdrawing funds from my savings for as long as possible by working part-time once I "retire".

How about you? Are you saving as much as you can? Is there anything you could do to save $1,000 or more extra each year? If you want some ideas, check out these ways to make more money. Perhaps they'll provide some ideas on how you can earn some extra income (which you can then put into savings).

Three Paths to $1 Million

MSN Money lists three paths to $1 million as follows:

Consider these three ways to retire with $1 million:

1. You invest $2,700 per year for 60 years, assuming an annual return of 5%.
2. You invest $14,500 per year for 30 years, assuming an annual return of 5%.
3. You invest $44,500 per year for 15 years, assuming an annual return of 5%.

The first scenario fits more comfortably in most family budgets, requiring a mere $225 a month. The total capital needed to generate that $1 million nest egg is a mere $162,000. For the second scenario, it is $435,000, and it's $667,500 for the third.

In short, compound interest on the proceeds from early investments puts money in your pocket while at the same time saving you money by lowering the outlays into your 401k or IRA. It's a win-win.

My thoughts on this:

• This is right down the middle of what I believe. The underlying advice -- save as early as you can -- is something I agree with 100%.


• As I've noted, saving for as long as possible is the best way to maximize your investment return.


• The numbers above clearly show the power of compound interest, something I've discussed again and again and again and again.


• This is what I've done in growing my net worth -- saving as much as I can for as long as I can. I don't have 60 years to save (even if I had started at 20, I wouldn't be done until I was 80, and I'd like to be done and retired faster than that) :-), and am kind of a combined version of the last two options. I've been saving for 20+ years now and have been saving well over $14.5k per year, so I'm doing fine.


• Anyone noticed that they used 5% in their calculations above? It used to be that we used 10% and moved it to 8% to be conservative. Now with the economy the way it is, we're using 5% -- and that might be too aggressive. Ugh!!

Any thoughts to add? I'm sure many of you have used time and saving to accumulate high net worths. Want to tell us about it?

How to Deal with Market Turbulence

Sound Mind Investing gives suggestions for handling stock market turbulence as follows:

• Remember that market down turns, while unpleasant, are a normal part of investing in stocks.
• Understand that even severe bear markets aren't insurmountable obstacles for long-term investors.
• Imitate the styles of the successful — avoid a trading mentality.
• Accept the reality of today's financial environment — expect market turbulence.
• Think of your monthly cash flow needs and keep sufficient liquidity.
• Focus on where you want to be financially in five to 10 years.

Here's what I'm getting out of this:

Don't panic. Remember that you're investing for the long term (assuming that you are) and realize that day-to-day ups and downs all smooth out over the span of 10, 20 or 30 years. Ignore the news if need be and simply keep doing what you're doing -- saving as much as you can on a regular basis (which will help you buy more shares when the market drops.)

I'll admit that this is easier said than done. It's especially difficult when you have someone calling your attention to all the bad news. I have a co-worker who relishes in the market drops (he's a bear currently) and will let me know with a "the market's down 300 points!" or "there's another 200-point drop" comment from his nearby desk. So I have to remind myself regularly that I don't need my investment money anytime soon and that it will all be worth much more in 15 years. And even if it's not, I have a decent enough savings rate that I'll still be ok in 15 years -- even if the market holds flat. ;-)

How about you? Are you holding steady with all the ups and downs in the stock market?

How to Maximize Long-Term Returns

The following is a guest post from Marotta Wealth Management.

I recently read two articles that provided insight on how investors should respond to a market downturn. The first was Richard Ferri's "The Power of Passive Investing" in the "Journal of Indexes."

He said, "Morningstar weighed in with a comprehensive study on dollar-weighted versus time-weighted returns. They calculated the 1-, 3-, 5- and 10-year time-weighted returns and dollar-weighted returns through 2009 for open-end mutual funds based in the United States.

"The Morningstar study found significant deficiencies in investor timing decisions. U.S. equity fund investors experienced a negative 1.4 percent gap in return over 10 years while bond fund investors experienced a negative 1.3 percent gap over the same period. In aggregate, the timing gap was negative 1.5 percent across all asset classes and sectors."

A time-weighted return is measured by how the fund performed with the dollars it had. It weights each time period equally as though someone remained invested continuously. A dollar-weighted return looks at the inflows and outflows of the fund. It puts a greater weight on the periods when people had more money in the fund and less weight when they had less money in the fund.

Simply put, investors did not experience the full return of the fund because they moved into the fund after it went up and moved out after it went down. By trying to chase returns, their portfolio underperformed the very funds they were invested in by about 1.5%. So if investment advisors simply dissuade clients from chasing returns and moving in and out of what might otherwise be good funds, they may earn their fee and then some.

This is just one benefit of a disciplined approach to investing. Financial advisors perform a service when they dissuade people from impulsive decisions that feel right emotionally but statistically are a bad idea.

The average investor puts money into funds that have done well and takes money out of funds that have done poorly. Using recent past performance to pick investment vehicles often means buying high and selling low. This is one reason that the average mutual fund holding period is three years or about one typical market cycle. Changing funds that frequently is a poor investment philosophy.

You should select funds because they represent an asset class you want in your allocation for the long term. Then you should pick a fund that tracks the index well and has extremely low expense ratios. Investors who choose funds based on recent past performance often keep inferior funds simply because the market is rising. Or they drop superior funds just because the market has corrected.

Make the decision to select a specific asset class based on the long-term characteristics of that subset of stocks. Size, style, sector or country are all possible characteristics you may choose to over- or underweight. Having made the long-term asset allocation, find the fund that best tracks that index for the lowest cost and stick with it.

If you are confident about your long-term asset allocation and one of your selections underperforms the rest of your portfolio, respond by rebalancing your holdings. As a result, you will buy more of what has gone down.

The second interesting article I read was "Incorporating Time into the Efficient Frontier" by David M. Blanchett in the "Journal of Financial Planning." His study builds on the idea that "the longer an investor holds equities the more the compounded average return tends to converge toward the long-term average."

Normally an expected investment return is selected by the expected real return versus the expected risk as measured by the standard deviation. Portfolios on the "efficient frontier" offer the highest possible expected return for a given amount of risk or volatility. Many investors do not understand the boundaries of the efficient frontier. They are unrealistic, expecting portfolios to have a higher return for a lower risk than is possible.

Unfortunately, many investment products are so laden with fees and expenses that including them in your asset allocation results in an inefficient portfolio. Excessive fees drag your performance down without reducing your volatility. For example, the gone-fishing portfolio I recommended in previous columns has an expense ratio of only 0.27%. The average mutual fund has an expense ratio about 1% higher, which is inefficient. And inefficient investments clearly cannot produce portfolios on the efficient frontier.

In the typical efficient frontier, stocks return about 6.5% over inflation and bonds return about 3.0% over inflation. These long-term averages have been measured over two centuries of data. Although we look at these statistics when building a portfolio, any given year--or even decade--produces unique risk-return data.

On average if you want an annual standard deviation of only 6%, you have to settle for an expected real return of about 3%. If you want a real return closer to 6.5%, you will have to tolerate volatility of close to 20%. This is the classic risk-return curve for a one-year investment horizon.

Although few investors have a one-year investment horizon, we all experience the markets one year at a time. In fact, we experience the markets one day at a time, and some days it seems like the sky is falling.

Although recently the Dow has dropped precipitously, it began in December 2010 at 11,050. Unduly concerned investors are measuring returns from the high-water marks, not even from levels as long as a year ago. This typical psychology affects even the most seasoned investors.

The only antidote for such emotional reactions is to adhere to a disciplined investment strategy designed to maximize returns over a specific time horizon. And that's where Blanchett's study can help. In addition to charting the one-year efficient frontier, he also charted the 5-, 10- and 20-year efficient frontiers.

His work confirms that different portfolios make sense over different time periods. Aiming for a 6.5% real return for one year requires enduring higher risk. The 5-, 10- and 20-year efficient frontiers reduce the risk considerably. Over longer periods of time, returns tend to revert to the mean.

We use these statistics when suggesting that clients put the next five to seven years of spending rates in cash and bonds and invest the remainder of their portfolio in equities. Dividing the portfolio in this way provides enough stable investments for the next several years along with sufficient appreciation for long-term financial health. Thus it allows clients the best chance to sleep well tonight and still eat well in 10 years.

One client, who is a bridge master, made the analogy that in bridge you have imperfect information. But you are always playing the odds, which is always the right decision, even if it turns out to be wrong in one particular hand.

Investing is very much like that. It is never a mistake to have a balanced portfolio and to select investment vehicles with low expense ratios. But asset allocation also means you will always have something to complain about.

If you don't have an asset allocation of low-expense investments on the efficient frontier, get one. Nothing is more important. And if you have such a game plan, don't let short-term fluctuations in the market deter you from a brilliant long-term strategy.

Free eBook on Gold Investing

Just found this today: Sound Mind Investing has a new (and free) ebook on investing in gold. I haven't read it yet (though I did get a copy) so I can't comment on what I think of it, but I thought some of you might want to check it out.

I do trust and value SMI's perspective on investing, so I'm guessing that I'll agree with their take on what to do about gold.

And for those of you who are suspicious, no, I was not compensated in any way for posting this.

Index Funds Versus Actively Managed Funds Versus You

US News talks about three investing numbers: 9, 7.5, and 6. Here's their explanation of each:

Nine percent is the annual historic growth of the S&P 500. The average investor could simply buy and hold the S&P 500 Index, go play golf, and look up in twenty years to see a nice achievement—9 percent returned year after year.

If, however, a retirement investor is not happy with this 9 percent success, he can hire a professional mutual fund manager to actively manage his money in an effort to beat the market. This brings us to our second number—7.5 percent, or the historic annual returns of actively managed mutual funds.

The spread between the historic returns of the S&P 500 and the historic returns of actively managed mutual funds is 1.5 percent or the amount collected in fees by these Wall Street pros. Which brings us to our third number: 6. According to Mauboussin's findings, 6 percent is the actual historic return that everyday retirement investors in America achieve over time.

My first thought when reading this: ha!!!!

Seriously, here are a few comments from me:

• The beauty of index funds is that their low costs have a built-in return versus actively managed funds. In effect, you start out 0.5% to 1.5% ahead simply by going with an index fund versus one run by a professional money manager.


• If you think you can do better than the average investor, you may be able to -- and still be well behind what an actively managed fund and an index fund can deliver.


• If you think you can out-perform an index fund on average, it's very likely that you're very wrong. This is why I invest like I do -- because it's a very rare individual investor who can beat the market (after fees.)


• Despite all this talk about getting the best return rate, the length of time you are invested in the market (followed by the amount you save/invest) is the most important factor in determining the success of your investments. So it's best to focus on both of these first and return rate last.

For those of you who don't know, I prefer Vanguard for my index funds, but Fidelity has a nice selection as well IMO. Any of you use these or do you recommend another company?

"Go Fishing" in the Calm Sea of Bonds

The following is a guest post from Marotta Wealth Management. FYI, I received this post a couple weeks ago. Not sure he'd offer the same advice now given what's going on with the U.S. government.

Adding bonds to an all-stock portfolio can boost returns and lower volatility, especially in choppy markets. Bonds should be a small but important part of your gone-fishing portfolio allocation.

Creating a gone-fishing portfolio begins with a top-level asset allocation. For a typical 40-year-old investor, the percentage in stable fixed-income investments would be 14.6%. The remaining 85.4% would be allocated among appreciating equity investments.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). These decisions are the most critical in determining the overall behavior of your portfolio returns.

In the stable asset classes, you loan a company money to be paid back at a fixed rate of interest. Examples include money market, certificates of deposit (CDs) and bonds. These asset classes are like the iron rods that support a sailing ship. They don't make the ship go faster, but they do keep it from capsizing in a storm.

Investors approaching retirement should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing their allocation to stability when stocks are appreciating helps secure future years of spending.

In a more sophisticated portfolio, we would divide the allocation to stability into short money, U.S. bonds and foreign bonds. For a 14.6% stable allocation, we would put 3% in short money, 5.8% in U.S. bonds and 5.8% in foreign bonds.

Short money includes any fixed-income investment with a maturity date of two years or less, which includes money market accounts and many CDs. Short money investments are not paying a great rate of interest right now. But when interest rates rise, they will adjust quickly and be among the first investments to gain from the higher rates.

Many risk-averse investors put their money in a bank account or invest in CDs. But like any other investment, cash has its own set of risks. It is dangerous because the dollar can be devalued so the same number of dollars won't buy as much as they used to. There are good reasons to hold cash, but holding too much for too long makes it harder to grow your assets and can jeopardize your financial goals.

The second asset class, U.S. bonds, generally pays a higher interest rate the longer their duration and the worse their credit quality. But longer term bonds drop more in value when interest rates rise. And bonds whose credit rating drops lose value too because of the chance of default.

Putting money in stable instruments because you want to reduce risk only to invest in high-yield junk bonds is counterproductive. So is increasing the term of a bond when interest rates are very low. We recommend higher quality short- and intermediate-term bonds. Invest a portion of your assets in stable investments, and if you want a higher return, put the money into appreciating assets.

Foreign bonds are the third stable asset class. They can balance domestic currency values and interest rates with what's happening in the rest of the world. And they sometimes pay a higher interest rate. Foreign bonds also appreciate when the U.S. dollar is declining in value. Foreign bonds are subdivided into bonds in developed countries and bonds in the emerging markets. Like U.S. bonds, foreign bonds are categorized by quality and duration.

Over the long term, stocks outperform bonds and bonds outperform cash. Appreciating assets are essential to your portfolio. They are the engine of your retirement savings. Even in retirement, you will need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low, fixed-income investments currently are earning below their historical averages.

But you aren't adding bonds to your allocation for their return. You are doing it to keep a portion of your assets safe when the markets drop. And when they do, you will rebalance by selling some of these safe bond investments and putting the money back into the markets.

This means you aren't all that concerned about bond yield. The appreciation side is your engine of growth. Put more money there if you want more appreciation. You also aren't interested in yield curves, inefficiencies in the yield curves or whether or not we are in a rising interest rate environment. All these are important areas where a more sophisticated portfolio management could add value. But you are specifically trying not to watch these issues. You are trying to go fishing.

The good news is that you don't have to eke every cent of yield out of your stable investments to meet your financial goals. You don't need to invest in high-yield junk bonds so long as you have a healthy allocation to appreciating equities. As a result you could invest your entire allocation to stability in a single U.S. bond index fund.

For example, the Vanguard Total Bond Market Index ETF (BND) has a low expense ratio of 0.11% and includes investment-grade corporate, U.S. Treasury, mortgage-backed and asset-backed securities with an average duration of 5.2 years and an average maturity of 7.4 years. The current yield is 0.65%, and the fund represents more than 4,900 bonds.

BND is sufficient for your gone-fishing bond allocation, but any short or intermediate relatively high-quality bond mutual fund or ETF would meet your investment needs so long as the expense ratios are low. As a second bond fund, consider adding iShares Barclays TIPS Bond ETF (TIP). It also has a relatively low expense ratio of 0.20%. And it consists entirely of Treasury Inflation-Protected Securities (TIPS).

The top-level asset allocation decision between stocks and bonds determines both the ultimate return you will receive and the volatility you will experience. Bond allocations tend to get complex as investors try to make bonds act more like stocks. Invest a little in bonds, but make them quality bonds. This strategy allows you to put a larger portion of your investments in appreciating stocks.

The purpose of a gone-fishing portfolio is to set a simple allocation for each asset class so you can sleep at night and rebalance once a year. Keep some in bonds so you have stable investments with which you can rebalance if the markets fall in value.

Why Do We All Hate Annuities?

The combination of a couple posts on annuities has had me thinking the past few days and I thought I'd share it all with you.

Let's start with Smart Money's suggestion that retirees should have fewer stocks and more annuities as follows:

Fewer stocks, more annuities. That, in essence, is the advice gleaned from two just-published reports for the benefit of those living in or approaching retirement.

Retirees should invest just 5% to 25% of their portfolios in stocks, or at least that's the case for those whose primary goal is to minimize the risk of running out of money and sustaining their withdrawals, said one report published by Putnam Investments new think tank.

And, Americans can avoid the risk of outliving their assets by saving more, working longer, investing wisely, delaying Social Security and buying a life annuity, according the Government Accountability Office (GAO).

A few thoughts on these:

• I know Putnam offers investing products, but do they sell annuities as well? Interesting if they don't since they'd be telling people to do LESS business with their company.


• "Saving more" -- something most people should be doing and the best way (IMO) of getting your retirement nest egg to where it needs to be.


• "Working longer" -- not something you can count on (what if you can't physically work longer)?


• "Investing wisely" -- easier said than done, though index funds offer a pretty good option for anyone.


• "Delaying Social Security" -- depends on how long you think you will live (I know, hard to determine).


• "Buying a life annuity" -- the topic of conversation today.

The heart of the issue is that annuities offer guaranteed income while stocks may go up or may go down and are thus not dependable for a steady stream of income -- something many retirees need and/or MUST have.

That's the same issue the NY Times recently discussed when it wrote on the annuity puzzle. The quandary is this: when given the option of steady income but with no ownership control of the underlying assets or a variable income that could go way up or could go way down but still be within the control of the owner, most people pick the steady income. But when it comes to practice, most opt for stocks over annuities -- they choose the risk over the guaranteed income.

Why is this? Basically, it's because Americans hate annuities. Yes, there's much more to it than that, but that's the bottom-line IMO. Some thoughts from the Times:

There are other explanations for the unpopularity of annuities, but I think two are especially important. The first is that buying one can be scary and complicated. Workers have become accustomed to having their employers narrow their set of choices to a manageable few, whether in their 401(k) plans or in their choice of health and life insurance providers. By contrast, very few 401(k)’s offer a specific annuity option that has been blessed by the company’s human resources department. Shopping for an annuity with hundreds of thousands of dollars at stake can be daunting, even for an economist.

The second problem is more psychological. Rather than viewing an annuity as providing insurance in the event that one lives past 85 or 90, most people seem to consider buying an annuity as a gamble, in which one has to live a certain number of years just to break even. But, as the example of Dave and Ron shows, it’s is the decision to self-manage your retirement wealth that is the risky one.

The most complex and unknowable part of that risk is in predicting how long you will live. Even if there are no medical advances in the coming years, according to the Social Security Administration, a man turning 65 now has almost a 20 percent chance of living to 90, and a woman at this age has nearly a one-third chance. This means that a husband who retires when his wife is 65 ought to include in his plans a one-third chance that his wife will live for 25 more years. (A “joint and survivor” annuity that pays until both members of a couple die is the only way I know for those who are not wealthy to confidently solve this problem.)

My take on these thoughts:

• Buying an annuity is certainly complicated. And there seems to be so much fine print. Are you comfortable forking over $500,000 while signing a document with 15 pages of 5-point font? I know I'm not really excited about it.


• Many who sell annuities aren't the trustworthy types. Many are "slick" insurance salesmen who you get the sense are just out to rip you off. I think these people have turned many off of annuities.


• Fees don't help either. There's a perception that annuities are expensive and have lots of fees. Compared to investing in stocks, they are and do. But they also provide a service/safety that stocks don't. Besides, the real comparison is the "value" they offer, not how their costs compare to those of stocks. If they offer what you want for less than what you can do it for yourself, they are a worthwhile purchase, correct?


• There are legitimate issues with the solvency of the issuing company. You don't want to fork over a boatload of money that goes bankrupt several years down the road. And picking the most solid of the solid companies isn't any sort of guarantee. Ten years ago no one would have thought AIG would have had the trouble they have had the past few years. And with insurance-company-killers like Hurricane Katrina and the tsunami in Japan seemingly on the rise, is anything completely safe with an insurance company?


• Americans certainly like to be in control of things, and annuities force you to give up control.


• There is certainly a case for the psychological argument. Maybe annuities inherently seem like a gamble that most people will never win.


• Perhaps it's the "death by a thousand cuts" problem. I mean, look at all of the reasons I've been able to list for why people may hate annuities. At some point, there are simply so many negatives that people probably just think there's no way it's worth all the trouble and potential problems.

I'm not sure what I'll eventually do with annuities -- whether I'll get one (or more) or try to go it the do-it-yourself route. One thing that will give me some flexibility is that I'll likely have much more saved than I'll need for income, giving me a bit more freedom to decide whether or not an annuity is the right move for me.

And if I do decide to go the annuity route, I will probably consider laddering them (including going with different companies for different annuities) as part of my overall strategy.

What's your take on the issue? Do annuities get an unfair bad rap or is the bad rap deserved? Anyone out there decided for or against annuities? Why do you think this way?

"Go Fishing" with Hard Asset Stocks

The following is a guest post from Marotta Wealth Management.

Hard assets have been one of the most significant asset classes over the last decade. From all indications, it will continue to be a critically important investment category to protect your portfolio from the effects of inflation and the continuing devaluation of the U.S. dollar.

Creating a gone-fishing portfolio begins with a top-level asset allocation. For a typical 40-year-old investor, the percentage in hard asset stock investments would be 17.0%.

Diversifying your portfolio will help lower your risk and increase your returns. One of the asset classes we use to achieve that goal consists of hard asset stocks. These hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver); base metals such as copper and nickel; and other resources such as diamonds, coal, lumber and even water. We recommend broadly diversifying your hard asset stocks by resource type, by geographic location of a company's reserves and by company size.

Investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Buying a gold mining company, in contrast, is a hard asset stock investment.

The S&P North American Natural Resources Index tracks hard assets. It consists of 62% energy and 15% metals and mining. These top-10 stocks represent about 43% of its holdings: Chevron, Exxon Mobil, Schlumberger, ConocoPhillips, Occidental Petroleum, Suncor, Freeport-McMoRan Copper, Apache, Barrick Gold and Halliburton.

We segment hard asset stocks like these into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks is generally less correlated with the movement of other asset classes such as bonds. Second, hard assets have a unique (and positive) reaction to inflationary pressures. And third, at certain periods in the longer term economic cycle, including hard assets helps boost returns.

As of the end of May 2011, this index was up 12.76% year-to-date compared with the S&P 500's 5.92%. Its five-year annualized return is 9.72% compared with the S&P 500's 2.62. Beating the S&P 500 by more than 7% for the past five years is just one of the benefits of investing in this index.

The beauty of hard asset stocks is that they are not highly correlated to other categories. Most importantly, the correlation between the S&P North American Natural Resources Index and the Lehman Aggregate Bond Index over the past year was -0.28. A negative correlation means that the bond asset class and the natural resources asset class are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk that inflation poses to a bond portfolio.

Over time, dollars lose their buying power and the goods and services we buy cost more. As an asset class, commodities generally maintain their buying power in dollar terms. Stocks as an asset class generally appreciate over inflation after dividends are factored in. And over the past decade, hard asset stocks have been appreciating nicely.

Because of inflation, cash, normally a safe store of value, has been the riskiest investment since 2002 when the U.S. dollar began losing much of its purchasing power. Since then, the U.S. Dollar Index has dropped more than 37%, from 120 to 74.7. It has also dropped more than 76% against gold as gold appreciated from 360 to 1536. The dollar has even dropped 37% against the euro as the euro appreciated from 0.90 to 1.43.

During inflationary times, U.S. bonds are not a safe store of value either. They pay a fixed rate of return in diminishing dollars. But a little bit of hard asset stocks helps balance the fixed-income portion of your portfolio.
The simplest allocation to hard assets would put 100% of your hard asset allocation in the iShares S&P North American Natural Resources Sector Index ETF (IGE) that tracks this index. It has a low expense ratio of 0.48% and represents more than 150 holdings.

A slightly more sophisticated hard asset allocation might put 60% in IGE, 30% in Vanguard REIT Index ETF (VNQ) and the last 10% in the iShares S&P Global Materials Sector Index ETF (MXI). If your allocation to hard assets was 17%, this would result in investing 10.2% in IGE, 5.1% in VNQ and 1.7% in MXI.

VNQ seeks to track the performance of the MSCI US REIT Index. It has an extremely low expense ratio of 0.12%, and its correlation to IGE was a relatively low 0.66 over the past year. It has more than 100 holdings. It was up 28.5% last year and is up an additional 14.1% year-to-date. Vanguard’s new fund, VNQI, tracks the foreign REIT index. We are considering adding this as well into the mix of hard assets.

MXI seeks to track the performance of the S&P Global Materials Index. Its correlation to IGE over the past year was a relatively low 0.78. It includes foreign mining companies such as Australia's BHP Billiton and Rio Tinto, Brazil's Vale, Germany's BASF, Canada's Potash Corp and the United Kingdom's Anglo American. The expense ratio is only 0.48%, and holdings number more than 120.

These two holdings should broaden your allocation to hard assets by including more REITs and mining and therefore provide additional rebalancing bonuses.

The purpose of a gone-fishing portfolio is to set a simple allocation for each asset class so you have time to visit some of these countries and enjoy the fishing. Include a hard asset stock allocation and rebalance each year.

Simple and Effective Investment Advice

I read this piece while on a plane recently and was pleasantly surprised to see a money "expert" be so basic and down-to-earth with his advice. Here's what I especially liked about what Andrew Tobias said:

Tobias's core advice -- spread your bets, keep your costs low, but before you do anything in the market, save every nickel you can -- has held up through six revisions [of his book], the latest of which came out this year.

Couldn't agree more. After all, didn't I say that the amount of time you invest and the amount saved are far more important than return rate? He's giving the same basic, simple, and effective advice.

The interview goes on:

What do you mean when you say that after a certain point, it doesn't help to know more about investing?

If you're using more complex strategies, that implies active trading. Transactions have costs. There are brokerage commissions. You have the spread. And then you have taxes if the trade's not in a tax-free account. Plus, you are competing with folks who are very smart. You may be smart too, but most people can't compete with the Wharton graduates who do this full-time.

Again, I agree 100%. This is why I invest like I do.

And finally:

The market's every bit as hard to outwit as ever -- you can have faith in that. So I still prefer index funds: With their low fees and terrific tax efficiency, index funds are like horses with 20-pound jockeys running against horses with 200- and 300- and 400-pound jockeys.

I detailed these thoughts (and more) when I wrote about the beauty of index funds.

I didn't know a lot about Tobias up until now. I had heard his name, of course, but didn't know what he wrote about or anything about his money philosophy. But now I've found a new "expert" to like and I'm even tempted to buy his book. Then again, I'm pretty sure I know what it says -- and that I already put the principles into practice. ;-)

Make All Your Money Work as Hard as Possible

Somehow I stumbled on Early Retirement Extreme's series of posts on how he became financially independent in five years (a very interesting read -- the gist is to live on 10% to 40% of what you make and save/invest the difference). In the last part of the series, he makes this comment:

One important lesson was that if you have $100,000 and a ROI of 5%, then spending 20 hours figuring out how to increase ROI from 5% to 6% is worth $1000 or $50 an hour. I was certainly not getting paid $50/hour in my day job. This meant that dealing with investments was now more profitable than my job, economically speaking. I decided that since I had saved the assets, I should learn how to invest them.

He goes on to tell how he then started to learn about investing so that he could maximize the return on his assets.

I have a few thoughts on what he has to say as follows:

• This "1% difference" is a compelling point, especially when looked at over time. For instance, $100,000 at 5% over 40 years leaves you with $704k. If you simply bump up the return rate to 6%, you get over $1 million after 40 years.


• Though return rate is important, the impact of the savings is driven more by the time and amount invested than by the return rate. If you add $2,000 extra savings per year to the $100k noted above at 6% you end up with over $1.3 million over 40 years. And if you save more than $2,000 a year (which most people can), you can end up with an even bigger nest egg.


• You can control the amount you save and the amount of time you save for much more than you can the return rate you get. So your first actions in making the most of your investments are to take these steps. Once you have these set, then you can focus on eeking out that extra 1% (if you dare.)


• The extra 1% return rate, while significant, isn't that easy to reach. Think of it this way, professional money manager who can consistently beat their competition by 1% are the best money managers in the world. More often the difference between "the best" and "the rest" is fractions of 1%.


• 1% saved in expenses is the same as 1% earned in extra return. Which would you rather have: an investment with 2% costs and a 10% return or one with 1% costs and 9% return? Wouldn't matter, right, since both return 8% in the end.


• Saved expenses are more reliable than extra earnings. Said another way, lower costs are GUARANTEED returns whereas "making better investments" to earn more may or may not pan out. This is one of the main reasons I invest using index funds -- their costs are so low that their net returns (gross returns less costs/expenses) beat most actively managed funds over the long term.


• All this said, I haven't made the most of my portfolio the past few years. We saved a good amount in cash when we were looking to buy a new house since we wanted to pay cash for it. Over a few years I had put together a nice house fund (while still fully funding my 401k, FYI). But once we decided not to buy, it took a while for me to reallocate those funds, so I probably had a couple years where I missed getting a good return on a decent-sized amount of savings. Shame on me. I've since mostly corrected this problem (I'm still trying to reach a balance of what should be kept in cash and what should be invested), but I certainly left money on the table for two years (though they were turbulent years for the market, so who knows what would have ultimately happened.)


• To me, the point about the extra 1% is less about literally earning an extra 1% on your investments and more about this: make sure all your money, whatever its purpose (emergency fund, college savings, retirement savings, etc.), is working as hard as possible for you because that extra amount you may earn by managing it correctly can be significant. This post is a reminder of this fact for all of us -- me included.

Any extra thoughts to add that I missed?

Gold: A Misunderstood Metal

The following is a guest post by MasterPo.

With the remarkable rise in the price of gold over the last 2 years (as of writing this – in spite of the recent pull back) as well as the apparent uncertainties, even declines, in more traditional icons of American economic prowess the yellow metal has once again come to the forefront of interest by both preppers and individual investors. Add to that the boom in ETFs (Exchange Traded Funds) and it seems like “gold for the masses” is the order of the day. Consequently almost every preparation blog, book, and podcast devotes quite a bit of time discussing the use of gold (and silver) in a SHTF or TEOTWAWKI event.

And most of them get it wrong.

In terms of preparing for an economic disaster they misunderstand the role of gold (and silver) in a preparation plan. In fact, one of the main arguments against buying gold – that being you can’t eat it - is closer to the real understanding of the purpose of the metal in a survival plan.

Trade?

Barter?

Maybe.

But the primary purpose of owning physical gold is not as a “universal currency” for if/when the dollar collapses. MasterPo highly doubt the supermarket will be accepting gold coins for groceries no matter what the American economy does. That is not to say some form of exchange or barter for gold won’t happen. It surely will. But that isn’t the main reason for owning gold.

The primary purpose for having physical gold is as a store of wealth in shaky economic times. Period.

It is true that if some calamity befell the entire world gold would probably be useless compared to more basic human needs like food. But the likelihood of such a worldwide disaster really is low. It would take something like a nuclear war or asteroid hit or other cataclysmic event for such to come to pass. A massive economic reorganization is a far more likely scenario in terms of national or global calamities. And as such, gold (and silver) will still be of value in whatever new currency systems come out from the aftermath.

And it is true that gold can go down just as easily as any other investment. Though to this argument I ask: For gold to return well below the $1,000/oz level the dollar would need to soar and the economy to grow soooooo much as to be unrealistic. In the longer term maybe. But not today, tomorrow, and not likely next week.

The exact value of that gold after such an economic event is unknown. But it will surely be far more than whatever the prevailing paper fiat currency is (was) just prior to the event. And that is its function: To store wealth for conversion into a more exchangeable form later.

If you are fortunate there may even be an opportunity to grow your wealth through gold ownership in the times of trouble. But that too should be seen as an alternate benefit of owning gold and not the primary reason.

History proves that physical gold is a viable means of storing wealth when transitioning from one economic reality to another. Far better than whatever paper currency is the normal at the time. The gold mined by the ancient Egyptians, Mayans, Greeks etc still holds value today. Even without the historical context, just melted down it has a high value as a metal.

MasterPo is not suggesting you should be selling everything you have and buy gold. Certainly if it’s a matter of paying the mortgage or buying a gold coin, pay the mortgage first! The future is not at all certain, in spite of recent national and global events. But just as you may be compiling stores of personal supplies, a store of gold or silver is important too so long as you understand the main purpose and not have unrealistic expectations of what you are buying it for.

Relax with a "Gone-Fishing" Portfolio

The following is a guest post from Marotta Wealth Management.

Summer is almost here. It's time to go fishing or take a trip or do wherever else you enjoy while on vacation. Unless your interests lie in investment management or you have a trusted fiduciary watching over your investments, consider having a portfolio designed to allow you more time to relax.

A gone-fishing portfolio has a limited number of investments with a balanced asset allocation that should do well with dampened volatility. Its primary appeal is simplicity. But a secondary virtue is that it avoids the worst mistakes of the financial services industry.

The efficient market hypothesis suggests that individual stocks are correctly priced by the market until new information becomes public, moving stock prices so they are again correctly priced. Superior returns then are the product either of luck or of trading on insider information.

There are two notable exceptions. First, stocks with a low price-to-earnings ratio, so-called value stocks, generally outperform the others. Similarly, companies with a smaller total valuation generally outperform large-capitalization stocks such as those in the S&P 500. Thus small-cap value stocks generally show the best returns over long periods of time.

Critics of the efficient market hypothesis point to specific times when pricing in the markets turned out to be wildly incorrect. Or they cite specific investment managers who have consistently beaten the market over time. But after a while new information made the correct price obvious. And given enough managers picking stocks, some lucky pennies are bound to come up heads 100 times in a row.

Even if the markets aren't perfectly efficient, they work well enough for you to reach your investment goals using all index funds.

Building wealth depends mostly on how much you save and invest. It also is closely associated with how early you start so your investment returns can compound for longer. The most important decision you make is how much to save early in your working career. Later in life, your most important investment decision is how you divide your assets among different asset categories.

Most investors mistakenly believe index investing is the same as putting their money in an S&P 500 fund, which consists of all U.S. large-cap stocks. We call that half an asset class. There are over 8,000 indexes. The S&P 500 is one of the many indexes we don't recommend.

Imagine the S&P was a financial advisor. It would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price-per-earnings ratio." In other words, the S&P 500 overweights large-cap growth rather than the more lucrative small-cap value. Having the right balance and mix of investment indexes is critical. Your investment gains will be directly related to the return of the asset allocation you select.

Your investment return will also be diminished by the expenses of running the specific investments you select to track your indexes. The lower the fees and expenses of the funds you use, the more of the investment return you get to keep. There is an additional drift because the fund you select does not perfectly track the target index.

These are the only factors determining your investment return. So you can follow a disciplined approach to building a portfolio of funds with low expenses with a target asset allocation that you rebalance back to annually or semiannually.

Rebalancing your portfolio provides a rebalancing bonus. The exact amount is proportional to the lack of correlation between the asset classes and the volatility of the markets.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. In secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage. But in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study of the same time period verified smaller gains for even more frequent quarterly and monthly rebalancing. And research on the Yale endowment attributed 1.6% of its annual portfolio returns to rebalancing.

Rebalancing can both reduce risk and boost returns. But you can't rebalance your portfolio if you don't have a target asset allocation to rebalance back to. That is part of the benefit of a gone-fishing portfolio over a buy-and-hold-and-grow-out-of-balance portfolio.

In other words, the genius of the gone-fishing portfolio is not only the time you can spend relaxing. It's the boost in returns you get from setting your target allocation and rebalancing annually or semiannually. Annual rebalancing is close to optimum. Twice a year, in May and September, is also excellent. Whenever the market is in the news for reaching new highs or lows is appropriate too.

So set your target asset allocation according to your age and situation, and rebalance on a regular basis.

Revisiting the Advice to Buy Real Estate

The following is a guest post from Marotta Wealth Management.

In 2010 I published a column entitled "Now's Still the Time to Buy a House." Investing is like chess in slow motion. It is important to review your moves to see how they turned out. Sometimes they don't turn out well. Our prediction about real estate, however, was brilliant.

A year ago I advised, "If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT [real estate investment fund] exchange-traded fund [ETF] (symbol is VNQ). The expense ratio is only 0.15%, and the yield is 3.6%. This is by far the simplest way to take advantage of this trend." Using that objective measure, the 12-month return on VNQ has been 22.7% compared to the S&P 500's return of 17.2%.

We currently invest about 23% of our allocation to hard assets in VNQ. For a typical 40-year-old, 17% would be invested in hard assets and 3.91% in VNQ. An allocation of less than 4% in VNQ may not seem like much because most people don't have a balanced portfolio that uses all six asset classes. Our allocation to VNQ actually overweights REITs by 9.2 times the normal U.S. stock allocation.

Our typical 40-year-old allocates 32.2% to U.S. stocks. Financials represent 15.5% of the U.S. stock market. REITs represent about 9.5% of the financial sector. This means that most investors mimicking the S&P 500 have only 1.5% in REITs. And because our U.S. stock allocation is only 32.2, they would only have 0.5% of their portfolio invested in REITs. Thus our additional 3.91% allocation overweights REITs by 9.2 times.

My father's investing advice was always "Make half a mistake." These strategic allocations to overweight certain sectors of the economy are attempts to balance the hope of superior return against the mistake of putting all your eggs in one basket. Novice investors holding only five funds might put 20% in REITs. Perhaps that would do well, but there are many sectors to overweight, and there are gains to be made from rebalancing between diversified allocations. In fact, a study by David Swensen, chief investment officer for Yale University, revealed that their endowment earned an additional 1.6% annually simply due to rebalancing transactions.

We haven't always been excited about investing in real estate. Early in 2005 my father George Marotta and I explained the coming subprime debacle and predicted "the bubble, if it is a bubble, could pop as late as 2006 or 2007." Our forecast was accurate. Real estate continued to rise that year. But it was relatively flat in 2006, underperforming the markets that appreciated over 15%.

In April 2007, I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise, leaving many lenders on the brink of bankruptcy themselves." In February 2008 in my column "For Now, Avoid Real Estate Investment Trusts," I warned again to stay out.

These dire predictions annoyed local realtors up until well after the financial implosion in July 2009 when I suggested to readers that now it was time to buy. I wrote, "Nathan Rothschild offered the contrarian advice to 'Buy when there's blood in the streets and sell to the sound of trumpets.' It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011."

Now that it is early 2011, I think we have reached the bottom and the housing market is beginning to pick back up. Personally I've purchased two properties in the last six months that I hope will offer good returns going forward. Buying a house is only slightly less work than having a newborn, and it is certainly much more expensive. For those who are looking to simplify their lives, I highly recommend purchasing some VNQ and going back to fishing.

Investment real estate isn't for everyone. You shouldn't have more than a third of your net worth bound up in real estate. For many families the home they live in provides them with more than enough real estate exposure.

A year ago I suggested you put perhaps 4% of your portfolio back in REITs and wait until early 2011 for the other half. Our firm's investment committee has been considering the other half for a few months now. We are currently looking at Vanguard Global ex-U.S. Real Estate Index (VNQI) that invests in real estate outside the United States. This ETF only started in November 2010, so it is a relatively young fund. But the expense ratio for VNQI is only 0.35% and liable to drop from there.

Last year I wrote, "I've heard a number of bleak predictions for the housing market recently. Everyone is expecting real estate to underperform the stock market for many years going forward. Maybe they are right." Now we know they were wrong.

Markets can turn quickly. There's still blood in the street. Don't miss this opportunity to look for a great real estate deal.

Do You Have a Market Evacuation Strategy?

Here's a piece from US News that says we all need a market evacuation strategy. What exactly is a market evacuation strategy? It's when you sell your investments and go into cash -- just before the market takes a big dip. Then once it's dropped, you get back in and buy at the bottom to make big bucks.

Color me skeptical. Isn't this what people have been trying to do (and failing) since there were markets? That said, let's hear them out.

Before we get to the "how's" of this "strategy", let's cover the "why's". Here's what the post says:

Examining stock market history, you can see how the market goes straight up for a particular period of time (five to seven years) and then suddenly, your portfolio seems to drop like a hot potato. This has happened so systematically that it makes the market seem like a well-oiled, broken machine.

And when they say "drop", they mean it -- noting that the market will have losses of 40% to 60% every five to seven years.

So, how do they suggest determining when the market will take a big fall? They say that "using technical information about the market, you can draw some conclusions about when the market is so overpriced and out of control that it is about to drop precipitously." Here are the four technical analysis tools they say you should keep your eye on:

Momentum. What is happening with market prices in comparison to the 200-day moving average or the 10- or 12-month moving average?

Yield spreads. As the market begins to show signs of weakening, fixed-income traders will begin to pull out of riskier bonds, such as high yield, and go into safer bets, such as government bonds. At that point you will begin to see a larger disparity between the rates on those two kinds of assets.

Volatility. The way to measure volatility is to keep an eye on that option pricing by looking at the VIX, the Volatility Index, also known as the "fear gauge."

Correlation. When riskier assets get sold en masse, the correlation of those various assets begins to move closer together. Assets that would historically move in very different directions begin to move together in almost lock step.

They conclude by saying that all four of these need to be pointing in the negative direction at the same time before you should make a move.

Here's what I say:

• This is a GREAT idea! You beat the drops and yet capture the upsides. If you did this for only a couple cycles and with any reasonable amount of money, you'd be fabulously well off.


• The only problem -- no one can do this consistently and accurately. If people could, they would (of course -- I would if I could.) But they can't.


• Can you at least get close? Maybe, maybe not. I know some commenters here will say that they can (and have) get out before a drop and then get back in before the big upswing, but my experience is that the vast majority of people will get out too early/late and get back in too early/late, hurting their performance way more than they'll help it.

What's your take on this issue? I'm sure there will be advocates on each side of the topic, so I'm interested to see the discussion.

Reasons Not to Buy Stocks

Yahoo has an interview with investor James Altucher who believes "the Dow will hit 20,000 and the S&P will eclipse 2000 before the current rally runs its course" (leading to, what he says will be a bubble-level valuation in 2013-14).

Let me just say that if his prediction is true and the Dow does increase more than 50% in the next few years, I'm outta here! Based on my current net worth, this sort of increase would give me way more than the minimum amount I need to retire -- I'd almost hit my full-on retirement number with that sort of growth (not to mention my added savings.) I think it would be time to cash out (at least in part) and take early semi-retirement.

But I digress. I don't want to focus on Altucher's market predictions (who really knows what the market will do anyway?), but rather the four reasons not to buy stocks that he lists at the end of the piece (the actual piece on his blog lists 10 reasons). They are:

It's really hard and very few people are successful at it. The very best investors in the world can only consistently produce 10% to 15% annual returns, so what hope is there for the rest of us?

The competition is ruthless, relentless and better connected (literally and figuratively) than the rest of us.

It's mostly a scam. In addition to insider trading and other outright frauds, "I would never ever trust any number that comes out on a 10Q, no matter how GAAP compliant it is," he writes. "Enron was GAAP compliant."

Ownership has its privileges. Citing legendary investors like Bill Gates and Warren Buffett, Altucher notes "the guys who make real stock market wealth never diversify and never sell" — and they also have 100s of millions of shares in the companies they run and/or founded. "Then there's the other 100 million people who own stocks."

So if you're not supposed to buy stocks, what should you do instead? Altucher's advice:

The best way to take advantage of a booming stock market is to start a company. Because everything goes up. If you have an extra $50,000 don’t put it into stocks. Put it into yourself. You’ll make 10,000% on that instead of 5% per year.

And if you're not the entrepreneurial type? Here's what he suggests:

Buy index funds or closed-end funds or "wait for another 2008 and buy a large basket of stocks and really ride them -- and you have to really ride them through all the volatility.

I rode the stock market through 2008 (investing all the way down, at the bottom, and all the way back up again) and have to admit it was a bumpy and nerve-racking time. Am I glad I did it? Sure, those investments have done quite well so far. But was it easy? No way.

What do you think about Altucher's advice to forget stocks and instead start a company/business?

Time to Rebalance in May and Call It a Day

The following is a guest post from Marotta Wealth Management.

The old stock market adage "Sell in May and stay away" suggests you can avoid risk and increase return by getting out of the markets during the summer.

Seasonal investing hit a high after Sven Bouman and Ben Jacobsen's 2002 study. The drop in the markets that summer also contributed heavily to the trend. Between 1950 and 2002, returns for November through March averaged 9.06% versus only 3.18% between May and October. Since 2002, however, the trend has been more muted. The recent difference between these numbers is statistically small for the wide range of returns.

The advice to rebalance appears this time of year whenever the markets have appreciated over the previous six months. Getting out of the markets entirely is generally a losing bet. Given their volatility and the strength of seasonal psychology, there may be some months when markets perform better. But that doesn't mean Treasuries can outperform stocks from May through October.

Rebalancing, however, is always a wise idea. Setting a target asset allocation is the most critical part of investment management.

Asset allocations can be set for a number of personal reasons. But the first customization is based on the age of the younger spouse. When you are young and actively adding at least 15% of your income to your investment portfolio, you do not need much allocated to bonds, the stability side of your portfolio.

Later in life, the percentage of your portfolio you are contributing each year declines compared to the amount your portfolio is appreciating each year. At that point, adding more to the stability side helps smooth portfolio volatility. It also adds dry powder to the appreciations side when the markets correct sharply.

Many investors believe they should switch to interest- and dividend-paying investments around age 65 to ensure sufficient retirement income. But from an investment point of view, a stock that appreciates 6%, a stock that provides a 6% dividend and a bond that pays 6% interest are equal.

Safe spending rates are often lower than the interest, dividends and appreciation generated. If you spend all of your growth, you are spending too much. Your portfolio's purchasing power will dwindle with inflation. Your retirement will be jeopardized.

The percentage of stable bonds should remain relatively low at age 65 and cover about five to seven years of safe spending rates. At age 65 the percentage in stability should be about 25%. The remainder of the portfolio, with a time horizon of 8 years or longer, should be invested in appreciating assets to keep up with inflation.

We use six different asset classes: three for stability and three for appreciation. We divide the asset classes for stability into short money, U.S. bonds and foreign bonds. We divide appreciation into U.S. stocks, foreign stocks and hard asset stocks. Hard asset stocks are not the same as investing directly in commodities. They are companies that own and produce an underlying natural resource. These include oil, natural gas, precious and base metals, and resources like real estate, diamonds, coal, lumber and even water.

Most investors have primarily U.S. large-cap stocks, mimicking the S&P 500, and U.S. bonds. We call this an asset class and a half. This is not a well-diversified allocation.

To rebalance your portfolio, you first need an asset allocation to rebalance back to. Here are some age-appropriate asset allocations using our six asset categories:

Age: 30, Cash: 3.0%, Bonds: 2.2%, Foreign Bonds: 2.2%; US Stocks: 36.2%, Foreign Stocks: 40.8%, Hard Assets: 15.6%
Age: 40, Cash: 3.0%, Bonds: 5.8%, Foreign Bonds: 5.8%; US Stocks: 32.2%, Foreign Stocks: 36.2%, Hard Assets: 17.0%
Age: 50, Cash: 3.0%, Bonds: 7.7%, Foreign Bonds: 7.7%; US Stocks: 30.0%, Foreign Stocks: 34.0%, Hard Assets: 17.6%
Age: 60, Cash: 3.0%, Bonds: 9.7%, Foreign Bonds: 9.7%; US Stocks: 27.9%, Foreign Stocks: 31.5%, Hard Assets: 18.2%
Age: 70, Cash: 5.0%, Bonds: 13.6%, Foreign Bonds: 13.6%; US Stocks: 22.8%, Foreign Stocks: 25.8%, Hard Assets: 19.2%

These are just suggested starting points. There are many reasons to adjust an asset allocation recommendation based on your personal situation or market conditions.

You can implement an asset allocation with your current favorite investment choices. Simply assign each investment to one of the six asset categories. Sometimes a fund may be split between two asset categories. For example, a global fund might be 60% foreign and 40% U.S. companies. Simply divide the fund across those two asset categories. Analyzing your portfolio against your age-appropriate allocation will show where you might adjust your investments.

In the past I described a "gone-fishing" portfolio of six long-standing mutual funds. Today, however, I suggest exchange-traded funds (ETFs). You can easily combine the six ETFs listed here with the age-appropriate asset allocation models in the chart to create your own easy-to-implement gone-fishing portfolio.

Add all of the stability percentages in the first three columns and invest in a bond ETF. Use the Vanguard Total Bond Market Index (BND) or the iShares Barclays Aggregate Bond Fund (AGG). We do worry about rising interest rates hurting longer term bonds and try to keep bond duration short. But the whole point of a gone-fishing portfolio is letting go of those kinds of concerns.

Take the percentage allocation to U.S. stocks and invest two thirds in mostly large cap and one third in small value. For large cap, a broad market fund is better than just the S&P 500. Use Vanguard Total Stock Market Index Fund (VTI) or iShares Russell 3000 Index Fund (IWV). For U.S. small value you have a plethora of choices. You could use the Vanguard Small-Cap Value Index Fund (VBR) or the iShares Russell 2000 Value Index Fund (IWN).

Next take the percentage allocation to foreign stocks. Invest two thirds in developed countries and one third in the emerging markets. For the developed countries, use Vanguard MSCI EAFE Index Fund (VEA) or the iShares MSCI EAFE Index Fund (EFA). For emerging markets, use the Vanguard Emerging Markets Stock Index Fund (VWO) or iShares MSCI Emerging Markets Index Fund (EEM).

Finally, put the allocation to hard asset stocks in iShares S&P North American Natural Resources Sector Index Fund (IGE).

The mostly iShares ETF portfolio has performed exceptionally well over the past five years. The S&P 500 only averaged an annual 2.62%, whereas this portfolio averaged 6.10% through the end of March 2011. And the expense ratio is only 0.36% compared to typical mutual funds expense ratios of around 1.20%.

The Vanguard ETF gone-fishing portfolio performed equally well returning 6.08% over the past five years. Also, it has an even lower expense ratio of 0.19%. We prefer the Vanguard funds.

It is always a good time to have a balanced portfolio. But even going fishing requires regular rebalancing. And now is the time to balance or rebalance your portfolio. Rebalance in May and call it a day, and please remember again in November.

Where in the World Should You Invest?

The following is a guest post from Marotta Wealth Management.

Finding countries where you can plant your investments in fertile soil may be one of the most important asset allocation decisions you make for the next several years.

In 2002 I coauthored a column with my father, George Marotta, entitled "Will the US Go the Way of Japan?" in the "Charlottesville Business Journal." Our answer to the question was no. We argued that when the United States has an Enron go under, there isn't a too-big-to-fail syndrome. But when a large Japanese company is in danger of failing, the government comes to the rescue. The company becomes a drag on their economy for the next decade or more.

In that column we wrote, "The ruthless culture that allows large companies to go bankrupt in the US hurts less in the long run than the Japanese style of business subsidies. In the US, the government keeps hands off business; in Japan the government interferes with the operations of business and commerce."

My, how times have changed. Now, unfortunately, the United States is going the way of Japan.

Now Japan is struggling to recover from a devastating earthquake. I was asked recently if that tragedy would stimulate its economy. Regrettably, nothing could be further from the truth.

I would suggest that everyone read Henry Hazlitt's classic "Economics in One Lesson." In Chapter 2, "The Broken Window," Hazlitt debunks the fallacy that a hoodlum throwing a brick through the window of a baker's shop is somehow good for the economy.

Certainly the baker has to pay to have his window repaired, but now he only has his window back and no money to buy a new suit. The community is poorer one new suit that could have been made and in exchange simply got its window back. But the community doesn't see what is never made.

The broken window fallacy may seem obvious, but it comes in many forms. Some pundits are mistakenly arguing that the earthquake and tsunami will be just the economic stimulus Japan needs to pull out of its malaise. This conclusion confuses need with demand.

In our country we print stimulus money and believe we have created wealth. Stimulus money may increase government spending, but the growth of government is a negative in the equation of economic prosperity. This fallacy mistakenly equates purchasing power with money.

Economic fallacies like these are "so prevalent," Hazlitt writes, "that they have almost become a new orthodoxy. . . . The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consist in tracing the consequences of that policy not merely for one group but for all groups."

The politicians in many countries focus instead on the short-run effects on a special-interest group and ignore or belittle the long-run effects on the community as a whole.

Japan wasn't the best place to invest even before March 11. Its economy is smaller now than it was in 1992. The MSCI Japan Index averaged an annual total return of -0.29% from March 1996 through February 2011. Japan dropped another 9% this month as a result of the earthquake. Most of Japan's troubles have been self-inflicted by its own government. Freedom matters.

Japan scored 72.8 out of 100 (mostly free) in the Heritage Foundation's Index of Economic Freedom. Since 1994, the Heritage Index has systematically measured economic freedom in countries worldwide. The foundation defines economic freedom as "the ability of individuals to control their own labor and property. In an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state."

Overall Japan is the 20th most free country, which isn't bad but is not great either. Not when 9 of the top 11 countries have large markets with easy ways to invest in them directly. In two important categories, Japan's scores are particularly poor. It ranks 145th in fiscal freedom. The top corporate income tax rate is 41%, the highest in the world. Even Japan realizes this is too steep. Next month they are cutting that rate to 36%. The U.S. top corporate tax rate is 35%, rising to 39.5% in 2013.

Japan also ranks 114th in government spending. Japan has some of the highest sovereign debt and deficit. Their ratio of outstanding gross debt to gross domestic product has risen from 68% in 1990 to about 230% in 2010.

Freedom matters. You can't afford to plant your investments in anything but fertile soil. If you simply invest in the MSCI EAFE foreign index, 22% of your investment is in Japan. What's worse, about 65% is in countries with low economic freedom and a high debt and deficit.

This isn't a reason to keep your investments here, however. Last year the United States lost its place in the list of countries with the most economic freedom for the first time in the 15-year history of the index. Part of the lower scores was a result of the U.S. debt and deficit exploding. If 65% of foreign investments are in countries with a high debt and deficit, then 100% of U.S. investments have the same problem.

Today, perhaps more than ever before, may be the time to overweight very specific foreign countries with low debt and deficit and high economic freedom. Put your investments in fertile soil where they can grow unimpeded.

Money Commandment #4

The book The 10 Commandments of Money: Survive and Thrive in the New Economy lists money commandment #4 as follows:

The old-school rules: Don't gamble in the stock market with money you can't afford to lose.

The bubble economy rules: There's no real risk if you stay diversified and invest for the long term.

The new rules: Risk is part of life. While you can't avoid it, you can make sure the risks you're taking are appropriate for your goals.

I actually think all of these are still true today -- at least in part.

For instance, do I think "don't gamble in the stock market with money you can't afford to lose" is good advice? Yes, I do. (The only thing I might disagree with is the word "gamble", but that's being a bit picky.)

Next, do I think it's true that "there's no real risk if you stay diversified and invest for the long term"? I think there's risk (did anyone ever think that there's no risk in investing?), but I think that if you are diversified and you are investing for the long term that the risk is reasonable and worth taking.

And finally, do I think that you simply need to accept risk as part of investing? Sure. But is this really a "new rule"? Isn't this what most of us (if not all of us) have thought all along?

Being an Active Investor is a Lot of Work

Here's a quote I love from the book The 10 Commandments of Money: Survive and Thrive in the New Economy:

Being an active investor is a lot of work, I'll warn you. You'll have to do extensive research, monitor your investments carefully and be disciplined about when you buy and sell. You will pay more as well: active management simply costs more in trading commissions, fees and taxes. I think most of us are better off acknowledging that we don't want to do all this work, particularly when the odds are so stacked against us. Fortunately, there is a better way: index funds.

Wow, lots to comment on here:

• I agree 100%. Let's start with that.
• Yes, it does take a lot of time and effort to be an active investor -- time and effort that most of us don't have (because we work and have lives.) Want a glimpse at the time and effort it takes to be a good active investor? Check out Why I Invest Like I Do. 
• Even if we did have the time and effort to be good active investors, many people don't have the education, skills, and temperament to do so. Simply anyone with enough free time can't be a great investor -- you have to have another set of unique skills that the vast majority of people don't have.
• Even if you have the time and the skills, that doesn't guarantee success. Mutual fund managers have all the time in the world, great skills, and a vast amount of resources -- and most of them can't beat index funds over time once expenses are accounted for. So why would you be any different?
• Costs play a HUGE factor in how well your investments perform. Thus, you want to minimize them. Active management doesn't do this. Index funds do. That's why index funds outperform the vast majority of actively managed funds after expenses.  
• Instead of focusing so much time and effort on return rate (which is what this conversation is really about), why don't we focus on the factors that are most important when it comes to whether or not your savings/investments will do well in the long term? And what are those? Saving as much as you can for as long as you can. So instead of talking about how we can spend an extra 20 hours a week to try and beat an index by 0.02%, let's instead focus those 20 hours on learning how to make and save more money. Then we can increase the amount we save over time -- something that will have a far greater impact on our investing performance than return rate will.

Yes, of course, some people can beat the averages even after expenses. But just because some people can do it, doesn't mean most (or even many) people can (some people can run a four-minute mile too, but most others can't; some people can write great works that sell a gazillion copies, but most can't, and so on.) So I recommend instead focusing on the priorities of saving as much as we can over as long a period of time as we can and leave our return rate in the hands of index funds (which will beat 80% or more of active managers over time anyway -- which is pretty good.) Try it for 40 years and you'll see why I recommend this plan. ;-)

How to Become a Millionaire in Three Easy Steps

CNN Money tells how to be a millionaire in three easy steps. It's a three-page post (or at least they've expanded it to that) that really boils down to making the most of these three factors:

• The time you have to save/invest
• How much you save/invest
• The return rate on your savings/investments

They go on to say that the longer you have to invest, the more money you invest, and the more aggressive (within reason) you invest, the faster you'll become a millionaire.

Wow, these guys are geniuses. ;-)

Yeah, pretty basic stuff. But they do make one point that I wanted to share with you all on a serious note -- this one about the impact of time on your investments:

When you think about getting rich, what jumps to mind? Saving more money? Getting that money to work harder for you? Sure, those are critical elements. But they're not nearly as important as time: How long you allow dictates how you pull the other two levers -- which is why you want to estimate your schedule before going on to the next sections.

I brought up the importance of time in investing in The Best Way to Maximize Your Investment Return, where I noted it was the one factor of the three that made the most difference in how your wealth would grow. BTW, #2 is how much you save. This makes return rate, the step most people spend the most time on, the least important of the group. So if people simply started saving more and doing it over a longer period of time (two factors they can influence much more than they can return rate), they would be much better off. Couple those with using index funds as your preferred investment vehicles (delivering you a good rate of return), and you've got a winning strategy.

CNN Money says (roughly) the same thing with this quote:

The single most important thing you need to know about building wealth: You're far better off being a dogged saver who's a mediocre investor than being a below-average saver who can knock the socks off the S&P 500.

Of course, if you can do everything well, then you're almost guaranteed to become quite wealthy.

The post does have an interesting chart that gives the odds of hitting $1 million in 20 years if you start with $250k and invest 60% in stocks and 40% in bonds given various annual savings rates. The results:

• Annual savings: $5,000; Chance of hitting $1 million in 20 years: 31%
• Annual savings: $10,000; Chance of hitting $1 million in 20 years: 43%
• Annual savings: $15,000; Chance of hitting $1 million in 20 years: 55%
• Annual savings: $20,000; Chance of hitting $1 million in 20 years: 67%
• Annual savings: $25,000; Chance of hitting $1 million in 20 years: 79%
• Annual savings: $30,000; Chance of hitting $1 million in 20 years: 91%
• Annual savings: $40,000; Chance of hitting $1 million in 20 years: 100%

With all this talk of saving $1 million, I know someone is going to say something like, "$1 million is not what it used to be" or "$1 million is not enough to retire on." So let me address these issues quickly:

• No, $1 million is not what it used to be. Nothing is what it used to be thanks to inflation. But $1 million still places an individual in the top few percentage points of all net worths in the US.
• Yes, $1 million is enough to retire on. Not a lavish retirement, mind you, but many people are retiring with far less than $1 million in the bank and are doing "ok."

Anyway, the key point here boils down to this:

If you want to become wealthy, invest as much as you can as soon as you can for as long as you can.

Yes, it's as simple as that!