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.

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!