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.

39. Winter Harvest

It's December, and it's time for winter harvest.

And I'm not talking about pumpkins or other vegetables. I'm talking about losses.

Each December I look at my portfolio and search for losers. This year, my foreign investment fund, FSIVX, did an excellent job tracking all non-US economies, with minimal annual expenses (less than 0.1%), and together with the rest of the world economy lost about 10% of its value. I bought this fund on the last day of December 2010 - pretty bad for an annual performance! But the reason I've just sold all of it is not because I decided  to get out of foreign markets. Remember - once you set a course, you need to stay with it. "Selling your losers and buying winners" is the same as "Selling low and buying high".

But, selling now has a huge tax advantage: all the losses can be realized as short-term capital loss, the best kind of capital loss. It can offset not only short-term capital gains, which are taxed at your marginal income tax rate, but also your ordinary income (up to $3,000 a year). And whatever you don't use in 2011, you can carry over indefinitely, to offset gains in upcoming years. In my case, for every $10,000 of loss I harvest I expect to get about $3,800 back from the IRS. Not a bad deal!

Once you sell a losing asset to harvest loss, you're left with two problems: a pile of cash, and a hole in your investment strategy. After all, I do want to be invested in foreign markets, in more or less the same amount of cash I've just raised.

What you don't want to do is to go back and buy the same investment (FSIVX, in my case). If you do it within 30 days, the IRS considers it a "wash sale", and all the tax advantage goes up in smoke.

But there's a nice loophole: you can invest the money in a similar but not identical fund without triggering a wash sale. As long as I pick a fund that doesn't track the same index as FSIVX does ("Morgan Stanley Capital International Europe, Australasia, Far East Index"), and is managed by the same company, the IRS considers it a different investment. I chose ACWX - very similar, almost identical performance to FSIVX, but tracking "MSCI All Country World Index except US" and managed by a different company. It's not my favorite fund, their expenses are higher, but they'll do - for 30 days. When I rebalance my portfolio in January (at least 30 days from now), I'll switch back to FSIVX.

To sum up, this is the schedule I propose for the tax-savvy investor:

• In December, before year end, harvest losses: sell enough losers to cover any capital gains you might have, and to offset at least $3,000 of income. The end-of-the-year timing guarantees that these losses will be used in the current tax year. Make sure you choose equivalent but not identical funds: this way you keep your financial plan and gain the maximal tax benefit. 
• In January, at least 30 days later, rebalance and switch back to your investment plan's funds. 

Happy Harvest!

38. The 10 commandments

"Investment, Demystified" is taking some time off. In the meantime, instead of my weekly column, I'd like to recommend Fidelity's 10 commandments of retirement planning - a great summary of many of the principles I've been advocating here.

With wishes of a Happy New Year (Shana Tova),

Your host,

David.

PS Feel lonely and left out? Add a comment below about topics you'd like see covered when I'm back from vacation, and I'll do my best to cover them in future columns.

37. The Dirty Little Secret of the Dow Jones Industrial Index

It's the second oldest index around: since its inception in 1896 it saw countless market cycles, from the great depression to the booms and busts cycles of recent years. It's often the first (or only) quoted index in news reports about the market. And it, supposedly, tracks the largest companies in the US - the bellwethers of the economy.

What can be wrong with that?

The dirty little secret is that the Dow Jones Industrial Average (DJIA) is a pretty crappy index, and a lousy way to measure market performance.

For a start, it tracks only 30 companies. Indeed, all are pretty big, from ExxonMobile to Bank of America, from Disney to Microsoft. But these are not even the largest companies in the US. In fact, the DJIA does not include Apple, which competes with ExxonMobile for the top spot. With so few companies in the index, can you imagine what including Apple would have done to the performance of the index in the last year?

Well, it's not difficult to figure this out, because the DJIA is a price-weighted index. In a nutshell, the value of the index is the sum of the prices of all the stocks in the index, multiplied by a factor, currently about 7.5. (The factor is adjusted when the companies are added or removed from the index.) If Apple were to be included in the index, the company meteoric rise from $200 to around $400 a share in recent years would have added 1500 points to the DJIA! Similarly, AIG stock's 90% collapse in 2008 contributed to a roughly 3,000 point drop in the index, only because the stock price was in the hundreds. Today, after a reverse-split, the stock trades around $22. A similar drop would contribute only to a 150 point drop in the index.

Even worse, the companies in the index have very different share prices. While ExxonMobile (XOM) is traded at $74 a share, Bank of America (BOFA) is traded around $6. This means that a 20% decline in BOFA accompanied by 2% appreciation of XOM will result in a modest gain to the index. If BOFA went bust tomorrow morning and its stock price went to 0, the direct impact on the DJIA would be a drop of 45 points.

Does it make sense to you? It doesn't make any sense to me. But yet, millions are watching this index and its movements religiously. Professionals, however, are likelier to use the S&P 500 as a benchmark for the market and the economy: it contains the largest 500 companies, and is cap-weighted, i.e., the contribution of different companies are weighted according to their total market value. Even fancy modifications of this index, like the equal-weight S&P I mentioned last week, are better than the ridiculous DJIA.

One reason people still use this aging monster is that, against all odds, it's highly correlated with the S&P 500 index. Check this chart, for example:

In fact, the picture from this graph shows that the DJIA is only 10% off the S&P over the last 5 years. Not bad for an index with such a questionable composition. Perhaps this shows how interrelated our economy has become, and how we all go up or go down together. Or perhaps I'm missing something, a magical touch that makes the DJIA the venerable index it is today. What do you think?

36. Index Games

I recently received a Consumer Reports publication including an article titled "New twists in index funds". The twist they present is not that new. What was new to me was the degree of deception in a publication I usually trust.

What is it all about?

Index funds, like their name, track an index of stocks. A reliable index for the US economy is the S&P 500, which tracks the performance of the biggest 500 companies in the US. It is market-cap weighted - in other words, it corresponds to the total value of the biggest 500 companies. Naturally, movement in bigger companies matter more than smaller companies: If ExxonMobile (the biggest component of the index) increases 10% in value, the index will move by a couple of percentage points. If the smallest company in the index moves by 10%, the index will badge very little. This makes sense to me - the economy of the US is more ExxonMobile, IBM and Apple than AK Steel Holding and Monster Worldwide (whose market cap is less than 1% of the the top components).

But, apparently, CR thinks otherwise:

Equal-weighted S&P 500 is a recent invention: take all 500 companies in the index, and weigh them equally. ExxonMobile is now as important as AK Steel Holding. Apple fortunes are as significant as Monster Worldwide.

Does it make any sense? Nope. But look at the graph! The blue line is higher than the red line! Must be a good thing, not so?

Kind of. As long as you bought before 2008 and sold now. I'm surprised that CR relies on such meager data to draw conclusions on the benefit of equal weighting. In fact, if you look at the graph carefully you'll see that between 2003 and 2008 the two indexes had identical performance, and in the last year the traditional cap-weighted S&P 500 is slightly better. The Equal-weighted version had the upper hand in two years - not a significant period of time for any long-term investor. And it can be easily explained by the observation that the modified index is heavily tilted towards small-cap companies. And yes, in some years small-cap will give better results than large-cap, in the same way that in some years large-cap is better than small-cap, banks are better/worse than technology, foreign markets are better/worse than domestic markets, etc. You can never predict these movements in advance, and a couple of good years for small-cap stocks don't say that they're superior. In fact, long-term research shows that although small-cap stocks, over the long run, have higher return than large-cap, they also carry a much higher risk. I would advice against anchoring anyone's portfolio on small-caps.

The solution - in my opinion - is to continue to diversify and invest in everything, from large cap to small cap, through more varied indexes such as the Wilshire 5000. Or invest in the S&P cap-weighted 500, if you prefer the increased stability of large-caps. But don't fall pray to short-term fads and tricks like the equal weight fashion. Besides paying higher fees for the novelty, you're not going to gain much.

Next week: yet another way to build an index, crazier than the two mentioned above, and yet used in the most popular index of all. Stay tuned!

35. Upside Down

Sometimes, it's worth looking at the world upside down.

When you look at falling stock prices, you should ask yourself: Am I a buyer or a seller?

If you're an investor, like me, you're a buyer. In this case, why should you be worried about falling prices? A market crash just means that stocks are cheaper, and you'll get more shares for you hard earned money. In fact, annual rebalancing and periodic, consistent investments force you, in a way, to buy low and sell high.

To illustrate this point, look at the stock market in the last 5 years. You can see the chart here:

The DJ opened at 12,090 at the beginning of this period, and closed at 11,433, or down 5.4%. Pretty dismal, all in all: a $100 invested in Sep 12, 2006 would give you $94.60 in Sep 12, 2011.

Now, suppose that instead of investing these $100 all at once, you invested $20 every year on Sep 12th. The DJ was reading the following values (approximately) on 2007 through 2010: 13,443, 11,388, 9,820, and 10,608. Even though the DJ ended up below its value at the of the period, your total investments will be worth $100.84, or 6.6% more than the alternative of buying and forgetting. Note that the time I selected was quite random, based on today. An investor who chose March 23rd as her annual day would have fared much better. An annual rebalancing against a conservative bonds funds would have had even more dramatic results: assuming a 60/40 balance and 0% growth for the bonds funds, your $100 would have been worth $120.80 at the end of the period: a gain of more than 20% in basically a flat market. Not bad at all! (I'm neglecting the value added from the bonds funds and also the commissions - these will not influence the result greatly.)

Why did this happen? Because in some years (such as the wonderful 2009), the market crash made stocks so cheap that your $20 got you much more than in so called "good" years. Furthermore, if you followed a rebalancing plan, you had to buy a lot of stocks this year. You've made market fluctuations and instability work for you.

In a sense, an investor who's not going to spend the money in the coming 5-10 years should hope for a market crash, in the same way that a renter who's looking to buy a house should be happy with the house bubble crash. As long as you believe that the long term prospects of the US economy are goods, you're going to win.

Let the sharks of Wall Street and hedge fund managers worry about falling prices. For us simple people, as Warren Buffet famously said, there's no reason to worry if hamburgers - or stocks - get cheaper.

34. What is your ROI?

ROI in the business world stands for Return on Investment. In simple terms, this is your gain as a percentage of your investment.

Mutual Funds often boast spectacular ROIs. Sites like morningstar.com use these ROIs to rank funds, giving 5 stars for top performers.

Readers of this column already know where I'm headed: of course, 5-star top funds are a trap. It's confusing and counter-intuitive: a tennis player who's won almost every match in the last 5 years is likelier to win the US Open than a player who lost half her games this year; a business that's been profitable every year for the last 10 years is liklier to be profitable this year as well; why isn't it the case with mutual funds?

There are many reasons for that. The main one is the famous "Past performance is no guarantee for future performance" warning, which appears in every fund prospectus (maybe they should get more graphic, like the new warnings on cigarette packs?) Statistically, there's no correlation between past success and future success. Investments that do very well one year can be a dog this year (Internet stocks anyone?)

Another reason is that funds may luck out: a fund manager with 10 funds or a 100 funds can choose the most successful one and promote it (while perhaps closing the least successful ones to improve his overall record.) A maximum of a hundred random results is a pretty high number, but it's still random and does not reflect any intrinsic special quality.

Perhaps the most mysterious aspect of ROI is that the ROI of a fund is not your ROI. Take for instance an Internet fund, established in 1995 and look at its record at 2005. You won't be surprised to hear the fund had meagre results: after all, the .com bust of the early years of the last decade erased 98% of the value of some companies (pets.com anyone?). Still, since the fund was incorporated in 1995, it managed to see the bubble inflate before bursting. The overall ROI over this 10 year period was positive, around 5% total. Pretty dismal, but not nearly as bad as the average ROI for an investor in the fund. As you can expect, as the .com bubble grew, more investors joined the party. While very few invested in .com stocks in 1995, by 1999 and 2000 billions of dollars poured into the market, and most investors bought these funds when prices were beyond laughable. These investors lost almost all their investments when the market crashed. The average return for an investor in this fund is about -95%.

The moral of the story? If a fund boasts ROI of 50% over the last 2 years, by all means, jump on the bandwagon and buy it. But only if you can buy it retroactively, starting 2 years ago. Buying it today will be as good (or as bad) as buying a fund that lost 50% over the last 2 years. And how confident will you feel doing that?

33. Reading the moostars

One of the weirdest sites out there is Decision Moose. This web moosite uses moosignals to time the market, and switch allocations between gold, bonds, US market stocks, etc. With a total of 9 mooselections, the head moose makes a weekly moosecall to divert all assets to one of these options, or stay put.

What can I say. The terminology is dumbfounding, and it contradicts everything I believe in. But I'll give this guy credit for two things: first, he managed to time the market pretty well over the last 10 years. Second, he's pretty honest about the entire venture. From the FAQ:

DOES MARKET TIMING WORK? 

Market timing is unproven. That said, every mutual fund salesman you'll meet-- except maybe the Vanguard 500 guy-- would have you believe that his fund manager is a better stock picker than anyone else in the world, and although few like to mention it, good timing is implicit in good picking. On the other side, academia continues to go to great lengths to disprove timing and promote diversified buy-and-hold investing. The controversy, then, is between a group with considerable practical experience, but a vested interest in timing's success (financial professionals who want to sell their expertise), and a group with no practical experience, but also no particular vested interest (academicians). Obviously, the creator of Decision Moose, a financial professional, thinks timing may indeed work, or he wouldn't be wasting his time on a site devoted to benchmarking a timing mechanism to prove its validity.

My main problem with this site is the old Anthropic Principle: our observations influence what we see via a selection bias; we wouldn't see the world as it is if we were not here, watching it. For example, this answers the question of why Earth is in such a perfect position relative to the sun: slightly closer, and temperatures will be too hot. Slightly further away, and it would be too cold. The anthropic principle simply says that if Earth was not in this exact location, we wouldn't be here to wonder about it - it's not a case of exceptional luck (or divine provenance, or intelligent design). Out of a billion planets, only the ones that develop life will wonder how come they happen to live in a planet with the perfect conditions for developing life.

How is this related to market timing?

Imagine a thousand brokers trying to time the market, each with his or her moose site. Every year, half of them will have above average results - by pure luck. The other half will have below average results, realizing they're no good at it and shut down their site.

After 10 years, you'll have on average about 1 moose site that managed to switch allocations consistently well, and beat the market every year. And it will be the only moose site around.

But this doesn't prove that next year it will have more than 50% chance of beating the market.

If you're not convinced, just look at analysts predictions: at any given day, about half will tell you to buy and half will tell you to sell. I don't feel I can trust either one. Half say we're headed to a terrible recession, and half say the worst is behind us. I just can't trust them, or even our dear, honest moose. But if you do, good luck and let's see in another 10 years how you've been doing!

32. A Message from Fidelity

And what does my broker, Fidelity, has to say about the market turmoil? That the stock market goes up and down, but you should stick with your strategy? That panic reactions rarely improve results? That the stock market is a huge distraction? That checking your stocks more than once a year (as Buffet suggests) is a folly?

Of course not. They're making money from trades. So this is what they have to say (my highlights):

Market volatility update

Dear David Meiri,  

The market volatility we've seen in recent weeks can make it very difficult to set, adjust, or maintain your investment strategies despite your best efforts to pay careful attention to the movement of the markets and its impact on your portfolio. While none of us can control the financial and economic environments, it is critically important to us that we provide you with the information, insight, and capabilities to help you be best positioned based on your investment strategies.

In other words: Fidelity encourages me to check my portfolio often, look at the markets moving up or down, and react - sell after a crash, buy after the stocks go up, and along the way, feel I "do something", while the reality is that I'll be wrecking havoc in my finances.

No thanks!

31. A Rebalancing Act

It's funny to read the analysts these days: they're bathing in the market panic, with useless advice such as "be active, stay with the winners, the coming days will tell us where the market is going", etc.

The demystified investor can sleep soundly, since she doesn't really care. Stocks going down only mean it will be cheaper to buy them. As long as you don't need the money now, and as long as you don't believe that the entire economy is going up in smoke, you should not be worried. And you should do nothing with your portfolio - unless it's your rebalancing day.

My rebalancing anniversary is December 25th. This is how it works. I set up a fixed ratio of my allocation goal (you can see it in my going naked post.) Let's assume, for simplicity, that your goal is 60% stocks and 40% bonds, invested in an S&P broad index fund and a well-diversified bond fund, respectively.

In a few months, when your rebalancing anniversary arrives, there are a few possible scenarios:

The market recovered to pre-crash numbers. You're still at 60-40. Nothing to do - hooray!

Stocks haven't recovered. Your balance changed from 60-40 to 40-60. You sell a third of your bond fund and buy stocks to return the balance to 60-40. The rebalancing forced you to sell high (bonds) and buy low (stocks). Hooray!

Or, stocks have recovered and passed their pre-crash levels, bringing your balance to 70-30. Everything looks rosy, the economy is looking great, but your rebalancing policy will force you to sell 1/7 of your stocks and buy bonds, returning to the 60-40 balance. Here, the rebalancing forced you to sell high and reduce your risk.

As long as the long-term prospects are positive, this method will ensure that you don't panic and sell after a crash, only to see the stocks bouncing back. It will also ensure that you're not tempted to over expose yourself to the stock market, thinking it can never go down. And, as a side benefit, it minimizes the number of transactions you do, commissions you pay, and of course taxes.

Of course, as I said in my last post, if you have a time machine or tomorrow's newspaper you can do much better. Unfortunately, I don't have them, and I'll have to stick with the second best option: the one listed above.

It's the third big market crash in 10 years. We recovered from the .com bust, the housing market bubble, the huge losses of the banks in 2008, the shock of 9/11, wars and other disasters. I don't see any reason to believe this time is different. The worst that can happen is a prolonged recovery or another mini-recession. So ignore the news, don't look at your numbers, don't try to predict the future, and, for god's sake, don't listen to Cramer or the other clowns. Enjoy the ride!

30. Don't Panic!

Contrary to the dire predictions, the debt ceiling crisis was averted.

Contrary to the optimistic predictions of a relief rally, the market tumbled the following day by 4-5%.

What should a demystified investor do?

First,

There are two excellent options, depending on the equipment you have.

If you happen to have a time machine, I would highly recommend going back to Wednesday (or, rather, two weeks ago), sell everything you have and buy gold.

In case you don't, a close second option is to turn off the TV, ignore the news, and stay the course. Remember, prices falling mean a better buying opportunity is coming. And your annual rebalancing day will use these attractive valuations to buy low (stocks) and sell high (bonds).

In any case, don't panic!

And, don't listen to all the experts who explain why this was expected, why it's happening now, and where we go. When times are good they'll predict unbounded prosperity. When the market falls, they predict doom and gloom. Neither version is correct, and the long term positive average is good enough. Stay the course and you'll be fine.

29. Doomsday

It could be funnier if it wasn't my own life savings: while many analysts say that it's likely that the debt ceiling will be raised at the last minute, and that even if it doesn't, the impact will be small and temporary, Credit Suisse says that stocks may fall 30% if the US defaults.

Is it time to panic?

I don't think so, and here's why:

• Market timing is a futile exercise. Stocks reflect the current expectations of all players - you can't assume you're smarter than everyone else and can predict the future better.
• Even if the debt ceiling is not increased, a default is unlikely. It's more likely that the effect will be something similar to a government shutdown (no money to pay teachers and soldiers) than a default (no money to pay interest and principal on debts.)
• Even if the stock market falls, will you know when to get back in?
• A last minute deal might push stocks up - when you're out. 

In short, like always, the best course of action is to stop reading the papers, stay the course, and check your portfolio again when it's time to rebalance. My rebalance anniversary is in 6 months. But I'd lie if I said that I can stop following the drama and the market. 

Personally, I gave in and sold 20% of my US holdings, but I had a good reason - a change in the way I calculate my holdings that was long due, and this week looked like a good time to implement it. 

For now, my advice is to take a deep breath, think long, and remember that this is all self-induced political drama, not any real economic development. See you all on the other side of Aug 2^nd.

28. Too hot to think?

As a heat wave is baking the North East, it appears that it's also melting some people's brains. For example, one of the chief clowns of the investment advice world is saying that you should stay away from technology in the summer. His reasoning? Companies have already spent their budgets in Q1 and Q2, and are not going to buy as much IT in Q3. This is true to some extent. Technology companies performance is cyclical: consumer electronics sells more towards the holidays, and the last few days of Q4 are always the busiest days for hi-tech companies such as the company I work for, EMC. But all that information is already well known, which means that it's already part of the price of the stock. There's absolutely no reason why the value of a stock shall rise or fall based on information that is already well known and is priced into the stock.

Suggesting to sell hi-tech at the beginning of summer and buying back when the weather cools down is one of the silliest ideas I've recently read. And I'm not the only one who thinks Cramer "Bear Stearns is totally fine!" is a total bozo. With this weather, I wouldn't be surprised if more silliness ensues. Drink a lot of water and stay cool!

27. Why Smart People Make Dumb Choices

In a survey done by the Vanguard Group, 85% of 401K participants consider themselves "unskilled investors" and would rather hire a professional to manage their account.

What about the 15% who consider themselves skilled and knowledgable? These tend to have the most education, have the highest incomes, and be higher up in the management chain. They also happen to have the lowest returns among the surveyed. How can that be?

One explanation is that smart people think they can - they should, in fact - get above average results. After all, this is what they're used to: above average intelligence, above average compensation, the corner office at work, etc. And so they try harder: they pick "winners", they sell "losers", they do their due diligence and research stocks and mutual funds, and believe that if they work hard enough they'll get above-average returns.

As we have seen, it's unlikely, or close to impossible, to consistently beat the index. The main result of all this activity is more fees, more days out of the market, more commissions paid to brokers, and, eventually, lower returns.

It's hard to let go of "being in control". It's hard to accept that average is the best we can hope for. Emotionally, intuitively, we all want to be above average, and we feel that the harder we try, the better outcome will have. We want to be in charge of our own destiny. And we believe that if we try hard enough, we will.

Take for instance your typical high-ranking executive in the corner office. Do you think they are modest enough to admit that they can't predict market movements? That they can't find the best analysts and investment tools? Of course not! They're too smart to lay their fate in the hands of the market. They'll buy, they'll sell, they'll switch course, they'll try to time the market, and, in general, a the losing game. As we saw in the past, Trade commissions alone and expensive management fees can eat a large portion of your investment over time. Add to that market timing errors, and you can see why those top brains end up with lower returns.

Unlike smart people, dumb people who follow simple dumb rules like those of Scott Adams achieve just average results - which is enough to beat the smart people. Sometimes it pays to be dumb!

26. Take care of the pounds, and the pennies will take care of themselves

An old English proverb says just the opposite: "Take care of the pennies, and the pounds will take care of themselves." In other words, a frugal life of saving a bit here and a bite there will lead you to financial freedom.

It's such a tempting thought! We'll buy the $3.99 a pound vine tomatoes instead of the $4.99 a pound fancy organic ones, or choose the $8 glass of wine over the pricy cocktail drink, or, as I did a few days ago, use the Amazon price-check app to find out that the $35 "How to cook everything" can be had for less than $20 at the Amazon bookstore. Hooray!

Funny how tempting it is to handle your finances in this way. After all, I've just saved 20-45% on the items mentioned above. Doesn't it add up at the end?

Well, yes and no. It does add up, but, perhaps, the time I'm going to spend on shopping online will be better spent on finding an index fund for my S&P 500 investments that has an annual fee of 0.07% instead of 0.08%. Sounds minuscule, but multiple it by the amount of savings and the number of investment years, and suddenly it's a little more important. But there are even bigger elephants out there in the room: what about your 401K investments? What about FSA (Flexible Spending Account for medical expenses)? If you have kids, have you looked into 529 plans? When was the last time you reviewed your student loan debts and checked if you can consolidate them with a lower rate? What about refinancing your mortgage?

Yup, it's not as much fun as bragging about saving 50% on those Nike you got online, but at the end of the day, we need to count dollars, not percentage points.

Like many other irrational behaviors, when it comes to money, our reptile brain leads us astray. We see the 80% discount we could save by driving to the outlet mall, and forget about the 2 hours it will take us to get there. If you were to buy a house today, would you drive two hours to save 0.02% off the price? But yet, a $100 saved on a shirt is as green as a $100 saved on a house. We think in portions and percentages, but, as far as your bank account is concerned, it's all the same.

Putting it another way, buying a $500,000 house is 5,000 times more important than buying a $100 shirt. If you plan to spend an hour shopping online for the best deal for the shirt, compare it to spending 5000 hours (or, 1.5 hours every day for 10 years) on shopping for a new house.

In reality, we all spend a little too much time on the "shirts", and too little time on the "houses". A better balance will save us all precious time and will also give us peace of mind. If you know that it doesn't really matter if that shirt cost was $50 or $150, since you more than made up for it when you bought that new car (or new house), you'll do you bank account a favor while freeing up your mind for more fun things.

So, take care of the pounds -- or the dollars -- and let those pesky pennies fend for themselves. They'll manage just fine.

25. Shedding Light on Your 401K

Have you checked your 401K lately? Is it alone, in the dark, begging for attention?

When I checked my 401K investments a few months ago, I found quite a few surprises. After a few years using the services of financial advisers, I decided to move to manage my finances on my own. Some of the investment they picked for me were fine, some were questionable. Many of them had high annual fees, which we know by now will doom you to low returns. On top of it, one of the funds had an outrageous load of 4.75% (meaning that for every dollar I put in the fund, I immediately lost 4.75%).

Luckily for me, the company I work for, EMC, has a pretty good selection of funds. I easily found index funds that suited my goals and complemented my overall investment strategy. You might not be as lucky, as this New York times article shows (thanks BG!).

Still, even with a poor choice of funds, and even with loads and fees, and even with employers who do not match employee's contributions, it's generally best to maximize your contributions to your 401K. The tax benefit alone is worth it. If you can also choose low-cost load-free index funds, you'd do even better. Just go and visit your 401K now, it's been sitting in the dark for too long!

24. Average is Good

Hard to be average, isn't it? When I used to date, the term "average" meant "below-average" (when it comes to character and personality) or "above-average" (when it comes to weight). It was never a good thing. Who wants to be average?

Yet, when it comes to investment philosophy, there are two important realization you should make:

1. Average is good enough.
2. Average is as good as you can have anyway.

The first insight comes from looking backward at the world economy and seeing the constant trend of growth, and how it's reflected in the stock market. Yes, there are setbacks: wars come and go, bubbles inflate and diminish as investors switch from irrational exuberance to gloom and doom every few years. At the same time, technology waves obliterate value and entire companies (Block Buster, Novell) while creating value in other areas (Netflix, Apple). But still, the overall picture is of growth - we make more, we produce more, we consume more, we create more, and our enterprises are worth more. This is why investing in the world economy has produced returns that are significantly above inflation for the last 100 years. If you ride this wave, you have excellent chances of achieving high returns. The numbers vary - some quote 8-10% average returns, or 5-6% net of inflation. These numbers assume very long term investing. Still, even people in their 40s and 50s should assume they can be invested for at least 30-40 years - there's no rule saying you need to convert everything you have to cash when you turn 65. Assuming a long investment horizon, you definitely want to ride this wave.

The second insight is that the market is so complex and so efficient that fighting it is futile. On average, all players in the market get, hmmm, average returns. This is the meaning of the term average, right? For every "winner" mutual fund (or a managed account professional), who beats the average, there must be a "loser", who gets below-average returns. You can't fight arithmetic. You can of course gamble - pick up a mutual fund at random, and you do have about 30% chance of beating the average (and 70% chance of ending up worse than the average). These are incredibly bad chances. Even casinos give you a 48% chance of beating them. The financial industry has gotten away with it for many years, but there's no way you should play their game.

There are many reasons for the below-average returns of mutual funds: excessive management fees, high turnover ratio, transaction costs and loads and tax inefficiency. We've covered all of that in previous blogs. But the main point is that the mutual funds and the account managers are fighting the windmills of the world economies and a market that is by and large efficient enough to force them into average returns.

By using a mutual fund or a portfolio manager you'll be signing up for diminished returns a priori, donating a fixed percentage of their account every year to the financial industry.

Bill Barker, writing for the Motley Fool, writes: "The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. For that reason, investors who are going to invest in mutual funds rather than in individual stocks should hold a very, very, very strong bias toward investing in index funds, which invest across the board in a stock market index." John Bogle in The little book of Common Sense Investing includes a graph of the number of mutual funds that have failed, on a year-by-year basis, to match the returns of the S&P 500. The results are staggering:

For once in my life, I feel that average is good.

23. Don't count on it!

An exclusive interview with John Bogle!

In Don’t Count on It, you discuss how we deceive ourselves, particularly with numbers. Can you describe what you consider to be the absolute worst illusion investors fall prey to?


The most damaging illusion for investors is their belief that they capture the stock market's return. For example, if the stock market provides an annual return of 7%, we know that the average investor's return will fall short of that by the amount of fees they pay. Those fees amount to about 2.5% annually for the typical investor, so their net return is down to 4.5%. Taxes might knock another 1% off of that, reducing the investor's annual return to 3.5% -- just half of the market's return. If you compound those figures over 50 years, $1 grows by $4.60 at 3.5%, and by $28.50 at 7%. In other words, the investor's cumulative return is less than 20% of the market's return. That's an enormous gap; one that can easily mean the difference between achieving one's long-term financial goals and falling well short of them.

If you could change just one thing about the practice of capitalism today, what would it be, and why is it the most important? 

The biggest problem with capitalism today is our tremendous focus on the short-term. Institutional investors--who own 70% of our corporations--are predominantly concerned with whether or not the quarterly earnings of the companies they own will meet the stock market's expectations. As a result, our corporate managers move heaven and earth to try to meet those targets, so as to keep their firm's stock price high and maximize their stock-based compensation. But building corporate value over the long-term is hard; there are no quick or easy shortcuts. And as the past decade has demonstrated, decisions made to boost earnings and stock prices in the short-term tend to end up destroying shareholder value over the long-term. The sooner we can realign our focus from the short-term to the long-term, the better for all concerned.


What do you think about ETFs? 

I like some; I am appalled by others. Specifically, I favor low cost ETFs that are focused on broadly diversified portfolios of stocks and bonds that investors can hold for a lifetime. These ETFs should provide investors with their fair share of whatever the returns our financial markets will provide. That's a winner's game.

On the other hand, I'm not happy with ETFs--the vast majority--that exist to enable investors to speculate, to play their hunches on which country or market sector will outperform or underperform over the short term. The turnover rates are enormous, holding periods are measured in mere days, and costs are far higher than those levied by broad market ETFs. That kind of speculation is a loser's game. So I believe that ETFs have the potential to play a significant role in the portfolios of long-term investors. Unfortunately, to this point their use seems to be dominated by those engaged in far more destructive investment approaches.

You talk about inspiring the next generation of leaders and your mentors in Don’t Count on It. What did your mentors have in common that you think is the most important trait in inspiring young people today? In other words, how can each of us be better mentors? 

I think at the most basic level, my mentors were good people; men of strong character who loved their work. They realized that the work they did made a difference in people's lives, and they did that work with a great deal of ability, pride, and professionalism. They woke up every day and tried their best to make the world a little bit better. That's what I took away from the relationships I had with my mentors, and the extent that I've been able to emulate them, I think, explains a great deal of what I've been able to accomplish in my own career.

My views on mentoring have a lot in common with the themes of Don't Count on It. That is, these relationships are largely built upon trust, and attempts to quantify them are doomed to failure. Mentoring, in my mind, is less about helping someone fill out a checklist of accomplishments, and much more about passing along the immeasurable qualities one needs to be successful in their field --character, professionalism, honesty, intellectual curiosity, even humor. If you possess sufficient amounts of those characteristics, you're likely to be successful in whatever field you work in.

To be completely honest, although the interview was probably exclusive, it was not done by your humble blogger. Still, this stuff was too good to ignore! 

22. ForEx and Magical Thinking

In my last visit to Israel I was asked for my opinion about a new, exciting, trendy way to make easy money. My friend N., a smart guy by any measure, recently went to a presentation about "ForEx", or foreign exchange trading. The idea is simple: currencies trade against each other all day long, and by identifying patterns that are "bullish" (the Sterling is rising!) or "bearish" (the Euro is falling!), you can buy low, sell high a few minutes later, and make tons of money. Better still, you don't even need to sit in front of the computer to do it: sophisticated software will identify these scenarios for you and issue buy and sell orders.

The presenter described how he'd been working for many years on developing 7 fail-proof strategies. He claimed that they have 90% success rate.  And of course, he'd be happy to share his success with all of us, out of the kindness of his heart. Charity has not passed from the earth!

Sounds too good to be true? Get Rich Quick schemes usually do, and this one is no exception.

Micro-trading has been around for a long while. Most day traders you'll see are broke, but ForEx day traders should be even worse off. The reason is that, while buying and selling stocks based on past performance is a folly, you at least own stocks -- which generally, over the long term, appreciate in value. You're just doing it in an especially counter-productive, expensive way. But currencies just trade among themselves, and the average yield on currencies is, by definition, 0%. 

When it comes to stock prices, academic research shows that past performance is no guarantee of future performance. Even worse, the past carries little to no information about the future, and whatever minimal gain you might extract from the analysis is lost when taking into account transaction fees. This is the random walk theory, made famous by Burton Malkiel in his groundbreaking book A Random Walk Down Wall Street. And no, the theory does not say that stock movements (or currency movements) are random - by all means they are based on the cumulative fears, hopes and of course information that traders have. The theory just states that they behave as if governed by random walk rules, in the sense that at any given moment, your current location (i.e., stock/currency price) is all the relevant information you can retrieve from the graph of the stock performance. IBM's stock price in the 70s is not relevant to whether it will go up or down tomorrow, or next month, or next year. IBM's stock price last week is as irrelevant. Add it all up, and you see that it's quite plausible that IBM's stock price in its entire history is not relevant to the prospects of the stock in future. 

But the human mind hates randomness. We try to find patterns in the world. When it comes to stars, it's called "astrology". When it comes to coffe, it's called Tasseography. And when it comes to stocks, it's called Technical Analysis.

The people who try to tell you otherwise use stock charts as crystal ball made of cups, deeps, heads and shoulder, fulcrums and other more exotic vocabulary of shapes. Based on these patterns, they predict where the stock is headed.

Of course, to be on the safe side, their predictions are always vague. Take for instance this guy (quoted from "A Random Walk Down Wall Street"):

The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downtrend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.

Sounds familiar, right? Every time I read stock analysis it's a similar dribble. But if you read it again, this guy is basically saying that if the market does not go up or down, it's going to stay flat. Amazing. 

Or perhaps I don't give these people enough credit. As N. continued to tell me the story, we both realized that there is one safe way for making money with technical analysis and ForEx. And no, it's not actual trading. One of the questions you should always ask these geniuses is: if they're so sure of their analysis and their chances of success (90%, no less!), why are they wasting their time here, among mortals, instead of making millions and retiring to Ibiza? The answer is, of course, that the only way to make money out of this voodoo magic is to sell it. This particular course N. was offered was about $3,000. Multiply it by 10 fools a month and you'll get a nice income stream. Good luck!

21. What I learned in Paris

I've just returned from a 2 week vacation in Tel Aviv and Paris. It made me aware of one crucial aspect of retirement planning that I hadn't mentioned yet. First, some pictures:

The food in Paris was, as expected, superb. But what you can't see in these pictures are the price tags. Like tomatoes at the fancy food shop Hediard for 50 Euro per kg ($34 a pound). Of course, these are exquisite tomatoes, watered exclusively with the tears of virgin nuns from Mont St Michel (or so I imagine), and you can find cheaper ones if you go to the market. But sometimes you have no alternative. Consider for instance a common appliance like Kitchen Aid mixer:

589.50 Euro is equivalent to $884. Compare that with Amazon's price of about $200, and you can see that this is no coincidence - life in France is indeed much more expensive than life in the US.

Which brings me to today's point: your retirement planning is highly dependent on where you want to be when you retire. The cost of living in a big metropolis like New York or Boston is much higher than in smaller, rural areas. France and Europe are much more expensive than, say, Costa Rica. And if you don't mind third world countries, you can follow on my sister's steps and retire to Goa in India and live quite comfortably for $500 a month. 

Putting it another way, if your dollars don't allow you to retire where you are now, perhaps you should consider other alternatives? Just make sure you don't go shopping at Hediard! Especially if you're Israeli (their Hummus is 48 Euros per kg). 

20. My Financial Plan (Part 2)

This is the second part of my "going naked" post, where I share with you my financial plan. The first part was published last week.

As before, comments are in red.

4          Asset allocation after retirement

Living expenses will be paid from my cash reserves. 2% cash is about $56K. I will withdraw money twice a year by selling positions. Choosing the position should be based on my allocation goal (rebalancing).

Rebalancing will be done once a year, on the shortest day of the year (Dec 21^st):

ñ  I will actively rebalance once a year all assets that deviate 10% or more from their goal.

ñ  I will grow my bonds allocation by 2 points every year, targeting an allocation of my age*2-70: age 45 → 20% bonds allocation, 55 → 40%, 65 → 60%, 75 → 80%.

ñ  For example, in Dec 2011 I’ll be 44.5, setting the bonds goal to 19%.

Rebalancing is extremely important. Besides making sure you remain on track, it's a neat way of forcing yourself to sell high and buy low - you sell your "winners" (assets that have appreciated more than your average portfolio) and buy the "losers" (assets that have appreciated less than your average, or even lost value.) It's counter-intuitive for most investors. We all want to keep our winners and get rid of the losers. But when it comes to investments, this instinct is dead wrong. 

Tax swaps: if an investment accumulated losses, it may be a good idea to sell it and buy an equivalent – but not identical – investment. For example, SCHB is identical to any other index fund investing in the broad US market, but not to an S&P 500 index fund (or Russell 3000 ETF). To make it acceptable by the IRS, these funds should be managed by different companies and track different indexes. Harvesting these losses will enable me to offset gains, or offset up to $3,000 of income tax annually. This may be difficult/impossible without allocating specific tax lots.

I'm on the fence regarding this tax strategy. It will make my tax returns much more complicated. I'll need to evaluate the potential annual benefit against the cost of hiring a professional to do my taxes. 

5           To-do list after retirement

ñ  Roll-over 401K into IRA (enable more investment options)

ñ  I will track my portfolio against the expenses and the plan annually, and adjust the maximal allowed withdrawal.

ñ  I will track my expenses on a calendar year and make sure I live within my means.

ñ  I will update this plan as needed.

The last bullet is perhaps the most important. Things change - your financial situation, family status, income, etc. It's important to maintain a good balance between "staying the course" and being flexible. Too much change and you risk abandoning your strategy. Too little, and you ignore life-changing events. By setting an annual review of the plan, independent of recent market turmoils, you'll give yourself a chance to weigh your situation with a cool head.

6           Withdrawals

My first withdrawal is going to be the lower between $93,750, adjusted to inflation, and 3% of the portfolio (all the sums are pre-tax and taxes will be paid from the withdrawals, not from the investing accounts). I still need to work out the methodology for further withdrawals. 

The sources for withdrawals will be chosen according to the following goals:

ñ  Rebalance the portfolio

ñ  Minimize taxes

ñ  Avoid penalties in retirement accounts (avoid 401K and IRA until I'm 70 ½; this gives the money the maximal time to grow tax-free without penalties)

ñ  Keep it simple

7           Other issues to consider

At some point I need to consider the following issues:

ñ  Is it worth paying off the mortgage? With a lower tax bracket, mortgage interest deduction may not be as attractive. Wait and see until the first tax return after retirement to see if I still itemize deductions.

ñ  When to start taking Social Security benefits?

ñ  Update will: add a document listing my property, bank accounts, Fidelity, 401K, RE, insurance policies, etc.

ñ  Consider creating AD/LW (Advanced Directive/Living Will) or naming a DHCS (designated health-care surrogate).

This section is a good place to park any ideas/questions you have during the year. During the annual review, pay close attention to the items here and determine what you can incorporate into your plan.

Last note: I'm going on vacation for a few weeks (Tel Aviv and Paris). I'll start reposting when I'm back in June. 

19. My Financial Plan (Part 1)

One of the recommendations I read while doing my research was to put my plan in writing. It sounded easy enough, but once I started writing it down I realized how many details are involved. It's a good exercise in making sure you got all your bases covered, as well as committing yourself - at least mentally - to doing the right thing.

As a reference, below you can find my plan - with some $ amount removed. I hope it can help you build yours. I added in red comments that are not part of the plan.

Is it perfect? No, but it's a basis. The important thing is not to tweak it endlessly. Flexibility is good, but don't make it too easy for yourself to change the plan. Consistency and keeping your direction and plan through turbulent water will win at the end.

So here it goes - part 1 of my plan. My next post will contain the rest of it.

My Financial Plan

1           Retirement Goal

My goal is to secure after-tax annual income of $75,000 with no debt (including mortgage) and no dependency of inheritance, social security, home equity or additional income. This number was calculated at the end of 2010 and should be adjusted to inflation. 

The most accurate way to calculate your required funds is to start with what you spend now. I downloaded my 2010 expenses from my bank account, and then removed all irrelevant entries: salary, transfers, mortgage, etc. To the total, I added new expenses I expect to have: more money for medical coverage, travel, hobbies, etc. Regarding the mortgage, since it's a variable expense with a limited lifetime, for this calculation only (!) I assumed I'll pay it off on my first day of retirement. This of couse is not what I'm going to do, but it makes the calculations much easier. 

Assuming 20% average tax on withdrawals, I'll need $93,750 before tax. With 3% annual withdrawal rate, this translates to $3.125M in 2010 dollars.

Yup, that's a huge amount but it's because I'm calculating the required funds to retire now, when I'm only 43. As I'm getting older, I'll need to save for less time (i.e., I don't expect to live to 200). This will reduce the goal.

This SWR (Safe Withdrawal Rate) is based on conservative assumptions: a portfolio with growth of 5% with inflation of 3%, lasting for 50 years.

You can read more about SWR in this previous post. 

Assuming 15% tax at retirement reduces all these amounts by about 6%.

I had long discussions with my CPA regarding this number. My calculations showed an average of 15%; his (more conservative) calculations showed 20%. It's pretty difficult to calculate your tax bracket at retirement, since your income will come from different sources, some taxed as income (interest, bonds), some as capital gain (stocks) and some not taxed at all (401K, principal of your savings.) Also, it depends on how much taxes you've already paid. For example, since I recently converted all my savings to index funds and paid taxes on all my accumulated gains, my base is close to my total savings - meaning lower taxes in future.

2           Asset allocation

My investment methodology promotes low-cost broad index funds. Whenever possible I will choose no-load, low-commission, negatively correlated, well-diversified index funds in the segments I invest in.

Why not managed accounts? Start with my first post and go from there... 

A current exception is my choice for Municipal bonds (MUNI), which is actively managed. 

Yup, my plan is not perfect. I couldn't find an index fund for MUNI that satisfied me. But, remember, the greatest enemy of a good plan is a dream of a perfect plan!

Asset Class	Low Risk	High Risk	Accounts	Funds	Comments
US economy		30%	Fidelity, 401K	SCHB, FSEMX	Broad market fund (Spartan index fund in my 401K)
		5%	Fidelity	SCHA	Small-cap
		5%	Fidelity	WMCR	Micro-cap
Real Estate (US)		5%	401K	VGSNX	10% of total US stock
International		15%	Fidelity	FSIVX	All world ex. US
		7%	Fidelity	VWO	Emerging Markets	Counted together as 15%
		8%	Yahav	TA-100 Meitav	Israel
Bonds	8%		Fidelity	BND	Tracking Barclays Aggregate (corp, government, municipal bonds)
	5%		Fidelity	MUNI	Municipal Bonds (PIMCO)
	5%		Fidelity	SCHP	TIPS bonds
		5%	401K	PHIYX	High-yield bonds (PIMCO)
Cash	2%		Fidelity, BOA	Money-market, BSV, BOA saving account	For immediate expenses, highly liquid. Grow to 4% at retirement.
	20%	80%

The table came out more complex than I anticipated.This is mainly because I split my savings between my 401K account and my Fidelity account. While the Fidelity account is very flexible, I'm limited in my 401K account to the funds chosen by my employer. This resulted in some asset classes (such as US economy) split between the two. Additionally, I have investment in Israel, which I count as "emerging markets". Probably, your table will be simpler.  

3           Managing my 401K

ñ  In a couple of cases I chose alternative funds due to the limits of my 401K plan (VGSNX, Pimco High-Yield). At retirement I’ll rollover my 401K to an IRA where I’ll have more flexibility.

ñ  The balance of the 401K is invested in Spartan Extended Index Fund (mid-cap and small-cap), creating further diversification. Currently this is 28% of my 401K, where the rest is REIT (36%) and High-yield bonds (36%). These correspond to 5% positions in my portfolio.

ñ  To minimize taxes, I should try to keep tax-inefficient funds in the 401K: bonds, REIT and mutual funds with high turnover.

ñ  However, since the 401K is going to be used last (at age 70.5), it should have more volatile stocks. These two considerations are incompatible.

It's never too early to capture future plans. As you can see, I'm not 100% sure how to manage my 401K in future, and I might change my plan by the time I get to retirement. Still,  it's easier to capture what I know now and revise it later than trying to figure it all out from scratch 5 or 10 years down the road. Write it down, and revise it as you learn more!

Part 2 -- next week!