Wise Money Decisions

This interview of Eugene Fama, who is commonly referred to as the father of the Efficient Market Hypothesis (”EMH”), was conducted in August 2009 by Dimensional Fund Advisors. 

A few highlights:

Responding to critics that the recent volatility has ”killed” the EMH: 

“The market can only know what’s knowable. It can’t resolve uncertainties that are unresolvable. So when there’s a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices. As far as I’m concerned that’s exactly what we’d expect an efficient market to look like.”

Paraphrasing other interesting comments:

Most behavioral finance advocates like to point out inefficiencies, but usually conclude that it’s too impractical to take advantage of these inefficiencies and therefore you’re better off to do your risk-return tradeoff.  In other words they conclude that you’re better off to presume the EMH is an accurate description of the way markets work.

The top insiders do better trading on their own company’s stock but interestingly only by about 1%.

The most potent challenge to the EMH is evidence of momentum in stocks that can’t be easily explained. Secondly, movements due to earnings announcements tend to persist longer that expected.  Those are the two biggest challenges. Remember, EMH is a model, not truth. It’s a simplification of the world that does a good job on almost everything, but a few things it doesn’t do a good job on, e.g. insider trading, momentum, and movement from earnings announcement.

The EMH is not a perfect explanation of everything that happens in the market, but it is the best working proposition for use by investors.  Most investors should presume that the only way to reliably affect the expected return from their portfolio is by varying the level of risk they’re prepared to take.  Nothing in the last 12 months has altered that. Some people are claiming the market isn’t efficient, but they aren’t claiming there are easy profit opportunities out there.  It’s one or the other.

Whether you agree or disagree with Fama and EMH, this is a must-see interview in light of the recent volatility in the debate about EMH (ha ha).

Seekingalpha has a fascinating and short interview with Roger Ibbotson (”fascinating” and “short” seem to be highly correlated for me).

If you want to learn more about Ibbotson, read the intro to the article.

In case you don’t have time to read the whole interview, here are the highlights and money quotes:

• Because many hedge funds had (have?) a similar strategy, many hedge funds had to unlever at the same time in summer 2007, contributing to the meltdown “as they rushed to the same exits.” 
• “In both cases, the quant funds that were able to stick with their strategies were able to quickly recover. But those who targeted volatility got whiplashed. Those who kept their leverage intact did reasonably well. Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.”
• “Investors often select funds with the highest returns, without tracing where the returns came from. Most hedge fund returns are actually associated with beta, rather than alpha….. they do not really provide alpha and can be replicated for less than typical hedge fund fees.”
• “The drop exposed the fact that many hedge funds are really not absolute return vehicles, but actually contain a lot of beta.”
• And the most interesting quote in the interview:  “[H]edge fund alphas are still positive, although not as high or significant as before….  [T]he majority of the returns can be classified as beta, then fees, then net alpha, in that order. Despite the fact that alpha makes up the minority of the return, it is still noteworthy that the net alphas are positive. This is in contrast to the mutual fund industry where there is little evidence of aggregate positive alpha, even on a gross level. On a net level, aggregate mutual fund alpha is usually negative.”

The last quote is interesting for a few reasons.  First, it shows that hedge funds are not about “hedging,” as most of their returns is beta.   

Second, it contradicts another study I’ve seen that concluded the hedge fund industry has net negative alpha.  Unfortunately I didn’t save a link to the study.  If I come across it I’ll post it.

Third and most intersting, it’s more ammo that mutual funds in general are bad investments. There’s too much to say about this topic.  I’ll save it for a future post, or series of posts.

If you are interested in asset allocation, or investing in general, you should check out Wall Street Journal’s graphs showing the correlation of various asset classes with the S&P500.

There are two graphs. 

The first shows a timeline from 1994-2009 showing the correlations over time.  The striking feature of the graph is the rise in correlation of just about every asset class with the S&P500.  For equities, it’s been increasing for several years.  For bonds, it’s a more recent rise (although notice that bonds were even more highly correlated with the S&P500 in the mid-1990’s).

The second graph shows similar data, except aggregated from 1973 to 2009. It also shows the correlation of each asset class with the S&P500 for 2008.  The point of the graph is the correlations became more extreme in 2008, either more positive (most asset classes) or more negative (short-term treasuries and TIPS).

The conclusion is that most asset classes become more correlated during a crisis, reducing the benefits of diversification.

Unfortunately I can only read the first 3 paragraphs of the attached WSJ article because I don’t have a subscription.  It seems to conclude that asset allocation as a strategy is not effective because the correlations rise during a crisis. 

I suppose there’s some truth to it if you only invest during crises.  But do you know anyone that only invests during crises?

On the other hand if you plan to invest long-term, the relevant data is the long-term correlation (the grey bar on the graph) and not the 2008 correlation (the blue bar).  I’m in the market long-term.  I don’t care if the blue bar rises during a crisis. It’s temporary.

And there’s one more salient point.  A well-thought-out asset allocation strategy, coupled with low fees/expenses and a strategic tax approach, is the only way to beat the market in the long-term that is : 1) Easily accessible to most investors, and 2) Legal. 

If you abandon an asset allocation strategy, you’re left with the problem of figuring out a better strategy. 

A few other points worth noticing on the second graph, going from right to left:

• The “U.S. Stock Market” to the right only shows a 0.64 correlation with the S&P500.  I would have expected something in the 0.90’s given that the S&P500 is often considered “the market.”  Not sure if their data is bad, or if there’s some other reason for the discrepancy.
• Hedge funds have a 0.35 correlation.  This shouldn’t be news to anyone, but hedge funds are not really for “hedging.”  There are half a dozen asset classes on the graph with correlations closer to zero, all of which would be better hedges.
• The emerging market stocks correlation is shockingly high at 0.99.  I would have expected much lower. 
• European stocks correlation is shockingly low at 0.05.  I would have expected much higher, perhaps in the 0.80’s.
• Junk bonds are essentially uncorrelated to the market, making them a good hedge against general market risk.

If you are interested in learning more about the benefits of index ETF’s vs. mutual funds (including both active and indexed mutual funds), you will appreciate this 6-and-a-half minute presentation from Vanguard. 

If you are already well-versed in the benefits of indexed ETF’s, the presentation doesn’t cover any new ground.  

Even so, if you like numbers as much as I do you will find some fascinating data in the presentation.

I got a laugh out of the warning at the bottom of each slide:

“FOR FINANCIAL ADVISORS ONLY.  NOT FOR PUBLIC DISTRIBUTION.” 

Clearly information this powerful should not be handled by the public at large.

Jim O’Shaughnessy of O’Shaughnessy Asset Management.

A few excerpts:

The 40 years ending February 2009 were the second worst 40-year period for equities since 1900, with only the 40 years ending December 1941 doing worse! …

We are talking about an event so rare, that most of us alive today will never see such an opportunity again.

Many will say that I got bullish too early, writing that stocks were a screaming buy in Fall 2008 and that they have only declined since then. That’s true. Yet major stock market bottoms are seldom defined by a single point in time. Stocks began presenting great opportunities in the fall of 2008, and those opportunities have improved even more since then. Disciplined long-term investors learn to take advantage of these broad market valleys and continue putting money to work as long as the huge opportunity remains.  

Now is the time for all investors to do the same — for young investors, this is perhaps a once in a lifetime gift, and they should do their best to open and make maximum contributions to their 401(k)s and other tax advantaged plans. 

For middle-aged investors like myself, I recommend increasing the equity allocation of your portfolio to 70 percent and consistently moving money into stocks over the coming months.

And for investors who are already retired, now is the time to increase your allocation to stocks, particularly if you are significantly overweight bonds. If you are 70 years old, the actuarial tables say you will live another 13 ½ years — and a robust portfolio will help you enjoy your remaining years more fully.  

I believe that this time will be no different and that investors who take advantage of currently depressed stock prices will be delighted with the outcome five to ten years from now. 

Nothing we don’t already know, but it’s good to get a reminder that stocks have followed historical long-term trends that tend to overwhelm the shorter-term trends, such as that of the last 18 months.  

And he has some very interesting charts about 40 year returns to back up his main point.   It’s worth clicking through just to see the charts.
 

From today’s Wall Street Journal Online article by James B. Stewart:

For the young and middle-aged, the sharp drop in their net worth is at worst irrelevant, and at best cause for celebration. Their peak earning years still lie ahead of them. They should be saving as much as they can now and putting it into the stock market at these depressed levels. Given the sharp drop that has already occurred, the long-term outlook for stocks and many other riskier assets is better than it’s been in years.

The latest Jeremy Siegel column defends his earlier column “Why Stocks are Dirt Cheap” in which he argued that the S&P500 was “extraordinarily cheap.”   Both columns are worth the read.

In the earlier column he stated:

No one can guarantee the future of the stock market. But I believe that stock prices are now so extraordinarily cheap that I would be very surprised that if an investor who bought a diversified portfolio today did not make at least 20% or more on his investment in the next twelve months.  

It’s not exactly a prediction, but even so it belongs in the Prediction Tracker. 

In the later column he responds to critics and concludes:

The low level of stocks today is not a result of investors expecting current depressed levels of earnings will persist, but rather a result of record risk premiums in the debt and equity markets. When these extraordinary risk levels return to normal, we can expect much higher stock prices. 

My portfolio hopes he’s right.

The mainstream press provides more bad financial advice than good, so it’s important to highlight the good advice when it appears.  

From Ron Lieber at the New York Times:

“It’s a question we’ve all asked in our darker moments of late: Why not just put all of our investments in cash, 100 percent, just for a little while, until things calm down?…

“By fleeing for the comfort of safe and insured, however, investors with a time horizon beyond a few years may be doing real damage to their long-term finances. If you’re tempted to make a big move to cash right now, you’re doing something called market timing. It’s an implied statement that you’ve figured out the right moment to get out of stocks - and will also know the right time to get back in.

“So let’s dispense with the first part straightaway. The right time to move out of stocks was a year or so ago, before various stock indexes the world over fell by one-third or more.

“If you missed that opportunity, you’re hardly alone.

“But if you sell now, you’ll be locking in your losses. And once you’re in cash, there isn’t much upside. In fact, with interest rates low, you’re likely to lose money in cash, because inflation will probably eat up the after-tax returns you earn from a savings or money-market account.”

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.

As far as financial planners, 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.