Wise Money Decisions

In my line of work I get a constant stream of phone calls from three types of people: headhunters, brokers, and financial planners.

The headhunters always ask the same thing.  They want to know if I’m happy with my job.  They’re a very sweet bunch to be so concerned about me.

The brokers and planners don’t ask about my happiness.  They want to talk money.  They want to know how much I have in investable assets.

To keep things simple, you can divide financial planners into two categories: fee-only investment advisers and salesmen.  Brokers are NOT investment advisers.  Brokers are a separate category.  More on that in a minute.

Investment Advisers

Investment advisers have passed the Series 65 exam (to be precise, the adviser’s “representatives” have passed the exam), are registered with the SEC or a state regulatory agency, and are legally required to act in the best interests of their clients. 

Financial planners other than “fee-only investment advisers” are more like salesmen.  They advise you to buy various products, typically insurance and investment products such as mutual funds or annuities.  Many are conduits that don’t invest your money directly, but instead farm it out to other advisers or mutual fund companies.  That results in another layer of fees. 

Other advisers are compensated for each trade they make on your behalf.  If you use this kind of adviser, it’s highly likely your account will be churned.  “Churning” is when your adviser makes unnecessary trades in your account to generate fees.

Brokers

Brokers are not investment advisers.  There is an important regulatory distinction between the two.  Brokers are not required under the law to act in the best interests of their client.  That’s why a broker who knows nothing about me or my financial situation can cold-call me and promise me a 60% annual return by putting a large portion of my portfolio into covered call options on a single oil refiner (which happened last week). 

A good investment adviser would not make that recommendation to me until he understood my financial situation.  A good investment adviser would learn about my financial situation and determine an investment strategy that makes sense for me.  He is obligated under the law to know my situation and make recommendations that are in my best interests. 

A broker is neither required to understand my financial situation nor act in my best interests.

Complicating Things

Now here’s where it gets complicated. 

Some investment advisers think they’re salesmen.  Rather than act in their clients’ best interests, they try to sell expensive, fee-laden mutual funds to their clients. 

Why would they do that?  Because the mutual fund compensates them with a kickback.  The higher the fee paid by the client, the higher the kickback.

This is not in the best interests of clients because you can stack the research a mile-high showing that fee-laden mutual funds tend to underperform the market.  But it’s standard fare for many brokers and investment advisers.

So how can you protect yourself? 

Don’t listen to brokers.  Their interests are not aligned with yours.

Use a “fee-only investment adviser.”  A fee-only investment adviser does not receive kickbacks from mutual funds or insurance companies.  His advice should be independent and not tainted by his own interests.

J.D. at Get Rich Slowly wrote about why investors are better off to ignore financial news.  He cites a Harvard study that says:

Investors who received no news performed better than those who received a constant stream of information, good or bad. In fact, among investors who were trading [a volatile stock], those who remained in the dark earned more than twice as much money as those whose trades were influenced by the media.

He concludes that:

The daily fluctuations of the stock market are especially meaningless to me. I’m still learning the basics of saving and investing. I get more from reading the words of Warren Buffett or devouring books like The Four Pillars of Investing than I do from watching talking heads speculate on why Apple’s stock price fell. 

Here’s my spin:

Like any good business, the financial press has one overarching goal:  earn money. 

They earn money by getting you to read their magazine, watch their show, or visit their website.  With few exceptions, they aren’t concerned whether their product makes you a better investor.  Making you a better investor isn’t their primary goal.  Making you a better investor doesn’t help them earn money.

The financial press is composed of journalists and entertainers, not investors.  Those that are investors are compensated with money or brand enhancement to appear on the show or write the column.  They’re not doing it out of the goodness of their heart. 

I’m not saying they’re dishonest.  And I’m not saying they’re incompetent.  Not all of them.  But you should understand where they’re coming from.  They say things because they’re paid to say things, not because they have important things to say.

Let’s use Jim Cramer as an example.  He makes a tremendous amount of money doing what he does.  And what does he do?  He’s not really an investor.  He’s an entertainer.  He was an investor earlier in his life.  But now he’s an entertainer. 

Does that mean you shouldn’t trust his advice?  Just because he’s an entertainer?  Let’s put it this way.  I only have so much time in my life to absorb financial information.  I’d rather spend it reading books and articles with good, solid investing analysis.  I don’t want investing advice from someone who comes up with things to say only because he’s got a half hour to fill every night.

There are many well-meaning journalists that produce good advice.  But there is also a lot of bad advice out there.  Learn to know the difference so you can ignore the latter.

I wrote about Bill Miller and his recently ended streak of beating the S&P500 here. 

An interesting article in the Wall Street Journal (”Mean Street: Losing Faith in Freddie Mac and Bill Miller” by Evan Newmark) discusses Bill Miller’s recent slide. 

Key quote:

The Legg Mason Value Trust is now significantly trailing the S&P 500 for the past 10 years. Over that same period, it trails 72% of its peer funds.

To get outperformance from the fund versus the S&P500, you have to go back 15 years or more.

I like Walter Updegrave’s Ask The Expert column on CNN Money.  His advice generally makes a lot of sense.

In March he got a question from a 28 year old with Roth IRA money in a 2045 target date retirement fund.  The reader’s account had been pummeled over the previous couple months and he/she asked whether he/she should do something different or just “suck it up” and keep investing (you can’t tell the reader’s gender from the column, unless “A.P.” is a non-gender neutral name that I’m not aware of).

Updegrave advised the reader that he/she shouldn’t “suck it up” because sucking it up is for sports not investing.  Then he used his next 828 words to give advice that can only be summed up as “suck it up.”

I’d like to add one important point to Updegrave’s advice.  There is no reason for the reader to be concerned about the ups and downs of a Roth IRA that is 30 years from its first withdrawal. 

In fact, the best thing that could happen to the reader is a stock market crash for the next 25 years, followed by a drastic upward climb just before he/she withdraws money from the account as the market takes up the slack of 25 years of under-performance. 

Why would that be better?  Because the reader would invest at attractive prices during the 25 years.  He/she would be worse off if the market steadily climbs during the 25 years.

It’s the same reason why I’m not bothered with the market’s awful performance the last few weeks.  After yet another horrible day today, it was announced the Dow is in recession territory at 10% below its all-time high from nine months ago. 

Music to my ears.  Every other long-term investor with a 5 year or longer investing horizon should be happy too. 

I just wish I had more money to throw in.

Ben Stein writes a biweekly column on the “Experts” section of the Yahoo Finance page. 

Ben Stein is an intelligent man (have you seen Win Ben Stein’s Money?  He’s a knowledge reservoir).  He also has the right big picture approach to investing. 

But yet I see his column as more ”celebrity” than “expert.”  Perhaps that’s just the point:  wise investing doesn’t require ”expert.”  Oh, and it doesn’t require “celebrity” either.  It requires clear thinking, a little know-how, and a lot of discipline. 

I like to read his column for a couple reasons: 1)  He has some wise things to say about investing, and 2) His celebrity undoubtedly brings in readers that wouldn’t normally read personal finance columns.  It’s interesting to see what kind of advice those people are getting. 

There’s a third reason.  Stanford Law School puts on a Jeopardy-like quiz show event as an annual fundraiser for a local legal aid society.  Ben Stein agreed to serve as the guest host for the 2004 event. 

I had a classmate, a close friend, who was a huge Ben Stein fan.  It was a dream come true when she was asked to pick Mr. Stein up from the airport, chaueffer him to the Friday night event, and take him to his hotel afterward.

When I saw her the Monday after the event, I asked her how awesome it was to drive Ben Stein to and from the airport.  I was pleasantly shocked when she said she not only showed Ben around town, but she also hung out with Ben in Santa Cruz over the weekend!  An hour of Ben Stein stories followed.

Ever since then I’ve maintained a casual interest in all things Ben Stein.

His Latest Column 

The latest Ben Stein column is short and sweet.  As usual there is not necessarily any unique insight or deep analysis, but there is a big picture idea that hits the proverbial nail on the head: 

Years ago, I received a letter that asked a brilliant question. The writer essentially wrote, “I read many business publications including the well known ones like Business Week and The Wall Street Journal. I observe that not only are they often at odds with one another. But they often have columnists within each publication who vehemently disagree. Moreover, they often turn out to be mistaken in their observations and predictions. How then do I know who to believe and what I should read to know the truth?”

The man’s question haunts me. The older I get (I am now 63 and feel every hour of it), the more clearly I see that much of what is in the media and in the financial media about investments, in particular, is simply nonsense.

I couldn’t have said it better myself.

There’s a well-written article in the New York Times on the growing debate over market-weighted vs. fundamental-weighted indexes.  The author Joe Nocera has done an exceptional job distilling a complicated topic into an easy-to-understand article.

If you have 5 minutes you should read the New York Times article.  If you only have 30 seconds here’s the 30-second version:

The world has been using market-cap weighted indexes.  The weight of each company in the index depends on its market capitalization.  Bigger companies have a greater weight in the index. 

Some believe that traditional market-cap weighted indexes overweight overpriced companies and therefore result in subpar returns.  Over the last few years there has been a growing movement that advocates the use of fundamental measurements (e.g. earnings, dividends, etc.) to determine each company’s weight in an index.  They have developed not only dozens of indexes, but also dozens of funds following such indexes.  They argue that the new funds generate superior returns over traditional market-cap weighted funds.

Robert Arnott, an advocate of fundamental-weight indexing: “It was very clear what was wrong with the index was that the weight was linked to the price.  If the price was wrong the weight was wrong.”

Opponents of the new movement complain that it’s not true indexing because it doesn’t seek to obtain the market return.  They claim it’s nothing more than a clever marketing scheme for what amount to actively managed funds. 

John Bogle: “The market return is the market return.” 

Bruce Greenwald, Columbia University finance professor: “It is a crime that they are marketing this as some kind of new theory they’ve come up with. All they are doing is dressing up a simple, well-understood practice.”

Supporters of the new movement (in no particular order):

• Robert D. Arnott
• Nobel laureate Harry Markowitz
• Charles Schwab
• Jeremy Siegel, well-known Wharton economist

Supporters of the traditional market-cap weighted indexes (in no particular order):

• André Perold, finance professor at Harvard Business School and a Vanguard director
• Vanguard founder John Bogle
• Burton Malkiel, author of “A Random Walk Down Wall Street”
• Clifford Asness, co-founder of AQR, a large quantitative hedge fund
• Bruce Greenwald, Columbia University finance professor

My Thoughts

I need to research the issue before I come to any firm conclusions.  But I’ll offer a few thoughts.

I sympathize with the view that traditional cap-weighted indexes can become skewed when stock prices are out of balance.  Also, I’ve long thought that a 500-company or a 3000-company market-weighted index is overkill when the top 20% of the index drives 90% of the index’s movement (that’s not a criticism of traditional cap-weighting, just a pet peeve). 

I like the idea of indexing based on something other than market capitalization.  However, fundamental indexing has the potential to introduce a great deal of subjectivity.  The whole point of index investing is to minimize the need for subjectivity. 

To the extent an index is based on subjective measurements, it seems like nothing more than a clever marketing strategy for active management (for now we’ll leave aside the fact that there is already some amount of subjectivity in many popular market-weighted indexes, including the S&P500.  Topic for another day). 

But if the index is based on something more objective, like earnings (and nothing else), I don’t have the same objection.  Note that one of the fund companies mentioned in the article uses earnings to weight their indexes, while the other uses a combination of earnings, dividends, and other fundamental variables.  There’s little or no subjectivity in the former, but a lot of subjectivity in the latter.

I love innovation and new financial products.  I don’t use most new products but I like that they’re available for research and for possible use if I decide it’s a good fit at some point.  I plan to watch the fundamental index funds for a while and see if they make sense for me. 

Bill Miller is a well-known stockpicker.  He is chairman of Legg Mason Capital Management and oversees some $35 billion.  Although not as famous as Warren Buffet, his reputation is on par with Mr. Buffet when it comes to picking stocks.  No less an authority than CNN Money proclaims him “the greatest money manager of our time.” 

Bill Miller is most famous for beating the S&P500 index 15 years in a row with his mutual fund Legg Mason Value Trust (LMVTX). 

During the streak there were several years that saw his fund underperforming the S&P500 leading into the final months or even the final weeks of the year.  But somehow he always ended the year with a miraculous finish to beat the S&P500 and grasp victory from the jaws of defeat. 

Nearing the end of 2006 he was in a familiar position: losing to the S&P500 with the year coming to a close.  There was a lot of media attention on whether this was the end of the streak. 

If memory serves me, he performed well at the end of the year.  But the deficit was too much to overcome and the streak ended in 2006.

What Does Bill Miller Prove About Active vs. Passive Management?

(Reader warning:  In the interest of space I’m about to make some generalizations.)

With the rise of index investing over the last 30 years there has been an ongoing debate about whether investors are better off choosing actively managed mutual funds or passively managed index funds. 

Supporters of passive management have compiled an impressive body of evidence indicating that passive management is likely to outperform active management over short periods of time, and even more importantly it is highly likely to outperform active management over long periods of time. 

Supporters of active management cite Bill Miller as proof that actively managed funds can outperform passive funds over long periods of time.  After all, Bill Miller did just that.  He beat the (mostly) passive S&P500 index for 15 years.

So who’s right?  Does Bill Miller prove that active management can beat passive management?

Evidence is Different than Proof

First, it’s important to remember the difference between proof and evidence.  Bill Miller might be evidence of some proposition, but not necessarily proof.  We have evidence of a Big Bang, but we haven’t proved it.  We have evidence of the Loch Ness Monster, but we haven’t proved it. 

If someone tells you that Bill Miller is proof that active management works, the proper response is that he might be evidence, but he’s not proof. 

Now that we all know the difference between evidence and proof, we can discuss whether Bill Miller is evidence that active management works. 

(For ease of use I’m going to use a shortcut.  When I say “does active management work” I’m really saying “can an active manager consistently outperform a passive approach over long periods of time.”   Similarly, when I say, “is active management better than passive management” I’m really saying, “can an active manager consistently outperform a passive approach over long periods of time.”)

Point

Supporters of active management see Bill Miller as evidence that active management is better than passive management. 

Counterpoint

However, supporters of passive management would rightfully argue that the existence of a single active manager that beats the S&P500 index for 15 straight years is a strong piece of evidence that active management doesn’t work. 

Passive management supporters recognize that there may be an occasional “lucky” fund manager that beats the index over a long period of time.  They would argue that with hundreds or thousands of fund managers in the world there ought to be more Bill Millers through simple random chance.  The index doesn’t have to beat all managers over a given time period, it simply has to beat the vast majority.  They would say the dearth of Bill Millers supports their argument that active management doesn’t work.

Point

Supporters of active management would argue that 15 years is simply too long for someone to beat the index by chance.  He must have special insight that allows him to do it year after year.

Counterpoint

Supporters of passive management would respond that 15 years may not be sufficient time for the index to prove its superiority over all other investing approaches.  (For some reason when I write the last sentence I picture Chris Farley saying, “All other tropical storms must bow before El Nino“). 

There may be a lucky active manager that beats the index for 15 years.  But continue for another few years and the lucky manager will eventually revert to the mean. 

I Got to Thinking…

There’s no question that Bill Miller has handily beaten the S&P500 index for 15 years.  But what has he been up to since the streak ended?  Unfortunately not much.  He has been beaten up the last couple years.  If this were a prize fight he’d be down for the count.

As a supporter of passive management I thought to myself, “If the last couple years have pulled down Bill Miller’s average return to that of the index, then passive management has once again proven its superiority, Bill Miller gets his comeuppance, and order reigns in the universe.”  After all, why should 15 years be the right testing period?  Why not 17-and-a-half?  Or twenty?  Or more? 

If the passive supporters are right, then the longer the testing period the more likely Mr. Miller should revert to the mean.

The Numbers

I gathered the numbers for SPY and for Bill Miller’s fund Legg Mason Value Trust.  I chose SPY because it’s the most well-known index fund that tracks the S&P500 and because it has data stretching back through most of Mr. Miller’s streak.   

SPY started trading in January 1993 so I started my comparison there.  By that point Bill Miller had already beaten the index for a couple years.

I’m not going to describe my methodology in detail since most of my readers want the bottom line without the details.  If you’re one of the chosen few that likes the details, post a comment and I can describe more in the comments.

From January 29, 1993 through the end of the streak in December 2005, Mr. Miller outperformed SPY quite spectacularly:

LMVTX:   13.7% annual return
SPY:        9.5% annual return

Miller’s numbers would look even better if I could include the first 2 years of the streak (SPY didn’t start until January 1993). 

Slightly more of Miller’s returns came through dividends.  Including the effect of taxes and taking into account the reinvestment risk would help close the gap a bit, but Miller still comes out far ahead. 

By the way, if you’re thinking, “Big deal, it’s just a few percent difference” then repent now.  A few percent is a big deal when compounded over several years.

Now let’s include the numbers for 2006, 2007, and 2008 through May 15 (from Jan 1993 through May 2008):

LMVTX:   10.74% annual return
SPY:          9.1% annual return

Including the last two-and-a-half years causes a slight decrease in SPY’s performance, but a staggering decrease in Miller’s performance.  Miller seems to be reverting to the mean.

Finally, I calculated the performance for an investor investing in LMVTX vs. SPY assuming a 25% tax on dividends.  SPY partially makes up the gap after-tax because a smaller share of its return comes from dividends.  The results (from Jan 1993 through May 2008):

LMVTX:   10.0% annual after-tax return
SPY:        8.8% annual after-tax return

If you’re like me, you appreciate the tax deferral opportunities of a fund with a low dividend yield.

(Although coming up with different numbers, Moneywise also concludes that SPY makes up ground on LMVTX once tax effects are thrown into the mix.)

Final Thoughts

Bill Miller earned his keep over the last 15 years as he thoroughly trounced the S&P500.  However, SPY is making up lost ground over the last 2.5 years.  It hasn’t caught up to Miller yet.  Only the future can tell if or when it will. 

In my view the existence of a single Bill Miller is strong evidence that active management can’t consistently beat passive indexing over long periods of time.  If active management worked (in other words, if active managers could consistently outperform the index) then there would be many Bill Millers that consistently beat the index year after year. 

Think about it.  The index has vanquished the vast majority of active managers over the years, but it doesn’t get any headline love from the media.  But when an active manager beats the index for 15 straight years it makes headline news in the financial section of the New York Times.  We’re still talking about it years later.

It ought to make you think twice before you pick an actively managed mutual fund.

Finally, if you believe that it’s just a matter of picking the right manager, you still face difficulty of identifying those managers ahead of time.  It’s once thing to marvel at Bill Miller’s outstanding returns over the years, but it’s quite another thing to identify the next Bill Miller without the benefit of hindsight.

Post Script

The New York Times (registration may be required) has this interesting graph showing Miller reverting to the mean after jumping out to an early lead in the late 1990’s and early 2000’s.

A few years ago two elderly California ladies concocted a brutal and dastardly scheme to make $2.8 million.  Their plan involved life insurance fraud and homicide.  They implemented the scheme over a period of years in the belief that a statute of limitations would prevent the insurance companies from contesting the fraud. 

Since this is a family site I’m not going to dwell on the details of the scheme.  If you’d like to satisfy morbid curiosity you can read the article (link above). 

Now the 77-year-old woman is in for life without the possibility of parole.  Her 75-year-old co-conspirator faces 25 years to life.  Prosecutors are not seeking the death penalty because both women will have died of natural causes long before the legal system could impose the death penalty. 

A Better Way to Make $2.8 Million by Age 77

Fortunately there are better, legal ways to make $2.8 million by age 77.  Let me illustrate what I believe is the easiest for the greatest number of people.

When you are 27 years old you commit to putting $243 per month in a brokerage account.  You invest your money in a diversified portfolio of low-expense funds with low dividend yields to minimize current tax liabilities.  You achieve an annual before-tax return of 10%.  You invest relatively tax efficiently.

By age 77 you have a portfolio worth nearly $3.7 million.  You sell everything, pay federal and state income taxes at capital gains rates (I’m assuming today’s capital gains tax rates for someone in California), and you have $2.8 million left.

Hmmm…. $243 per month sounds easier than insurance fraud and murder.  It takes 50 years of commitment, but the commitment is not very burdensome (only $243 per month) and doesn’t take a lot of time once you get the hang of it (passive index investing).

Inflation Hurts You….

Of course $2.8 million will not be worth as much in 50 years.  At 3.5% annual inflation it will be worth only $500,000 in today’s dollars.  How much more do you need to invest each month to overcome the effects of inflation? 

The answer is rather sobering.  You would need to invest $1,360 per month to end up with $21 million before tax.  You would pay over $5 million in tax when you sell everything at age 77, leaving you $15.6 million.  After compensating for inflation, your $15.6 million is worth $2.8 million.

Yikes.  $1,360 per month is a lot harder than $243.

I’ve got three tricks up my sleeve to make things easier.  The first involves inflation.

Read the rest of this entry »

Today I read a Rich Greifner article at Motley Fool titled “Are We Headed for a Recession? Who Cares?“  Like many articles at Motley Fool these days, it’s mostly intended as a sales tool for its newsletter.  But there is some good information nonetheless.

It makes many of the same points I made in “Are We in a Recession? Does It Matter?“  The main idea is that you shouldn’t base investing decisions on whether we’re in an official recession:

“By the time it’s determined that the country is in a recession, odds are that the economy is already close to recovering. For example, the last trough in economic activity occurred in November 2001 — but the NBER didn’t make that determination until July 2003. By that time, the economy had been improving for over a year and a half!”

The stock market is a forward-looking indicator, while recessions are backward-looking.

Mr. Greifner needs only two sentences to sum up the main point of my post “Historical Behavior of the Stock Market During Recessions“:

“Wait, stocks can go up in a recession?
Since 1945, there have been 11 recessions lasting an average of 10 months each. But according to a recent article from Hulbert, during these recessions, the stock market actually rose seven times — and the average market return during all 11 recessions was 3%!”

In other words, the stock market does just fine during recessions. 

Conclusion

Historically, exiting the stock market during a recession is a bad idea.  It’s nice to see the Motley Fool back up my work (or vice versa!).

Several weeks ago Standard & Poor’s released a report that volatility in the S&P500 index was at a 70 year high.  The report states that the number of significant daily market moves, defined as days with a greater than 1 percent change in the index, has soared since summer 2007. 

The first half of 2007 saw only 12.9% significant daily market moves.  The second half of 2007 rose to 38.6%.  During the first few months of 2008 the percentage of days with significant market movement has risen to 51.9%.

It’s Great to be a Long-Term Investor

When I see reports of increased volatility it reinforces my reasons for being a long-term investor.  Short-term volatility is not a concern for people that hold diversified portfolios over long time periods. 

I plan to hold a diversified portfolio for the next 20 years, plus 10 more years after that.  And then maybe another 10 years after that.  The kind of short-term volatility described in the S&P report does not cause me any concern. 

I Like Volatility

Not only do I feel no concern over the S&P report, I actually like the report.  I love to see volatility!  Volatility helps me achieve a better return.  I have adopted an investing strategy that follows long-term upward trends, and it does better when there is volatility along the way. 

Also, higher volatility tends to push some investors away from stocks and toward safer investments, like CD’s or money market accounts.  As those investors flee stocks there are better returns for those of us that stick it out. 

If you’re academically inclined, you may find the following Wikipedia pages interesting:

Securities Market Line

Capital Asset Pricing Model

Modern Portfolio Theory.