In October I argued that the bailout would be a decent investment for the government.  So far so good.  The government has nationalized significant pieces of large financial companies (which is bad), but in exchange our financial system has not collapsed.  Though it will take time, nothing so far suggests that the government won’t get most or all of our money back on the first $350 billion (the auto industry’s $25 billion may be an exception).

Running through the logic  of a bailout:

1. A company that is viable in the long run is about to run out of cash
2. If the company goes bust, systemic problems will ensue
3. No private entity will loan it cash because of a system-wide liquidity crisis
4. The government steps in as a “lender of last resort” and provides the cash at a painfully high price
5. The company recovers and the government liquidates its position

Print and Invest

Essentially, in a bailout the government prints money, then uses it to buy assets (like AIG, which is now 80% owned by you and me).  The assets are in a real company, which then strives to make money.  The value of the company is tracked on a public stock exchange, and we can get an unambiguous read on the value of the bailout investment.

Print and Spend

A stimulus is a whole different animal.   In a stimulus, the government prints money and then spends it on tax reductions ($275 billion in the current proposal) and infrastructure ($550 billion).  The theory is that these tax cuts and investments in infrastructure will be a smart, productive use of cash, and that the US economy will grow as a result.  In practice, governments are terrible at spending money productively, and the increase in government debt will reduce private investment, making this a zero sum game.

A Zero-Sum Game…at best

The global total of private investment every year is equal to the total of private savings, corporate savings, and government savings.  Think about this for a minute, and you’ll see that it makes sense.  Investment is simply the flip-side of savings, and if you total up all of the savings in a given year, you get the net change in investment.

When governments operate in a deficit, their savings are negative.  Every dollar of increased deficit means one dollar less of investment by the private sector.  Put another way, when the US government increases its debt by $825 billion, that’s $825 billion that must be borrowed.  In borrowing that money, the US government is competing against other uses of people’s savings.  If the US government gets the money, then the money won’t be used elsewhere for private investment.

Public vs Private

The purpose of any investment, public or private, is to increase future income.  So if the government takes money from private investment, then it had better use the funds more wisely than the private sector would have, otherwise future income will go down.  Given the general success of Capitalism as a way to allocate resources, this is a tough hurdle.  Hmmm….the stimulus isn’t sounding quite as rosy.

Here’s the logic:

1. The US Stimulus plan will be financed with borrowed money, increasing the US debt.
2. The added debt displaces other uses of the funds, specifically private investment.
3. Therefore, stimulus plans only increase income when they move resources from less productive to more productive uses than the private sector would have identified.

There are a few caveats to this whole argument.  First, if the US can borrow money from the rest of the world, it will take away from private investment in other countries, and not in the US.  This will be true as long as the world has an endless appetite for US Treasury securities.  The fly in this ointment is interest rates.  The more debt the US has, the more a tiny movement in interest rates can cost US taxpayers.  The government is always purhcasing more debt as notes come due.  If there is less demand for some reason, the interest rate paid will be higher than before.  This can get expensive very quickly.

There are a few other technical macro-economic arguments to be made, including the effect of the net change in inventory levels – call me if you’re curious, and I’ll steer you towards further learnings.

So, what’s an investor to do? 

For starters, get out of intermediate and long term US treasuries.  Long term treasury funds like Vanguard’s VUSTX were up over 22% last year.  That’s both unheard of and unsustainable.  Even short term treasuries are iffy but probably OK.  The next safest best in fixed income right now is TIPS, or treasury inflation protected securities.  These US gov’t securities are indexed to inflation and go up when inflation rises.  These funds took a beating last year, dropping almost 3% as inflation fell to nothing, and they are poised to rise with any increase in inflation off the current zero base.

My clients are also in municipal bonds, which continue to offer great returns, and both investment grade and high yield corporates, both of which took tremendous hits from the fixed income “flight to quality”, and are now still cheap but bouncing back.  Both munis and corporate were hurt by the liquidity crisis, but don’t have major underlying problems at their current valuations.

On the equities side, the US Dollar continues to be very strong, pointing the way for good returns to international investments.  This is trickier terrain and must be done very carefully to avoid getting burned.

Posted on January 26th, 2009 No Comments »

2008 has delivered a lot of lemons, and not much sugar.  We’ll have to content ourselves with just a little bit of lemonade.

The half-glass of lemonade I’m pouring today includes an exploded investing myth and a $1,400 tax tip that everyone can use. (Please see my Terms of Use - I’m not an accountant)

First – our myth
 
I’ve had quite a few conversations with investors who are afraid to trade lousy, loss-ridden mutual funds for fear that they will miss out when the market  “bounces back.”  The obvious problem with this argument is that yesterday’s losers may not be tomorrow’s winners.  Many tech stocks hammered in 2000 did not ever bounce back. 

The more subtle and interesting problem is mutual fund turnover.  Most investors buy and hold mutual funds for long periods.  The 1099 forms they receive each year go to their accountant along with their (much larger) W2, and they either get a refund or make a payment without thinking much about why their “buy and hold” strategy is sticking them with a tax bill.  Turns out that mutual fund managers are furious traders, buying and selling stocks at a breakneck pace, and it’s THEIR trading with YOUR money that determines the taxes that you pay.

The average mutual fund turnover is 85% per year.   If you’re curious about a particular fund, Yahoo Finance includes Turnover data.  Use the left navigation to choose Fund > Profile, then look on the right under Fund Operations.  You can see that Fidelity Magellan’s 57% turnover is below the category average of 97%.

The bottom line is that mutual funds that did worse than the market do not own the same stocks they lost your money with – they own different stocks that may once again lose to the market.  So don’t be afraid to get rid of lousy funds, especially if you’re doing it within the context of a new and genuinely strategic approach to your savings. 
 
As an FYI, the quasi-index funds I use have turnover of 5-14%.  It’s difficult to go lower than this because M&A forces some turnover.

Second – a (related) tax tip (note my Terms of Use - I’m not an accountant)

By selling your lousy funds and losing stocks, you can bank a large capital loss, and each year you can deduct $3,000 of capital losses from your income.  You can carry these losses forward as long as you live, taking $3,000 off your taxes every year you continue to have more losses than gains. 

Let’s explore how this works with an example:

1. All of your money is invested in the Fidelity Contrafund mutual fund.  Your original investment, made a few years ago, was $100K.  Now it’s worth $60K.  You choose to sell it all and reinvest the proceeds elsewhere.  You now have $40K in capital losses, more or less.
2. You take $3K off of your income taxes.  This is “above the line,” meaning you get this deduction even if you don’t itemize your deductions (such as if you don’t own a home).
3. You carry $37K in losses forward to be subtracted from the cap gains portion of future 1099s.
4. Your $3K reduces your actual taxes by around $1,400 (i.e. the taxes you would have paid on the $3K in income that you sheltered with your $3K capital loss).
5. You buy one each of a Nintendo Wii, a Four Seasons Spa gift certificate, and a Rolling Stones genuine imitation framed gold record.  Happy holidays.

Note what’s happening here:  the government is actually subsidizing your stock market losses by giving you a tax credit in $3K increments.  This may not seem like much, but it’s still free money for very little effort.

If you switch to a low-turnover strategy at the same time (as my clients do), you can avoid significant capital gains taxes for the next 20 years, enabling you to stretch out your capital losses and potentially recoup much of them from the government.

Posted on December 16th, 2008 No Comments »

The root cause of the global financial meltdown is now clear:  Too Much Money.  Where did all of this money come from, and why is it a problem?  The answer will take us far beyond sub-prime mortgages.

Turns out that the current worldwide economic catastrophe and impending recession is Japan’s fault.  OK, it’s not quite as simple as that; Greenspan is partly to blame too.  You can think of sub-prime mortgages as the straw that broke the camel’s back.  They are only a symptom, not the underlying disease. 

Somebody had to be buying these sub-prime mortgages, and that somebody had to get money from somewhere.  The Bank of Japan is where they got that money, or at least a lot of it.  The disease that has the economy on its back is caused by Too Much Money (too much liquidity for you wonky types).  And you thought that was just a problem for athletes and movie stars.

Let’s learn about the “Japanese Carry Trade,” which created much of this poisonous money.

Since 1995 the Bank of Japan has been loaning money at 1% or less.  From 2001 to 2006 the rate was 0.1%, and the rate today is 0.3%.  This created the Japanese Carry Trade, whereby hedge funds and investment banks borrow money from Japan for practically nothing, and then carry that money over to the US and other countries and invest it in whatever strikes their fancy.

You might think that the Bank of Japan is taking a horrible risk by loaning money for free, but the Bank of Japan is responsible for Japan’s economy, and that economy depends on exports.  By loaning money at 0%, the Bank of Japan creates a ton of yen.  This is because the 0% rate is very attractive, and many investors bite, creating many loans and trillions of new yen (estimates of the carry trade range from 100-300 trillion yen, or $1-3 trillion).

Remember the laws of supply and demand:  if you have a lot of yen, then yen aren’t worth as much.  Cheap yen means cheap Japanese electronics, which means jobs for Japanese people.  With lots of Japanese people employed, the Japanese economy continues to grow.  To the Bank of Japan’s way of thinking, a few bad loans is a small price to pay for a growing economy.

For those involved in the Japanese Carry Trade, there is of course a risk:  that whatever you buy with your free yen will decrease in value, leaving you scrambling to find the yen to repay the Bank of Japan, because 0% interest still means that you owe them 100% of what you borrowed.

As the free money piled higher and higher in the global economic system, far outpacing increased production of actual stuff, two things happened:

1. The prices for things of real value, like stock in real companies, went sky-high. 
2. A market sprung up for complicated things that had no underlying value, such as sub-prime mortgages, because people were so much less diligent about what they were buying, because everything was going up..up..up…

Why would people buy things of no value?  The tide of money had been rising for so long that investors became less thorough in their evaluation of new investments.  Many of the people making recommendations on what to buy were getting paid to be middlemen, and they frankly didn’t care about the underlying value anyway.  Kind of like a bad investment advisor who suggests you “try” something you don’t fully understand and don’t need because it went up in value last year…

Where is Greenspan in all of this?  He was busy emulating Japan and lowering the US interest rate, which dropped from 6% to 1.25% after the stock market crash in 2002.  While the rate did pick up for a few years between 2005 and late 2007, it’s back down now to just under 1%.  This created a boom in re-financing, as people took money out of their homes and speculated with their new capital, in a domestic version of the global Carry Trade.  This had the side benefit of keeping the US dollar low, which “helped” our economy.

Back to our story on the Japanese Carry Trade.  Let’s assume you posted some collateral with the Bank of Japan, and now that collateral has fallen in value, as it did over the past year.  You’ll have to rush to sell whatever you own so that you can pay the Bank of Japan.  If you own US Equities, and they’ve gone down in value, you’ll have to sell a lot of them. 

This is basically what just happened, and the results are now visible:  with the value of collateral down, the amount of outstanding yen loans is down, and there are less yen around.  This has driven the yen to an all-time high in value, with $1 US buying only 97 yen versus the usual level Japan has preferred of around 120 yen.  (Remember that when you can buy more yen for $1 US, you can also buy more Japanese electronics for $100 US, which as we said keeps Japanese people employed.)

So, where does that leave you and me?  The current instability and panic has everyone fleeing to US Treasuries, and this has created some highly unusual mini-bubbles, including one that is especially compelling in municipal bonds.

Right now tax-free municipal bonds are paying in the 5-6% range for longer durations.  Compare this to the 10-year Treasury rate of 3.84%.  Since munis are tax free, for most people this is an effective yield of almost 6.5% versus taxable investments.  That’s well over the best CD rates, and is just plain crazy good interest.  For my part I’ll continue to move high-tax-bracket clients into munis for the fixed income portion of their taxable portfolios.  If you own bond funds or have a messy portfolio of government and corporate bonds, now is a good time to rationalize and redeploy.

Posted on November 18th, 2008 No Comments »

We’ve all heard about Credit Default Swaps, and how they’re the great bugaboo that could rear up and kill the entire world’s economy. Warren Buffett called them “financial weapons of mass destruction.” Since that’s pretty scary, we should all have a clever metaphor for explaining what they are.

Credit Default Swaps (CDS) are like you buying fire insurance on your neighbor’s house. You have nothing to do with your neighbor, nothing to do with their house, but you think you have a pretty good idea about whether or not their house might burn down. So you find someone else who will take a fire insurance premium payment from you every month for 5 years. If the house burns down, you get paid. If not, you paid a bunch of premiums and got nothing in return. You made a bet, and you will win or lose.

Let’s extend this metaphor a bit. Suppose you built a clever model that showed that the 1,000 houses in your neighborhood each had a 1% chance of burning down in the next 10 years. If you could buy fire insurnace on all 1,000 houses such that the cost of the insurance was less than what your model showed you would make when 1% of them burned, you’d have a pretty good bet. In theory, you’d have a winning bet. You might even be able to sell your side of the bet to someone else, who would then take over the premium payments. Free money!

Naturally, the person selling you the insurance would be a fool who built a lousy model and shouldn’t have sold you the insurance in the first place, since when all of those houses burn they’ll have to pay you a fortune. Maybe they’ll even go bankrupt as a result of having to pay you for your neighbors’ burned-down houses!

Or maybe the person on the other side of the bet, to whom you pay premiums, will sell the insurance policy to someone else, who you don’t even know! You’ll be paying every month, and then when the houses finally burn down, the person who owns the insurance policy turns out to be just some loser, like a bank in Iceland or something. They’re broke, you’re out the premiums you’ve paid, and no one benefits from the burned-down houses.

Let’s kick this up to Defcon 5. Suppose that everyone is selling everyone else these crazy insurance policies on other people’s houses. The Credit Default Swap market is estimated at $58 trillion. That’s nuts!!! The entire world’s publicly traded equities and debts are worth only $35 trillion.

In actuality, Credit Default Swaps are like fire insurance on municipal and corporate debt, and on mortgage-backed securities. If the municipality issuing the bond goes into default, then the person paying the monthly premium on the CDS wins the bet, and the person taking the premium has to pay.

Of course, it’s only when municipalities and other bond issuers start to default in huge numbers that you can see whose clever model is better, and who is toast. Unfortunately, if the people with worse models don’t have any money, then the “winners” are toast too. These “winners” then have to write down the value of their CDS assets, meaning they have to take them off their balance sheets. This reduces their assets, possibly affecting their credit ratings, possibly causing a run on their assets by nervous investors, possibly destroying the entire planet.

In reality, the government will step in and regulate the CDS market. One possibility, for example, is that you can only buy fire insurance on your own house. Another is that the rules around how to value these insurance policies will become transparent, so that banks can’t fill their balance sheets with nonsense that can evaporate overnight.

Then we can safely go back to hearing on TV about how some other country’s economy is imploding, and not ours. And then we have nothing to worry about.

By the way, clients of Ross Asset Advisors were (and are) protected better than most from these problems. This is because I use 2-year globally-hedged government debt (or its municipal equivalent) as the majority of my bond allocation. The fund I use is up 2.09% YTD as of October 16. These instruments are not exposed to any company that is encumbered by Credit Default Swaps. The purpose of bonds in a portfolio is to provide stability and ballast, so that risk can be taken with equities. Longer term and corporate bonds have not been demonstrated as being useful in this regard, since they have volatility almost like equities, but much lower returns.

Posted on October 20th, 2008 No Comments »

Between the $85 billion AIG bailout and the $700 billion “Emergency Economic Stabilization Act of 2008”, every one of the 305 million US citizens is now in debt another $2,600.  Is it heresy to suggest these loans are good business?  That we will get paid back plus make a profit from this new debt? 

If you want to argue that we’ll profit from these loans, then you’re in good company:  Warren Buffet said just that on a PBS interview with Charlie Rose.  I agree with Buffett, and you can too.

Remember how the AIG deal is structured:  the government gets 80% of the company, then loans it up to $85 billion for 2 years at 12% interest.  Holy smokes, did someone just say 12% interest?  Meanwhile, thanks to investors leaving the markets, the US government is borrowing money more cheaply than ever: 1/20 of a percent at a recent Treasury auction.

It’s easy to see how the AIG bailout will make us money: it’s one company, and it’s done.  The mortgage bailout is just beginning – but we’ll get through it OK.

Let’s start with some assertions to help justify why the Mega-Bailout is going to make money: 

• Treasury Secretary Hank Paulson is really smart, and he now has total discretion to invest the $700 billion any way he pleases.  Here’s what the bill says about who can question his authority:  “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”  Wow – I don’t even have that kind of power in my household.
• Oceans of bad loans need to be sold to someone for market prices.  None of the sellers expect to get full price for them, but no one wants to buy them at ANY price.  Do you want to buy any mortgages?
• Everyone with money is deleveraging, meaning that they’re trying to keep more deposits vs loans than they used to.  So there’s just no money floating around.

The problem is simple:  even at a fair price no one is stepping up to buy the bad loans.  When everyone is selling and no one is buying, a savvy buyer can get a good deal.  That’s what Paulson is going to do:  be the savvy buyer.  He didn’t claw his way to CEO of Goldman Sachs by being somebody’s fool. 

The world’s three richest people are currently on a buying spree.  Buffett just put $3 billion in GE and $5 billion in Goldman Sachs.  Carlos Slim bought 6.4% of the New York Times in early September, and even Bill Gates is spending some money – on Monday he bought 5.6% of Strategic Hotels & Resorts, which owns various hotels operated under brands like Fairmont, Four Seasons, and Ritz-Carlton.

What NOT to argue:

These bailout efforts aside, the economy isn’t just going to bounce back.  A reasonable guess is that we’ll have a recession of between 6 months and 3 years.  Unemployment, currently at 6%, will probably rise.  If Hank Pauson does a bang-up job we’ll hopefully see unemployment stop at 7%, but 10% is certainly possible.  That’s a lot of miserable people – hopefully it will not come to that.

The bottom line is that we live in a self-healing system.  Look around you – aren’t people still productively doing what they do?  Sure, we buy too much stuff from overseas, but that just ties the world’s economies together.  In 10 years this will be no more than a memory, and the next disaster will again be compared to the Great Depression.  Meanwhile, our standard of living rises every 10 years like clockwork.

So what’s a non-billionaire investor to do?  Same as yesterday:  correctly choose a stock/bond allocation, identify how much small and value tilt you want in your portfolio, diversify globally, reduce fees and taxes, and pay more attention to your friends and family.

Feel better?

Posted on October 8th, 2008 No Comments »

With media outlets clamoring to write ever more alarmist headlines, there are precious few voices of reason to be heard in the press. Let’s pull up a few thousand feet and answer some questions:

• How did last week’s downturns actually look compared to other big drops since 1950?
• What global investment performed best in the last 10 years, when the S&P 500 was doing terribly?
• What was best in the 10 years before that? (you guessed it – the answer is completely different)

First let’s take a look at the 15 biggest drops in the S&P 500 since 1950, in chronological order:

This week’s two drops, coincidentally at 4.7% each, look scary when combined. But after Friday’s rally, the actual S&P 500 was up for the week by 0.33%! It’s true – Monday morning we were at 1251, and Friday’s close was 1255.

Keep in mind that during this tumult, hundreds of billions of dollars left the stock market for money markets and bank accounts, missing Friday’s 4% rally. Truly, reacting to headlines can be hazardous to your financial health.

Capitalism has proven to be the equal of every challenge it has faced in the last century, and the failure of Fannie Mae, Freddie Mac, Lehman Brothers, and possibly AIG will be no exception. The world will survive without the advice of Lehman Brothers. Mortgage-backed securities don’t exist because of Fannie and Freddie – they exist because they make sense as financial instruments. Including AIG, these 4 firms represented less than 1% of a diversified US equity portfolio on June 1, 2008, and an even smaller proportion of a global strategy.

What is not in doubt is that the S&P 500 was a poor investment over the last 10 years. This points to the importance of global diversification. Over the last decade, emerging markets the world over have been tremendous growth engines.

Let’s take a look at how 4 major indices compared. If only we’d known in advance to put all of our money in Emerging Markets.

 
Here are some definitions, for those of you less familiar with this index stuff

• MSCI Emerging Markets Index – this is a good benchmark put out by Morgan Stanley Capital International (MSCI). Emerging markets are places like Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela
• MSCI EAFE Index – This is the Europe Australasia Far East (EAFE) Index. Kind of like the S&P 500 for the Developed World outside of the US. Developed Markets are places like Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom
• Lehman Brothers Aggregate Bond Index – an index comprised of all US bonds, including government, mortgage, and corporate.
• S&P 500 – These 500 companies comprise approximately 75% of the total US market capitalization. Roughly another 6,200 mid- and small-cap companies comprise the rest of the US public equities market.

Now let’s look at these same four indices, but for the 10 years from 1988 to 1998. This is the period directly prior to the graph above.

Hmmmm. Looks like the S&P 500 was the big winner. The other developed countries (EAFE) lagged even the US Bond Index.

The obvious lesson here is that if you can predict the future, you win!

The other lessons are:

• If you don’t own the stocks of individual companies, you won’t get killed when an individual company blows up. Buy indices to avoid the “uncompensated risk” of owning individual stocks. The rule here is: if you’re not going to own 100 stocks in a given asset class, then the Index provides higher returns with less risk than owning individual stocks.
• In the long run, investing in the S&P 500 alone is probably fine…but the “long run” can mean 30 years or longer.
• If you want to do well in the less-than-long-run, your portfolio needs to mirror the global economy, with a tilt towards those places where tremendous growth is happening.
• Bonds are very safe. You want some bonds or you will likely freak out when your overly-risky portfolio loses 50% of its value and doesn’t recover for 3 years

Posted on September 21st, 2008 No Comments »

Adding to the currently scary investment climate is the cheap (and cheapening) US dollar. Once considered THE reserve currency of choice, it is now one of a number of choices, and less of a standout every day.

Financial writing is most interesting when it predicts the future, as this article does: Why the U.S. Dollar Will Continue to Lose Value.  While prophesies are entertaining, as a financial advisor I need to actually tell people what to do to prepare for the future. 

It’s easy to play a bunch of What If games about the US Dollar, and whether it will grow or decline in value.  At the end, you’re still left with a few decisions:

1. How much to allocate to US vs International equities
2. How much to allocate to US vs International bonds, including especially foreign exchange holdings

In equities, my general goal is to mirror the global economy with asset allocations, allowing for a tilt towards small and value companies.  This means a hefty international component.  Whether the dollar goes up or down, the long term bet is that the global economy will continue to grow, with outsize growth (and risk) coming from smaller companies worldwide. 

My recommendations are also made based on predictions, in a sense, since I’m suggesting to people that the smart bet to play is on the long term health of the global economy - Capitalism writ large.  It’s just a boring sort of prediction, since it’s been true over every 10 year period since the late 1800s.

I stress to prospective clients that the best way to view their portfolio is as something that will give them a boring 20 years, at the end of which they’ll have done better than anyone who tried to spice things up.  They may not have any stories to tell about how they turned $20K into $300K, but they won’t have any skeletons to hide either about how they turned $400K in $0.

Posted on July 30th, 2008 No Comments »

So I’m sitting at my desk, doing research into international real estate index funds, when all of a sudden I’m in an earthquake.  Or at least I think I was.  Nothing on the news so far.

There was a bit of gentle shaking, a pause, then some more gentle shaking. Before we could press ourselves inside the nearest door frame, it was over.

Posted on July 29th, 2008 No Comments »

Active trading strategies can become incredibly complex.  They remind me a bit of astrology:  the inner workings of the system are so complex that you quickly get lost inside.  With each failure to predict the future, you figure you just need to learn more, and there is an endless variety of active trading strategies to learn.  It’s all too easy to forget that underneath all of the terminology and tactics are some basic assumptions that don’t prove out - namely that active strategies don’t beat index strategies in any study I’ve ever seen (see Efficient Markets).

Seeking Alpha has huge content depth on active trading.  I found this thread interesting because it shows how complicated active strategies can be.  In theory you’re supposed to do all of this complicated stuff before you go on vacation.  What about when you go to sleep at night?

Check out the 3rd comment down, by BSchecker.  Clearly someone that got burned by active trading and is trying to get the word out.  His voice is totally drowned by those selling advice. 

Although I don’t find it so, the problem for most people is that index investing is kind of dull.  It’s not compatible with thinking that you’re going to win the lottery by discovering a “secret” trading strategy (that is sold on the internet for $200/year). 

It’s also much easier to write endless articles about active trading than it is about indexing. New active trading strategies require little more than some complicated options wrinkle plus a few claimed anecdotes of success.  To actually push the boundaries within indexing you have to do academic-caliber work.  Even then you’re mostly just proving that this or that active strategy fails relative to indexing.

Posted on July 26th, 2008 No Comments »

Published on the Motley Fool:  Will Dividend Stocks Survive? 

I remember when the Motley Fool was first launched in 1993 by two optimistc brothers who felt that anyone could pick stocks.  Now it seems that the entire site is a sales pitch for their newsletters.  Turns out that not just anyone can pick stocks - at least not as well as Motley Fool newsletter authors

The article suggests that there should be a debate about whether or not Dividend ETFs are a good idea given the recent decline in the markets.  The idea is that people who bought stocks for their dividends are now facing capital losses.

Framing the debate in this way is flawed.  The real question should be: Does it make sense for a long term investor to treat the presence or absence of a dividend as a criteria suitable for defining an asset class?

The answer is “No”.  Paying a dividend is one approach to rewarding shareholders.  So are stock buybacks.  So are making wise investments in the business that will drive growth.  Further, dividends are not guaranteed - they can be decreased at any time - so they aren’t a reliable source of income through all market conditions the way that bonds are.

The 3-factor model is widely accepted as the best depiction of which variables drive long term differences in returns.  None of the factors relate to dividends:

1. Equity Markets: meaning equities have higher return and risk than than bonds.  This is the classic “Beta”
2. Company Size: smaller company stocks have higher returns and risks than larger companies
3. Book-to-Market: lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks

When I build portfolios, I often include a value or small company tilt, meaning that we slightly overweight small and value companies in the portfolio relative to their actual market cap versus the S&P 500.  The extra risk of these investments is mitigated by having a sensible fraction of assets in bonds.   I’ll typically do a small company tilt both domestically and internationally.

Posted on July 22nd, 2008 No Comments »