46. How has it been working for you?

On Oct 1, 2011, The Economist ran a cover story that told investors: Be Afraid. The subtitle tells you everything you need to know about the dire views of the author: "Unless politicians act more boldly, the world economy will keep heading towards a black hole."

So, did you listen to the experts? Or do you think that you're smarter than them?

A great article I read today, It's Time To Stop The Plundering Of Investors, brings this example. We hear every day contradicting views from analysts, economists, brokers, MSNBC, and way too many experts who all just know the future. It's funny how they have no doubts. Of course, it's the same people who did not tell you to get out of the market in 2008 to avoid the greatest recession since 1929, and the same people who did not tell you to get back into the market in late 2009, to enjoy a recovery that doubled share prices within 2.5 years. But having no clue never stops them.

And that Economist story?

The S&P 500 hit a a low for 2011 on Oct 3, and since then went up by 28%. Pretty bright for a black hole, I'd say.

45. Don't Read This!

More accurately, don't read the financial news.

Why?

Here's a sample: the headlines from Yahoo Stock Market headlines this morning --

So let's see what we have here:

1. "Stock futures little changed", although manufacturing data in Europe doesn't look good. Slight negative, it seems. But then...
   
2. You need to watch these 3 ETFs! What the hell does that mean? Is it like watching TV? Is it going to be exciting or funny? Again, meaningless advice. But wait, there's more!
   
3. "Major indexes on roller-coaster ride". Weren't they "little changed" a moment ago? Sounds like a lot of ups and down, probably down, because of that manufacturing data, but...
   
4. "Wall-Street looks to extend the rally into April". Hmmm, maybe this means the stock market is not going down or staying where it is, but actually going up? But then, this roller-coaster worries me. Wait, there's more!
   
5. "For stocks, a stable and impressive climb in 2012" - no roller-coaster after all?

In other words, within 5 headlines in a single day, analysts are predicting that the stocks will go up, will go down, will remain where they are, will be stable, and will have a roller-coaster ride. 

Maybe I find it all confusing and meaningless because I'm not watching the 3 ETFs show?

44. A Word From Fidelity

An excellent article in Fidelity today: The pros guide to diversification. Readers of this column will be familiar with Fidelity's analysis, but it's interesting to see the accompanying charts they use to illustrate their main points:

• Diversification allows you to reduce risk without reducing returns
• Negative correlation is key: your portfolio should contain asset classes that tend to move in opposite directions
• Periodical rebalancing is required to keep your traget allocations on mark; it may also increase your returns in the long run. 

Unlike me, Fidelity "allows" you to own individual stocks, but warns you against having any stock crossing 5% of the portfolio. This means tracking, researching, buying and selling at least 20 stocks. I find it much easier to stick with index funds and let the day traders and Fidelity experts buy and sell on the news. 

All in all, a great article and great advice. They must be reading this blog :-)

43. Year of the Yo-Yo

An interesting article in the New Yorker last week discusses the financial performance of 2011. I agreed with some of James Surowiecki's points, but I think he's missing a couple of important observations. First, the writer makes the correct assertion that 2011, a year with wild swings, ended up where it started, more or less: the S&P 500 down 0.03%. Per Surowiecki, this tepid performance will send many investors with long-term horizons looking somewhere else to park their money: what's the point of investing in a market that, after making your fortunes climb and fall like a republican primary candidate, ends up more or less at the same point? A market with high-volatility is good for nothing except heart burn.

Well, not exactly. Even a market that does 0% over the long run can be a source for profits, exactly because of the volatility. True, if you invest $100 in 2001, and 10 years later you sell them after the S&P 500 did exactly 0%, you'll get 0% appreciation of your money. But passive index investing is not just about invest-and-forget. An important part of it is about rebalancing: a smart investor, either through consistent, periodical investments ($10 a year over 10 years instead a lump sum of $100) or through annual rebalancing, can rip benefits even in a volatile market. In fact, the more volatile  the market is, the bigger your benefit is. Volatility is the investor's best friend, as long as you believe in a positive long-term trend and have the stomach and discipline to keep your plan. The writer says that "while crazy volatility may be great for traders (who live for the chance to make two per cent a day), it’s lousy for the rest of us." It doesn't have to be.

However, volatility is not everyone's friend. I have to admit I gleefully read Surowiecki's description of hedge-fund woes:

You might think that volatility would allow people with superior information and market sense to get ahead. But last year money managers did a very poor job of playing the market. According to estimates made by Goldman Sachs, as of the last week in December 72% of core large-cap mutual funds had underperformed their market indexes. The average stock-market mutual fund was down almost three per cent for the year. And hedge-fund managers, who are supposed to thrive on volatility, did even worse, with hedge funds that focus on stocks falling more than 7%. Strikingly, some of the biggest flops came from superstars: Bruce Berkowitz, whom Morningstar named one of the money managers of the past decade, saw his flagship fund fall more than 30%; the hedge-fund manager John Paulson, whose bet against mortgage-backed securities a few years ago has been called “the greatest trade ever,” saw one of his funds drop nearly 50%.

So much for these geniuses. -50% in one year! Makes you happy about your -.03% return, doesn't it?

Is it time we stopped believing that the lucky hedge-fund/mutual fund manager from last year has some divine knowledge, and if we just trust him with our money (and 5% annual fees) we can get a few crumbs from his multi-billion table?

As my friend Danny says, people often try to hang out with the wealthy, hoping that some money from the rich will rub off on them. Why they don't realize is that it's the other way round: these financiers became rich by rubbing other people's money off on them. But far from Surowiecki's advice, "the only way to win the game is simply not to play", I believe that you can play it smart and simple, and win this game. Good luck!

42. The Best Investment Advice

My friend Barrett pointed me out to this interesting New York Times article, The Best Investing Advice? Maybe Not the Conventional Method. DAL Investments analyzed the returns on 306 mutual funds for The New York Times.

The 306 funds in the study were founded before 1989 and still exist, which in my opinion already tilts the analysis in favor of active funds: fund managers routinely close under-performing funds. Selecting only funds that survived for 22 years creates a bias by removing all the ones that were deemed two dismal to attract customers. (Watch out next time you read an ad that says something like "all of our 12 funds have outperformed the S&P 500 index in the last 10 years". Perhaps they started with a 100 funds 10 years ago.)

Still, even with this sample, none of the funds beat the index consistently; none of the "star managers" picked up the right strategy every year; they all had good years, bad years and catastrophic years; and at the end, their average performance was just that - average, or less than that. Of course, looking back at the funds you can find the "best performing one" and the "best fund manager" - but that would be true for monkeys drawing darts at the Wall Street Journal stock charts. The fund with the lowest expenses, the Fidelity Spartan 500 Index fund, was ranked 161^th, with average annual return of 7.58%, more of less in the middle of the pack.

Although DAL did not find a direct correlation between expenses and returns, it is interesting (but not surprising to readers of this column) that the two worst-performing funds, the Stonebridge Institutional Small-Cap Growth Fund and Midas Magic, did charge the highest fees in the study at 3.4 and 3.84 percent. Their annual returns were 2.66% and 0.58%. On the other hand, they did make the fund managers gloriously rich - so at least someone was happy.

More careful analysis (such as done by John Bogle) that accounts for the selection bias shows that 60-70% of funds underperform the index they try to beat. For me, average is still good. But if you like more risk taking and betting on new and exciting strategies, this article contains an interesting option: a fund that follows "hot trends", selling "losing funds" and buying "winners". Of course, you'll pay through the teeth with expenses and short-term capital gain tax. But you should trust DAL - I'm sure that their recommendation to invest in this fund has nothing to do with the identity of the fund manager. Wonder who this is? Read the article! As for me, I'll stick with my index funds.

41. One Year Anniversary

It was Dec 27^th 2010: before Osama was killed, the debt limit crisis of the summer, and before the economic recovery started stalling, then restarting, then stalling again, then restarting again. Or something like that.

But, most importantly, it was before the first of my Investment, Demystified blogs!

I hope you, my 6 readers, have enjoyed them as much as I have. I'm looking forward to another year of writing about exciting world of personal finance and investment, and wish you all a wonderful 2012!

40. Don't Blink!

Sometimes it seems that the smarter people are, the dumber they manage their portfolios - and their lives, for that matter. In his new book, Life, Fast and Slow, the economist and Nobel Prize laureate Daniel Kahneman tries to understands why this happens. While the explanations are complex, the bottom line is pretty simple: over-confidence is the main culprit.

I've seen it again and again at my workplace: brilliant people, who are right 99% of the time, often have a blind spot when it comes to the 1% of the time where they are wrong. In other words, they assume that they're always right. I think we all know people like this. Steve Jobs was one too - and while he brought one successful product after another to Apple, he also had some dazzling failures that he could never own.

But back to Finance. Recently, I've read "Don't Blink! The Hazards of Confidence" in the New York Times, which made me think of how over-confidence is manifested in management of personal finances.

Kahneman describes how, in his army days, working as a psychologist, he and his peers never let the facts "confuse" them - they knew that their methods are sound, and any evidence to the contrary was discarded with or without reason. Analysts, astrologers and other fortune tellers have the same bias: they know they're right, they believe in their ability to predict the course of the stock market (or the stars, or what the future holds for you), and you can't confuse them with facts. Even if the facts show no correlation between their predictions and the reality: a completely random, unpredictable, efficient and chaotic market.

It's perhaps the greatest scheme of our time, that so many bright people, so many MBAs and PHDs are spending so much time in this futile pursue of a holy grail called "alpha" - these super investments that are better than yours. But perhaps the tide is changing: from Kahneman to John Bogle more and more people see that those pursuits serve no purpose, bring no benefit to investors, and only reduce average portfolio returns by their annual fees and commissions.

The amazing revelation I had reading Kahneman's article is that this is not a huge conspiracy. It is not a well-held secret, passed from one generation of financial gurus to another. It's much worse than that: they actually believe in it. Against all odds, against scientific evidence, these people and firms, many of them very smart, truly believe that they, with their superior knowledge and skills, can edge an advantage in a market that follows a random walk pattern. Kahneman recalls how he presented financial management company with analysis of their own numbers, demonstrating that the bonuses they give to their star analysts have no correlation with future success, and proving to them that any relative success is transient and random. In fact, he proved to them that their entire merit system is giving random precious gifts to people who don't deserve them. They just stared at him, said "thank you" and "goodbye" and that was it. They believed too much in their system to let the facts confuse them.

Wall Street is asking us every day: "are you going to believe us, or your very own eyes?" I suggest you open your eyes.