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!