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.