RULE 8 Avoid Seduction

Early post this week. Leaving for Guatemala tomorrow and be back next Friday. 

At this point, we know how to manage our investments.  We know the importance of controlling our expenses.  We know how to identify low cost, well diversified funds . We know the value of sticking to an appropriate asset allocation. We know not to procrastinate.

Still there are potholes.  When it comes to money, it is easy to be seduced into believing there are easy riches.  Before you pooh-pooh the thought and say it can't happen to you, recognize that really smart people with high priced advisors get caught up in various schemes. Like those whack a mole games schemes continuously pop up.

In this chapter, Andrew goes over the various kinds of scams and even gives an example of a "too good to be true" scam he got caught up in.

For my part, I recommend that people limit to 10% of total assets any kind of investment other than low-cost, well diversified indexed funds targeted to a well-defined asset allocation.  So if you come to me with a newsletter whose recommendations are supposedly earning stupendous returns, or a small company your brother-in-law has uncovered, or an investment that pays a guaranteed 24%, my response will be "fine, keep it to less than 10%."

A further caution I suggest is to not let your money manager take custody of your assets.  I read recently of an elderly lady who was talked into selling her house and signing the check over to her advisor to invest.  Ouch!!!!

Follow the news diligently, and you'll see people fall for Madoff-type Ponzi schemes on a regular basis.  I have a client who came to me after an advisor had spent years in a church gaining people's confidence before fleecing them.  Scam artists are everywhere!

Rule 7 Peek Inside a Pilferer's Playbook

Your portfolio or the broker's pocket?

This is the second part of this week's reading.

Andrew begins by presenting some of the typical responses you will hear if you talk to most broker's about index funds.  Understand that brokers don't like this talk because it is a short step away from them making less money and even not needing their services!

The response I like is where the broker will ask you why you are willing to accept average returns or average performance by using index funds that achieve market returns.  The answer is simple:  the market returns handily beat the performance of most brokers after taking into account all fees and costs.  The average return is actually far superior!

Although we understand this now, the fact is that this is counter intuitive.  Seeing a well-appointed office and poring over a bunch of fancy research reports with fast talkers naturally leads the brain to assume that the advisors you are meeting with can beat the markets.  After reading this chapter you'll understand  that this assumption has dearly cost many on their road to a successful retirement!

You'll be surprised to learn in this chapter that much of the pension fund money in the U.S. is managed with index funds.  These are assets managed by the so-called "best and brightest" - graduates of the top finance schools in the country.  If anyone could beat the market, it would be this group!

Embedded in this chapter are references to really good books to read and authors to know as you continue your journey to learn investing:

• Dan Solin, a securities litigation attorney, wrote The Smartest Investment Book You'll Ever Read.  Here is a talk he gave to Google employees you'll want to watch: http://www.youtube.com/watch?v=Y0LSG2omvEg
• William Bernstein - The Four Pillars of Investing.
• Bill Schultheis - The New Coffeehouse Investor.  Schultheis emphasizes the efficiency of using well-diversified, low-cost index funds.  He argues that you may want to enjoy your retirement and life in general by avoiding spending an inordinate amount of time picking stocks and timing the market.
• Burton Malkiel - A Random Walk Down Wall Street.  This is the bible of the genre.  It details the evidence in favor of the so-called efficient market hypothesis - the hypothesis that says that using publicly available information to beat the market is futile. 

At the end of the chapter is a quote worth reflecting upon by Jack Meyer, former head of Harvard University's Endowment Fund:

"The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees...Most people think they can find fund managers who can outperform, but most people are wrong. You should hold index funds. No doubt about it. "

Strong words from one who has been around the block!

RULE 6 Sample a "Round-the-World" Ticket to Indexing

This week there are two parts to the reading and, therefore, two related posts.  This is the first part - pages 101 - 107. The second part is Rule 7, p.125-136.

Pages 101 - 107 present a real-life example of a doctor in the U.S. who converts from an actively-managed advisor account to an indexed approach at Vanguard.  The asset allocation, using just three low-cost, widely diversified funds should be familiar from the previous chapter.  Pay special attention to the discussion on p. 103 having to do with the paper work involved in moving from his previous advisor to Vanguard.

Paperwork stops a lot of people.  This is how you get from where you are to where you want to be. Notice especially that the doctor completed the paperwork online, but he also had a Vanguard rep on the telephone.  This, I believe, is important whether you are moving to Vanguard, Schwab (whom I prefer), TD Ameritrade, or whomever.

Notice that you want your statements in front of you.  These will tell you and the rep the type of accounts you will open and how you will fund them.  Depending on your situation, you may want someone knowledgeable at your elbow if you are not fully cognizant of what you are holding.  For example, you may have large unrealized gains that realizing could result in a big tax hit.  You may have load funds that require special consideration.

On page 107, Andrew introduces the concept of target date (life cycle if you have a TSP) funds. These do the rebalancing, etc. for you.  One point Andrew makes is not to just accept the fund corresponding to your expected retirement date but to pick a fund with an appropriate allocation.  If you have decided that the percentage in bonds should correspond to your age, go with that!

You will see, as Andrew goes over the history of the doctor's indexed account, that rebalancing is easy, and that the portfolio weathered the worst downturn in the markets since the 1930s quite nicely.  If you are not familiar with the market history of the 2008 downturn, you may want to read this section a couple of times.  You hear a lot of horror stories about the 2008 downturn.  What you don't hear as often is the bargains astute investors picked up in early 2009 as prices dropped significantly!

I expect that there will be a market downturn of at least 15% within the next several years.  Part of your preparation is understanding how portfolios fared in the last downturn.

My Favorite Investment Chart

As promised, here is a post describing my favorite investment chart.  It shows how diversification reduces volatility, the value of sticking with an asset allocation, and the folly of chasing the hottest sectors--among other things. Here's the chart, titled "BlackRock ASSET CLASS RETURNS A 20-Year Snapshot":

Source:BlackRock

CLICK TO MAKE LARGER  To appreciate this chart ,you may want to go to the link above and print out the 2 pages comprising this chart for future reference and study.

The chart shows yearly returns of 7 different market sectors, including cash, international stocks, bonds, etc., color-coded each year.  The best-performing sector is shown at the top of the column, and all sectors are shown by performance in descending order.

Quiz question:  Quick:  Which was the best-performing sector in 2000?  Answer: "Fixed Income." Fixed Income is the bond sector.  What was its return?  11.6%.

Notice that Fixed Income was the best-performing sector for 3 years from 2000 thru 2002 and then fell close to the bottom in subsequent years.  Look closely at the table and you'll see this happens often with various sectors.  Sadly, investors don't understand this and chase the hottest sectors and, thereby, hurt their performance.

Several Wall Street firms put out charts similar to this one (referred to sometimes as periodic table of returns), but the reason I prefer BlackRock's is that it shows a diversified portfolio -  shown as the white box.  You'll notice that the diversified portfolio is never among the top 2 performers; but, by the same token, is never among the bottom 2 and is among the bottom 3 on only 2 occasions.  Simply, it is a visual depiction showing that diversification (the white box) reduces volatility.  Notice also when you print the chart out that the actual diversified portfolio is described in the very last footnote on page 1 - basically it is 65% stocks/35% Bonds.

The second page shows the cumulative and average numbers.  Note that the diversified portfolio returned 7.9% yearly on average, which grew $100,000 to $461,667.  You'll also notice that 

Source: BlackRock

although there were sectors that outperformed the diversified portfolio over the 20-year period, they had considerably greater volatility as indicated by the standard deviation.

A final basic point to pick out from the chart is  how Fixed Income performed when the stock market dropped.  Check especially those years when Large Cap stocks had negative performance (for example, 2008 when Large Cap was down -37%!).  This will give you a feel for the hedging property of bonds!

The chart can be used to answer a lot of questions that might occur to the curious investor.  For example, you may wonder what would have happened if you started 20 years ago with $500,000, took out 5%/year on an inflation adjusted basis (would need yearly data on the Consumer Price Index), and had a diversification of 70% stocks/30% bonds.  Using an Excel spreadsheet can answer a question like this, or your own variation, fairly easily.

Spending time with this chart will certainly pay large dividends (I apologize - I couldn't resist) ;)

RULE 5 Build Mountains of Money With a Responsible Portfio

 With Rule 5, Andrew explains how to construct a 3-sector portfolio that historically has outperformed professionals, is low cost, and takes very little time to keep on track.  The three sectors are the broad U.S. stock market, the international stock market, and short maturity bonds.

Today it is very easy to invest in funds that track these markets, i.e., are indexed to these sectors.

Once the portfolio is constructed, it needs to be kept on track.  As Andrew points out, this is very easy and takes very little time.  The jargon for doing this is called "rebalancing."  It is so easy that it is part of the family of so-called "coach potato" portfolios that Andrew mentions.  The thrust of these portfolios is that you can have very good performance and actually spend your retirement and working years, for that matter, enjoying life rather than stressing out over your investment portfolio.

To show how easy it is, let's assume that you have a $100,000 IRA at Schwab.  Following Andrew's example, you want $33,000 (one-third of the portfolio) invested in the broad U.S. stock market.  With a little research, you find that SCHB is the ticker symbol for the Schwab fund that tracks the broad U.S. stock market and that it has an expense ratio of only .06% .  To find how many shares to buy, you get the price by putting the ticker symbol in a quote box and then divide the price into  $33,000. Or, you can use the Schwab calculator that pops up on their site when you do a trade.

The point is that all of this is that the mechanics are easy to carry out, once the basic philosophy is understood.  Again, the key is to get an appropriate asset allocation, control emotions by sticking with the allocation through ups and downs, and invest in low-cost index funds.

WHAT KIND OF FUNDS ARE YOU INVESTING IN IN YOUR 401(K) ?

The ticker symbols for the international stock index at Schwab is SCHF, and the symbol for the broad bond market is SCHZ. With these symbols, you hopefully know how to get a quote on each (hint: go to www.schwab.com and use the quote box at the lower left) and figure out the number of shares to buy.  That's it!  15 minutes and you have a portfolio that (again for the umpteenth time) has historically outperformed professionals after all costs are taken into account.

For other providers, such as Fidelity and Vanguard, you just need to find funds corresponding to those of the Schwab funds described here.  Whomever the fund provider for your IRA and 401(k), the principles are the same.  You are looking for low-cost index funds.

An important part of this chapter is Andrew's explanation of how bonds work.  This is a part of the market that most investors don't understand.  The key, as Andrew explains with examples, is that bond prices and yields move in opposite directions. Because they do, they tend to offer a really good hedge when stock markets drop. Read this section of the chapter very carefully.

Later in the week, I will present a chart that illustrates how this hedging ability of bonds has played out over the past 20 years. It is my favorite investment chart, so be sure to look for the post!