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Strange Advice From the Motley Fool

This week I came across an article on-line published by the folks at the Motley Fool.  For those of you who do not know, this company gives a lot of good sounding investment advice, but in reality they are similar to every other “traditional” financial advice provider out there.  At the end of the day you are paying them for advice on what companies to buy, and which to sell.  In other words, they believe in stock picking.  But according to this article, not a lot.  I’ll explain.

The first point they raise in the article is that you should not buy high and sell low; but that is what everyone does.  The author even confesses their guilt in purchasing a rather famous, now defunct, stock at a very high price.  You might as well lifted this part of the article from one of our classes.  Their point:  don’t let emotions get in your way.  Stay disciplined.  That is good advice.

But then the advice gets… murky.  They say don’t “day trade”.  I’d agree.  The research shows that the more people trade, the worse they do.  They give an example of someone doing 10,000 trades a year and raking up $100,000 in trading costs.  Hard to overcome.  But that is a ridiculous example.  Trading once a day would only be 730 trades a year by comparison.  So that begs the question, what is day trading?  If “day trading” is bad, then is just trading “once and a while” ok?  The fact that the article hides is that whether you trade once, or hundreds of times, the research shows your likelihood of beating the market is not good.  You can’t both believe the market is beatable, and yet be against day trading.  Here is why.

Assume that the M.F is right.  Let’s say you (or they) can pick stocks with the probability of 70% being correct, at a gain of $100 per time (and when I mean gain, I mean gain as in better than what the market as a whole did).  Out of the rest lets say 20% of the time you break even (or match the market), and 10% of the time you loose $100 (or do $100 worse than the market).  If I do 730 trades, one a day, I will realize a gain of $36,500 assuming I pay $10 per trade in commission.  I think we could all agree that that would be day trading, right?  And if these are trades of $10,000 a piece, I don’t need a big price movement to get ahead $100.

Now let’s shrink this down to 10 trades.  Hardly day trading.  Well, in that case I would make $500 based on those same costs and odds.  In both cases, since the market is “beatable”, it pays to trade.  In fact trading more doesn’t hurt you (unless you perhaps take it to the absurd extreme like the article does)!  It can actually help you to a point.

Now, let’s flip it.  Let’s look at real life probabilities.  Lets assume that 30% of your picks work and profit $100, 40% break even, and 30% lose $100.  If you did 730 trades, you would lose $7300.  If you did 10 trades at these odds, you’d be out $100.  Your winners cancel your losers, and you’re out the costs of playing the game.  In the real world, you would have been better off just owning “the market” and not trading.

Does anyone get the irony of this article?  The Motley Fool sells you on the idea of letting them help you pick a few winning stocks by paying for their advice.  Just trading a “little bit”.  Inherent in this proposition is the belief that the M.F CAN pick winning stocks.  But I just showed you above, that if the M.F CAN pick stocks, they should give you TONS of picks so you can make TONS of money.  They SHOULD give you a trade a day.  Here is why they don’t.  If they did, they’d rack up huge loses for their investors through trading costs.  They know they can’t pick winners consistently. By keeping trading to a minimum, they hope to hit just a few more winners than losers, just enough to keep you along for the ride for another quarter.

 

 

 

 

 

Election Hysteria

The Labor Day Holiday has now concluded, and summer has reached its official end by most measures.  It’s now the final stretch for the 2016 election season.  Or at least that is what I am seeing over and over again on my internet browser headlines.  2016 seems to be a particularly charged election with alleged “drastic consequences” with the election of either presidential candidate.  I have heard on more than one occasion that investors have decided to “wait and see” before they take any action, based on what the election outcomes will be.

Out of all of the possible events to effect the market, I can tell you that political elections on the whole are vastly overblown.  Now, I am sure the market will have a temporary, one or two day reaction; but it isn’t likely to change it’s trajectory.  The media is very good at playing on peoples’ fears and emotions, making dire predictions about things to come should [fill in the blank] be elected.  The very thing that could effect economics, i.e. economic policy, is not set by the president.  The Federal Reserve will continue to set interest rates, while it takes the cooperation of congress to pass fiscal policy.

Here are some interesting things to note.  By many sources our two greatest presidents were Lincoln and FDR.  Were these people admired by all?  Were they destined for greatness from day one?  No.  One was a Republican, the other a Democrat.  Neither were without their detractors.  In fact Lincoln’s path to the presidency is rather interesting.  He was certainly not the clear frontrunner for his party’s nomination.  In fact, part of his plan for nomination entailed printing counterfeit convention tickets for his supporters at the 1860 convention. http://www.greatamericanhistory.net/nomination.htm.  That doesn’t sound very distinguished to me.  And FDR had plenty of detractors in his time.  Although fondly remembered, he took a lot of criticism from Republicans, but also from other liberals on the left, many of them against the Civilian Conservation Corps’.  He also broke with tradition by running for an unprecedented 3rd term.  The bottom is you can never tell how any one presidency will actually turn out once they get into office.

But furthermore, there is not clear evidence that the market does any better under a democratic or republican house/senate/or presidency.  There are not enough data points to make a determination.  And, the market has done very well under both– as business goes on regardless of who is in power.  So if you are losing sleep over this November, my advice to you is to relax, trust the process our predecessors put in place for us, and focus on the long-term.  The country will likely be around long after this next president leaves office.

 

State of the Markets Address

I thought it would be fitting to pen a “State of the Markets” address, seeing this is the day after the president’s final state of the union address. In this post, I hope to address where the markets have been, where they are now, and where they will go.

 

But before I do that, I want to remind people of the human tendency to believe in the permanency of the current state, and how it “must” and “will” perpetuate into the future. Back in 2008, I printed off an article that read “What $300-a-Barrel Oil Will Mean for You”.  It was from Barron’s magazine (not exactly a low rate publication).  At the time gas prices were high.  China was expanding rapidly.  Oil was supposed to be rarer and rarer to find.  We were told we didn’t have enough refineries.  The narrative seemed completely logical!  In fact, most of the statements in the article were probably true.  But I have to repeat one of the article lines just so you can read it: “We will see $300 a barrel – or roughly $250 in today’s dollars- because oil supply will be so short.  If you want that oil, that is what you will have to pay for it. That will be in 2015, after the peak of oil [supply]”.  Needless to say, that prediction was very very wrong.  Today oil and gas are cheap.  However, at the time, the article seemed so spot on.

 

The same can be said today. We have all sorts of problems.  ISIS, the National Debt, the cost of Medicare, crumbling infrastructure–and a litany of other problems.  It seems to make logical sense that this most recent decline in the markets is just a first step in the permanent unwinding of society.  But then again, we have had problems before.  In the early 40s the Allies were not winning World War II.  In the early 70s we faced an oil embargo and the stock market was halved.  We almost went to war with the USSR in the 60s.  A fundamental requirement for investing, is being able to accept the negative news of today, and believe that businesses and economies are resilient, and will preserve through many storms.  If you do believe that this is “the end”, you might as well take your money and bury it in your back yard.  A positive long term outlook is required for investor peace of mind.  Otherwise investing will be a stressful endeavor filled with fear and anxiety.

 

But, if it is your belief that this is indeed NOT the end of it all, then we must assess where we are, and whether or not it is unique in the long history of the markets. Let’s start with a brief review of where the major markets have been.  By most broad measures, the international stock markets (in aggregate) are in bear market territory (a decline of 20% or more).  US large stocks are not yet in bear market territory, but are about half way there.  US small stocks are in bear market territory by most measures.  So let’s acknowledge that.  Many areas of the market are in a bear market.  Then we must ask, how frequent is this?  If we look at the US market (as measure by the Dow Jones), a bear market (decline of 20% or more) occurs every 3 ½ years.  When was the last bear market for the Dow Jones?  2009. That is 6-7 years ago if my math is right.  The average duration has been 338 days.  That is from high to low- the ride down.  So, from history we can see very clearly that declines of 20% or more are very routine, happening every couple of years.  There is nothing abnormal about what is occurring now.  If you are interested in the duration of bear markets, from beginning to recovery, the average time is about 3 years (this is according to an article from wealthfront.com from 2/12/15).  The article looked at market corrections in the S&P 500 index, a US large company stock index similar to the Dow.

 

So, if we distill the above down to a few points, they are as follows:

a) The markets can and do decline. End of statement. That is reality.

b) They do so frequently. Every few years on average.

c) The sharpness of this decline is 20% or more, and will come with all of the expected gloom and doom media coverage.

d) They take time to play out. On average it will be a few years from top, to bottom, and back to the previous high.  Patience is required, along with a positive attitude.

 

Instead of being portfolio destroyers, these declines are actually opportunities to buy in at lower prices. That is where the money is made.  Not by investing just when things are rosy and the markets are high.  I believe Warren Buffet once said he would welcome a 50% decline in the value of all of his stocks- for that very reason.

 

No one can predict with certainty when this bear market will end, but at some point, it will. A new bull market will emerge, only to be followed again by another bear market in the never ending cycle of the markets.  While this history replays itself time and time again, it is only human nature to feel that this time “things are different”, or “we have never had this”, or “we can’t come back from these circumstances”.  Each of these statements could have been made about a prior bear market, but yet here we are today.

 

I’ll leave you with one of my favorite investing verses from Ecclesiastes 1:9 that sums up the disciplined view of investing:

“What has been will be again, what has been done will be done again; there is nothing new under the sun.”

 

Breaking the Vicious Cycle

If you have been watching the markets at all this year, you know it has been a rocky start to 2016.  As I write this the S&P 500 Index is down 5.91%,  and the MSCI ACWI ex US Index is down 6.29% (an International Stock Index).  While there are several ideas I could write about, I thought I would talk about what troubles me as a financial advisor, and it is not the markets.

It is an inevitable fact that markets correct.  They go down, and sometimes they even crash.  It’s an inescapable fact of investing.  And sometimes they go that way for a long time.  I recall earlier in my career enduring the market decline of 2000-2002.  It was three agonizing years of poor performance.  And during that time many investors made emotional decisions that were, in retrospect, perhaps a mistake.

So much of the failure of investors lies in their inability to endure market declines, and trust or understand the markets.  The markets themselves are usually never the problem- the problem is a reaction to them.  If we look at the historical returns of owning equities, volatile as they are from year to year, they have been a great long term hedge against inflation.  So many people do not understand what they own when they own stocks, or equities.  When you own stocks, whether individually or in a fund, you own the very companies that make everything we see before us in the world.  From homes, to planes, to the truck that hauls away your garbage- companies that produce the goods and services that society needs.  So, for the market to really truly decline perpetually, it would mean the total decline of our economic system, as all companies slowly become worthless.  That is the sole scenario where investors, and everyone, loses.

So many investors encounter a period of market decline and volatility, and because the returns are not immediate they “give up” on sound investment strategies.  Make no mistake, there is no get rich quick method to investing.  More often than not, if it seems to good to be true, it is.  Think about it; if a certain investment firm really had it all figured out as their product advertises, why would they need your money?  What really makes my heart ache for investors, is that their failure is so preventable, and yet predictable.  The process goes like this.  Investor invests, markets perform poorly, the impatient investor abandons their plan, and the markets rebound and the investor misses that rebound.  The investor’s new plan is a loser.  So they abandon plan b, and again go in search of the silver bullet of investing.  They go from strategy to strategy, and will likely earn about 3-4% per year, according to DALBAR’s annual QAIB Study.  That is the vicious cycle that all investors must escape to be a successful investor.  Only disciplined, educated, and steadfast investors truly earn “market” rates of return.

If investors were really educated, and understood what disciplined investing looked like, they could avoid the vast majority of issues.  That is why education is so important.  Please join us this year for our investor education series courses, to become a more disciplined and educated investor.

Target Date Funds, Buyer Beware

I recently came across an article in an industry publication that really, quite frankly, irritated me.  The authors of the article seemed to be lauding the recent performance of target date funds, and how wonderfully they were doing for retirement plan participants.

If you are not aware of what a target date fund is, it is typically a “fund of funds”, or a single fund comprised of many underlying funds.  The ideas is, that as a person nears retirement, the composition of the fund automatically slides from being more aggressive, to being more conservative.  It is supposed to be a simple, one stop shop solution; addressing risk as you age, and also providing “diversification” in one fund, due to its structure.  They often have a year in their name.

The most troubling part of the article for me was how it was showcasing the great “3 year returns” of selected target date funds.  These funds were all fairly equity based, as the ones I will reference were all “2045” funds, in other words designed for folks retiring in 2045.  Sure, the three funds I will reference did return 15-16% annualized over the three years, but no one bothered to look inside and ask “why?”.

I am going to tell you what each of these funds owns, and you can tell me why perhaps this performance, although pleasing, may not be high for the right reasons.  Just because you get good results, the ends do not justify the means.

First we will look at T. Rowe Price Retirement 2045.  According to my analysis, this fund contains 52.49% Large US Company Stocks, 31.49% Large Int’l Stocks, and 12.18% Fixed Income.  TIAA Cref Lifestyle 2045 fund contains 54.56% Large US Company Stocks, 30.09% Large Int’l Stocks, and 10.52% Fixed Income.  And the Putnam Retire Ready 2045 Fund contains 45.09% US Large Co Stocks, 14.98% Large Int’l Stocks, and 39.93% Fixed Income (oddly quite high).  Now, what do all of these funds have in common, or should I say all lack?  You will notice that each of these funds have very small amounts of Small Co stock (domestic and foreign) or have none at all.  All three fail the diversification test in my view.  I can go on at length about how this is poor diversification, but that is an entirely different article.  The only reason that these funds performed well in the short-term past (3 years, very short term!), is that most of their assets were in the BEST performing asset class over that time: The S&P 500 Index, or US Large Company Stock.  They guessed, and got lucky.  That was the big secret.  It is not because they are a good solution for investors.  These funds will go whichever way the S&P 500 Index goes.  Just another example of how investors must be diligent against misleading information.

Beware the Imitators

The other day while driving in to work I was listening to the local sports station. Every morning, as part of their advertising, they have a local business come on for a scripted interview with the business owner or sales manager– essentially a 3 minute commercial.  On this station it is usually the local Toyota dealership, or a particular local financial advisor.

 

I do take some interest in what our competition is talking about, so I paid particular attention when I knew it was going to be the financial advisor. Much to my surprise the advisor started to talk about “beta”.  Beta is a term from the world of finance, and actually is used in a very influential and basic model that is meant to explain the movement of securities prices and expected return.  I was surprised to hear the advisor talk about something scientific in nature.  But I was equally surprised to hear what came after.

 

While it was nice to hear an advisor talk about something based in science, the problem was he was just plain WRONG in his explanation- or at least very incomplete. He said that BETA was a measurement of how volatile a portfolio, fund or stock was.  So, the market he said, has a beta of 1 (that is right).  If you had a beta of more than one, your portfolio was “more volatile” than the market.  And if the portfolio had a beta of less than one, it implied it had less volatility.

 

Unfortunately this is the wrong definition. Beta is a measurement of correlation and risk as it relates to the market. It explains the movement of a portfolio in relation to the market, and is used to calculate an expected return.  If a portfolio has a beta of 1, it just means it is the market’s mirror image (moving in lockstep with it), and does, by default, have a volatility equal to the market’s.  But let’s say a portfolio has a beta of zero?  Does that mean no volatility?  Not at all.  It just means that there is no discernable correlation or link between the return of the portfolio and the return of the market.  Or in other words, it means that the return of the market will not affect the return of your particular portfolio- they move independently.  His definition is especially wrong when you look at negative betas.  Does a beta of negative one mean that there is “negative” volatility or no volatility?  No.  That simply means that the portfolio tends to behave the exact opposite direction of the market.  Its volatility could be exactly the same.  Standard Deviation would have been a better fitting concept if you want to measure volatility.  A portfolio with a 0 beta or negative beta could still be very volatile.

 

Advisors will use any number of smart sounding terms to try to prove their knowledge or savvy. It is hard for individuals to decipher what is accurate and what is not.  (My wife even said, really Jeremy? Who would be able to tell that he was wrong??).  That is an unfortunate problem.  But this is a good example of the importance of your own due diligence.  Just because an advisor uses fancy words doesn’t mean they are using it correctly.  Do your own homework to see if there is actual substance and knowledge behind the words used.

 

Taking Stock

 

This week sure has been a wild one! It has been some time since we have had this kind of volatility, so it has come as a shock to some. Let’s look at the triggering event for this volatility, and what relevance it has to long term investors.

The Chinese stock market has not been strong lately. Below is a chart of the Shanghai Composite (curtesy of CNN Money). Notice how volatile their market is. This is because their market is largely dominated by individual investors (retail investors). Little investors like me and you. Contrast that with the US Market (S&P 500 index in the chart) which is largely dominated by institutional investors. Notice how much of a run up there was before this crash; almost a tripling of value. There are two major forces that always drive markets: fear and greed.   This is clearly and example of the later.

shanghai

The volatility in the Chinese stock market has had spillover effects into other global stock markets, at least in the immediate term. It is a globally connected world today, so this is not to be unexpected. But it is important to take an assessent of what markets have done as a whole year to date and see if that is in any way out of the ordinary.

As of 8/25 the S&P 500 (large US stocks) are down about 8% year to date. International stocks as a group have actually done better, down about 6% (as measured by the MSCI ACWI ex US). The point being, none of those numbers are in fact, unusual. How many years, on average are negative in the US Market vs positive?  One in 10? One in 6? Well, going back to 1900 it has about one in every four years. If you are going to be a successful long term investor, you have to accept that 3 steps forward, one step back is an inevitable and expectable part of the process. Because the media is very interested in selling fear, they will sensationalize what is going on, and try to paint the direst picture possible. Don’t be fooled. Bad investment decisions are made in the heat of the moment. Remaining grounded, calm, and sticking to the plan are the keys to long term success.

Investor Patience

Watching the Grass Grow.

Watching Paint Dry.

Waiting for a Pot of Water to Boil.

Long Term Investing.

Some things in life take a lot of patience.

For many long term, diversified investors, it wasn’t too concerning that 2014 was a relatively flat year. After all, most people can understand that the market doesn’t always go up- and flat feels better than down. However, some investors may be getting to feel a bit squeamish that 2015 is playing out in the same fashion- or perhaps going in downward direction in light of the most recent moves.

Have you ever heard the saying “there is nothing new under the sun?” Well, the same can be said of the markets. All manner of market behavior has been, and will be, experienced in the future. Bull markets, bear markets, and yes, flat markets. The only alternative is that view is that this market correction is indeed the end of days (and in that case, the value of your IRA will soon be irrelevant). I personally don’t believe that this is the case.

We don’t have to look too far back to see examples of time periods where portfolio values did not make progress. If I look at the GIPS audited returns from one of the managers we follow, their long term growth portfolio essentially broke even from March of 1998 through March of 2003. That is five years of ups and downs, but with no overall progress. Even more recently we can see the same thing from early 2006 until the third quarter of 2011- over a 5 year period.  Investor gains are not made evenly over time.  They are made sporadically and quickly, with no discernible pattern.   Investors run into problems when they become frustrated– or scared and sell out or change strategies. When the next market uptick occurs, they are left on the sidelines and do not participate in the gains. Market corrections are in a way transfers of wealth from those you cannot hold on, to those who are disciplined and instead see opportunity.

Disciplined investor behavior is the biggest factor in determining your investing success. If you are not a client of ours, is your advisor talking to you about market volatility, or providing monthly educational opportunities? If not, perhaps it’s time to fire your broker, and hire a financial coach.

What is an Average Return?

Our July class will focus on expectations. It’s important to have realistic and rational expectations about the performance of portfolios. Without realistic expectations, investors may be easily convinced to abandon a solid long term plan after only a short period of low performance. Or, they may form too lofty of expectations after periods of very strong performance.

One of the ways investors can become confused is by the use of average returns; with the expectation that most years are close to average.

In the real world however, we rarely ever experience an “average” year.

Here is an example. If we look at the 1993-2013 performance of Matson Money’s Long Term Growth portfolio, gross of fees, the arithmetic average annual return was 9.93%. (Keep in mind ¼ of the portfolio is not in stocks). But looking back at these years, how many actual years had a 9% return? The answer: Just one. 1997 with a return of 9.86%. What if we include years where the return was either 8, 9, or 10%? In that case we have 1997, and 2005 (with a return of 10.27%). So, out of the 21 years, only 2 were near average. But this next statistic should surprise you. Out of those 21 years, how many years had a return of under 5% or over 11%? The answer: 17! Most of the years were not even close to average. Since that is the case, investors must be weary of looking too closely at short term performance (either low OR high), to create expectations of long run returns. “Average” returns are the result of a combination of very low and high performing years, not consistent repetition of the same returns year over year.

We hope to see you in class over the next coming months.