Thursday, January 31, 2008

“Worry-Free Investing” Book Review, Part 2

This is the second part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

Once we factor out the heavy emphasis on low-risk (and low return) investing, this book contains a vast amount of useful unbiased information. For example, Chapter 3 shows how to plan for retirement including figuring out how much money you will need to retire, minimizing taxes, and minimizing investment fees.

Chapter 4 covers saving for college. The cost of education beyond high school has been rising faster than inflation for some time. Whether this will continue is anyone’s guess. The authors discuss the many different college savings plans available in the US.

In Chapter 5, the authors discuss investing in a home and the various ways a home can be turned into a retirement asset including a reverse mortgage. There are many things to consider when it comes to reverse mortgages, and the authors do a good job of explaining them.

Chapters 8 through 13 contain a wide range of other useful information. Topics include investing myths, the steps to take in making a financial plan, the nature of financial advisors, and the benefits of index funds over actively-managed mutual funds (see here for more information on this last topic). The book also lists web sites that provide accurate unbiased financial information.

In part 3 of this book review, we examine the authors’ argument against investing in stocks.

Wednesday, January 30, 2008

“Worry-Free Investing” Book Review, Part 1

This is a review of the book “Worry-Free Investing” (Prentice Hall, ISBN 0-13-049927-7), by Zvi Bodie and Michael J. Clowes. This book is aimed at Americans, but many of the ideas are relevant to Canadians as well.

The authors are clearly very knowledgeable about a wide range of practical investment matters as well as academic work on investing. The book contains a lot of useful information and practical advice explained clearly. In this regard, it is much better than most investing and personal finance books.

The main drawback of this book is the overemphasis on safety. The authors recommend extremely safe investments that, unfortunately, offer low returns. To meet typical goals such as an adequate retirement income and paying for children to go to college, the safe investments recommended by the authors require people to save large amounts of money every year because they will get low returns.

The particular investments the authors recommend are Inflation-protected Bonds (I Bonds), and Treasury Inflation-Protected Securities (TIPS). The equivalents in Canada are called Real-Return Bonds (RBBs).

The idea of these investments is that they pay a guaranteed rate above inflation. So, if the guaranteed rate is 2% and inflation turns out to be 3%, you get 5%. But if there is some economic upheaval that drives inflation up to 10%, you will get 12%. This gives you inflation protection.

Many people will not be able to save as much as needed to make the authors’ investment strategy work. The result for these people is that they will be guaranteed to fail to save enough money. Riskier investments such as stock index funds offer the kinds of returns that give these people a much better chance of saving enough to meet their goals.

We have to question how the word “risk” is used in the financial world. It is used to mean the degree of uncertainty in how much money an investment will make. The value of stocks jumps around a lot and are therefore risky. Bank deposits are very predictable and are said to have low risk. But, if I don’t save enough in low-risk investments, then I will have a 100% risk of not having enough money when I need it.

Taken to the logical extreme of low risk, even I Bonds carry the risk of default by the US government. An even lower risk strategy is for you to give all your money to me. This gives you a guaranteed return of minus 100% with no uncertainty. Most people have to take at least some risk to achieve their financial goals. The challenge is to figure out what risks give you the best chance of getting what you want in life.

See part 2 of this book review in the next post.

Tuesday, January 29, 2008

Intrinsic Value of the Whole Economy

In the previous post, I discussed the idea that a stock has an intrinsic value that is different from the current price of the stock. The stock market can become irrational and sometimes value a stock well above or well below its intrinsic value creating profitable opportunities for knowledgeable investors.

So what? Most of us can’t figure out the intrinsic value of a stock any better than we can pick lottery numbers. If you’re like most people who fall into this camp, your best bet is probably to avoid individual stocks and invest in low-cost broad index funds. (See this post for more about index funds.)

There are index funds that allow you to own a small slice of an entire economy. You can own your share of stocks in the US, Canada, and other countries. The better index funds have very low Management Expense Ratios (MERs).

The stock market as a whole has an intrinsic value just like an individual stock. US markets dropped about 10% in the first 3 weeks of January. Is it really plausible that the long-term prospects of the US economy dropped by 10% in those 3 weeks? Of course not.

Whether you are optimistic or pessimistic about the US economy over the next 50 years, there hasn’t been enough new information in 3 weeks to lower its intrinsic value by 10%. If the US goes into a recession, how much difference will that make over 50 years?

Stock markets fluctuate much more wildly than the total intrinsic value of the businesses that make up the market. In the short term, prices can move away from intrinsic value, but over the long term, the stock market must track the total intrinsic value of the businesses. If you believe that the economy will eventually recover from a downturn, then you can be confident that the stock market will recover as well.

If you believe that the US is doomed to lose out to other countries over the long term, then you shouldn’t hold US stocks, bonds, real estate, or even US dollars. If you believe that the US economy will chug along much as it always has with good periods and bad, then index funds are a good investment.

The next time stock prices drop sharply, stay calm. If you believe in the US economy over the long term, then you can be confident that prices will recover eventually. Just don’t put money in the stock market if you’re going to need it soon.

Monday, January 28, 2008

Intrinsic Value

What is a stock really worth? One answer is “whatever the stock is trading for in the stock market.” Unfortunately, this is not a useful answer. The stock market just tells you the price at which people are willing to buy and sell a stock.

The true value of a stock (also called the intrinsic value) is determined by the value of the business represented by the stock. If a business is worth $10 million, and there are a million shares, then each share is worth $10. But, how do we determine the value of a business?

Suppose that we know what is going to happen to ABC Company. ABC will pay a $1 dividend per share each year for the next 50 years and then close down. Now each person can decide how much to pay for a share that will pay $50 over 50 years. Some might be willing to pay $10 and others $15. This amount that you are willing to pay is your assessment of the intrinsic value of the business.

Suppose that you decide that the intrinsic value is $15. If you find that the majority of people think the intrinsic value is $10, should you change your mind? You might think it through again, but if your reasoning was sound and the stock is worth $15 to you, then you should start buying it for $10.

If you are knowledgeable and confident about your assessment of the intrinsic value of a stock, then you shouldn’t be swayed by the particular price of the stock on a given day. You should buy more stock when the price is below $15 and sell when it is above $15.

Of course, the real world is not as simple as this. We don’t know for certain what returns a business will produce. But knowledgeable stock investors still do their best to estimate the intrinsic value of a stock. They then buy stocks that look significantly undervalued and sell them when they become overvalued.

Sometimes stock prices go up or down for a good reason. When there is good or bad news about a stock, knowledgeable investors update their intrinsic value calculations based on this news. Then they look at the stock price to decide whether to buy, sell, or do nothing.

This all works very well for investors who can evaluate businesses and calculate intrinsic values well enough to beat the average market return. What about the majority of us who have no idea how to figure out the intrinsic value of a business? Has this whole discussion been irrelevant for the average person?

The short answer is no. I’ll show in the next post how this discussion is relevant and can help you to stay calm during turbulent conditions in the stocks markets.

Sunday, January 27, 2008

Broken Merchandise Strategy

I don’t usually write about consumer items, but I just had an interesting experience. I bought a scanner from a well-known chain store. When I opened the box, it contained a note from the last sucker who bought this scanner with an explanation of what is wrong with it.

The note came with actual pictures of scans gone wrong. I’m grateful to this anonymous person who took the time to help out the next sucker to buy this scanner (me in this case).

The two pages of explanation were not exactly hidden. They were the first thing that I took out of the box. Obviously the store employees never even looked inside. They just put it back on the shelf to sell it to someone else. Nice.

I don’t see much point in naming the product or the store. But, I do like the consumer strategy of including a note any time you are forced to take a defective product back to a store. For your altruistic side, you are helping out other people.

For fun, you could even include an email address with your note if you would like to hear from the next purchaser. More advanced strategies could involve leaving more than one copy of the note: one that is very obvious to find, and the other a little more hidden. This way if a store employee opens the box and removes the easily found note, the other note will still be there to be found by the next purchaser.

In the event that the store actually fixes the product, presumably they would find and remove both copies of the note.

I am always annoyed when I have to waste time returning defective products. Playing games with notes takes a little more time, but makes my day a little brighter.

More on the Rogue Trader

We are starting to see the fallout from the actions of a rogue trader, Jérôme Kerviel, in France who lost $7 billion of bank Société Générale’s money.

Bank officials insist that this rogue trader acted on his own. The bank’s investors aren’t so sure. I don’t see what difference it makes. Huge bets were made that put all of the bank’s assets at risk. What difference does it make whether Kerviel acted alone or not?

Either the bank officials are guilty of authorizing these huge bets or they are guilty of running a bank with such lax safeguards that a junior trader could put all the bank’s assets at risk. The end result is the same for the bank’s investors: they could have lost much more money, and the bank officials are to blame.

Even if these bets had made money, instead of losing $7 billion, bank officials would deserve to be held accountable for taking unwarranted wild risks.

If it turns out that Kerviel made fraudulent trades, he would deserve to be punished. But this punishment should be roughly the same as if he had lost only $7 million. The difference between $7 million and $7 billion is the responsibility of bank authorities.

Saturday, January 26, 2008

Rogue Trader in France

A rogue trader working for a bank has managed to lose a record $7 billion making unauthorized trades. The trader, Jérôme Kerviel, worked at the bank Société Générale in France. He lost the money trading in the European stock index futures market.

Stock index futures are essentially side bets between two parties on whether the stock market will go up or down. This rogue trader made about $40 billion in bets that the stock market would go up, and as we have seen over the last week, those bets didn’t work out very well. When the bank discovered the huge bets, they sold them off quickly and ultimately lost $7 billion in the process.

There have been many stories about rogue traders over the years. One thing all the stories have in common is huge losses. Don’t these rogue traders ever get lucky and make money?

My guess is that many of them do make money, at least for a while. What would bank management do if they discovered a rogue trader who risked billions, but had made a billion dollars for the bank? Would they fire the guy or promote him? Either way, I’m guessing that the story wouldn’t make it to the press. So, we only hear about enormous losses.

It’s hard to understand how a bank’s control procedures could be so weak that one person (or even a few people) could put all of the bank’s assets at risk. Even if all the risk is held in customer accounts (some of which may be bogus), automated tools should be able to detect a suspicious huge net risk across all customer accounts.

A rogue employee at a car company might be able to create fake orders for a hundred or even a thousand cars. But, the scale of this rogue trader’s fraud is like tricking General Motors into making a million extra cars based on false customer orders. You’d think that General Motors might figure it out before building too many new car manufacturing plants.

A bank’s management should be responsible for knowing the risk level of its investments. It is unacceptable to simply blame a rogue trader. If a trader is able to put the bank’s entire asset base at risk, then the blame goes straight to the top.

Investors often choose to invest in banks because of the perceived safety and regular dividend stream. These investors deserve to be told how much risk the bank is taking with its assets. Whatever rules exist for this type of disclosure, risk information is either not known or is not conveyed to individual investors in a way that they can understand.

Friday, January 25, 2008

Why Does Diversification Work?

In my previous post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility. The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get. This explains the inconsistency among various reports of average stock market returns.

One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear.

Let’s go back to the example in the previous post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everything over 3 years, even though the average outcome is that $10,000 grows to $7 million.

Suppose now that we have two independent versions of this investment (A and B). There are now 4 equally likely outcomes each month: both up, only A up, only B up, and both down. Let’s look at three different investment approaches:

1. Put $10,000 into investment A and let it ride for 3 years.
2. Put the $10,000 in investment B.
3. Use a combined (or diversified) strategy where we put $5000 into each investment, and after each month pool the money and split it up evenly between the two investments again.

Here is a typical outcome after 3 years:


Incredibly, both investments A and B on their own dropped down to $180, but the diversified approach grew to $36,000! Even more amazingly, look at what happens when the money is split evenly among 100 different independent instances of this type of investment:


In this case, the money grew fairly steadily all the way up to almost the $7 million expected return that we calculated earlier. Diversification among identical independent investments doesn’t change the expected return, but it does reduce volatility which drives the most likely outcome closer to the expected return.

This may seem too good to be true. That’s because it is. In the real world there aren’t investments that offer such high returns. Also, investments are not completely independent. For example, spreading money among a number of good stocks reduces volatility, but only up to a point. The stock market as a whole still has volatility because the returns of all stocks are correlated.

This idea of correlation is important for mutual fund investors. An investor may feel better owning 20 different mutual funds, but if the funds own all the same stocks, then the funds are highly correlated. This means that they all tend to go up and down together, and the investors have not reduced the volatility of their returns much.

In the examples used here, we saw the benefit of diversifying among investments with identical attributes. There would be no benefit if you diversified into a poor investment. For example, if you own 3 good stocks and you diversify into lottery tickets, your expected return and your most likely return will both go down.

Diversification is good for your investment returns, but only if each individual investment has a good expected return.

Thursday, January 24, 2008

Understanding Investment Risk and Volatility

In a previous post, I showed how the average real return in the US stock market from 1926 to 2000 is 9.3%, but that this translated into a compounded real return of only 7.4%. The reason for this difference is the volatility of the returns. Let’s go for a better understanding of the cost of volatility without any advanced math.

A Simple Example

Suppose that you have $10,000 invested for two years. In the first year you lose 10%, and the next year you make 10%. It might seem at first that you have your $10,000 back, but that isn’t exactly right. After the first year you were down to $9000, and then in the second year you earned 10% on that $9000 to get a total of $9900. In the end you lost 1% of your money.

However, the annual returns were -10% and +10% for an average return of 0%. The lost 1% over the two years is not due to a negative expected return; it is due to the volatility of the returns. The average return is 0%, but the compounded return is about -0.5% per year.

Another Example

Extreme examples are sometimes useful to bring out subtle points. Let’s consider an example that is unlikely to exist in the real world. Suppose you find an investment that returns either +100% or -60% with equal chance after a month. Each month either you win and your money doubles or you lose and 60% of your money disappears.

On the surface, this sounds great. Adding up the returns and dividing by 2, we see that the average return is 20% each month. If you could compound $10,000 at 20% per month for 3 years, you would have $7 million! You decide to go for it, and here is the result:


What happened to the millions? The original $10,000 is down to $180. A first thought is that due to bad luck, the investment returned -60% more often than +100%. But, it turns out that both happened exactly 18 times.

To understand this, we need to think about it in a different way. Instead of +100%, think of it as multiplied by 2. Instead of -60%, think of it as leaving you with 40%, which is the same as divided by 2.5. So your investment is multiplied by 2 half the time and divided by 2.5 half the time.

Now it makes perfect sense that the investment value would drop. Starting with $10,000, after one rise (to $20,000), and then one drop (to $8000), we have lost 20%. Over 3 years, this happened 18 times. The compounded monthly return is -10.6%.

Does all this mean that the original calculation of the average return being +20% and expecting to have $7 million at the end is wrong? No, it doesn’t. If you repeated this experiment enough times, you would find that on average you would really get $7 million. In over 98% of the trials the return would be less than average, but in a very small fraction of the trials the return would be an outrageously large amount. It is these large amounts that inflate the average to $7 million.

The most likely outcome is still that you will lose most of your money. In real life, this effect isn’t as dramatic, but the idea is the same. The average stock market return from 1926 to 2000 was 9.3%, but due to the volatility of the returns, the compounded return was only 7.4%.

In the next post, see how diversification can reduce volatility and reduce the gap between the average return and the compounded return.

Wednesday, January 23, 2008

A Stock Market Crash?

I know I promised a discussion of risk and volatility, but that will have to wait. The stock market is crashing! Shouldn’t we be doing something?

Yesterday morning the newspapers and online news sources were nearly unanimous: stocks are headed down and it’s going to be ugly. It can be tempting to sell everything at times like this, and many investors will sell.

But if you do sell, when will you jump back in? Maybe you’ll buy once the market rises consistently for a week or two to show that the carnage is over. But this amounts to selling low and buying high. This is the opposite of what you want to do to make money.

Any attempt to time the trading of stocks to make more money is called market timing. It can be tempting to try market timing, but be aware that there are others out there who are trying to beat you at this game.

Collectively, market timers can’t make more money than those who simply buy and hold their stocks. In fact, on average they have worse results because they have their money on the sidelines some fraction of the time and are losing out because the market rises most of the time.

To win at market timing, there have to be others who lose at market timing. It’s like playing poker: for there to be winners, there have to be losers. If you plan to try market timing, you have to ask yourself: am I better at this than other people are? If you prove to be an average or below average market timer, you will lose money.

As it happens, my own portfolio rose 3% yesterday. I’m not mentioning this to gloat; I could quite easily lose 5% today. The point is that the stock market will turn around eventually. It’s just that nobody knows for certain when this will happen.

You will be disappointed if you miss a significant jump in stock prices because you panicked and sold. Often the best thing to do is nothing, especially when our emotions are getting the better of us.

Tuesday, January 22, 2008

Inconsistent Reports of Long-Term Stock Returns

I intend to review the book “Worry-Free Investing” by Zvi Bodie and Michael Clowes, but for now I want to discuss one part of the book that reports historical US stock market returns that are higher than I was expecting.

In Chapter 6, the authors discuss US stock returns from 1926 to 2000. They actually give real returns, which means the returns after inflation is subtracted out. Based on the historical data, they calculate the average yearly real return on stocks to be 9.3%. But, others say that the long-term real return on US stocks is 7% (for example, see this essay by Peter Diamond).

This may not look like a big difference, but if you play around with one of the many free retirement calculators available online, you’ll find that an extra percent or two of return on your investments each year makes a big difference over the long term. So, which one is the correct historical average return?

It turns out that they are both right because they are talking about different things. The 9.3% figure comes from taking the returns from each of the 74 years, adding them up, and dividing by 74 (a simple average). This is what we usually mean by the average return. It is sometimes called the arithmetic average to distinguish it from other types of averages.

According to Bodie and Clowes (see pages 86 and 87), $100 of stock in 1926 rose to a value of $20,000 in the year 2000 (after factoring out inflation). If the stock market had risen by the same percentage every year instead of jumping up and down, what return would have given the same performance? Instead of 9.3%, the answer is 7.4%. This is the average compounded return (also called the geometric return).

The difference between the average return and the compounded return depends on how much returns vary from one year to the next. The more an investment’s value jumps up and down, the bigger the difference between the two kinds of average. This may seem similar to what is going on with risk-adjusted returns, but they are not the same. Risk-adjusted return calculations artificially penalize volatile investments by more than this difference between the averages.

Which of these two averages is the right one to use? That depends on what you are using it for. If you want to know the average return for one year, then use the arithmetic average. If you want to know what is likely to happen if you let some money ride for a long period of time, use the compounded return.

This may all seem paradoxical. How can both averages have any meaning? For those who are interested in the math, I recommend reading this short essay by Brian McCulloch. For those who want to understand it without the math, see this post for a simple example that explains this paradox and its connection to risk and volatility.

Monday, January 21, 2008

Book Review: Identity Theft

Graham McWaters and Gary Ford work for financial institutions and are writers and public speakers on financial matters. This is a review of their book, “The Canadian Guide to Protecting Yourself from Identity Theft and Other Fraud,” published by Insomniac Press. Although there is some focus on Canada, much of the material is relevant in the US as well.

This book is a useful guide to the different types of fraud that people need to understand and avoid. The authors do a good job of personalizing the material with victim stories. Some types of fraud covered are debit and credit-card fraud, gathering personal information from computers on the internet, real-estate fraud, investment scams, and telephone-based scams.

A frequent problem with personal finance and investment books (and self-help books in general) is repetitiveness. It’s not unusual for a book to have only 20 pages of real content repeated in multiple ways to produce a 200-page book. This book is better than most, but is somewhat repetitive and could easily be cut to half its length without sacrificing any content.

The authors do a good job of explaining the details of how fraudsters operate. In this respect, the book is somewhat alarmist. The authors also do a good job of giving advice on how to avoid becoming a victim and what to do if you are victimized.

Because I was already aware of most of the different types of fraud discussed, the most interesting part of the book to me was the discussion of who ends up on the hook for financial losses. This is the most difficult type of information to gather, and I wish the book had more of it.

Banks usually replace small amounts stolen from bank accounts, but what if a fraudster steals a quarter million dollars from an investment account? Will the bank gladly replace the money? If not, how is this likely to be resolved in the courts?

If I buy a house and later discover that it was sold to me illegally by someone other than the true owner, someone will be out a lot of money. In some ways everyone involved is a victim due to the time and effort that will go into resolving the issue, but what factors will decide who ultimately loses the large sum of money stolen by the fraudster? Some possibilities are me, the real owner, my lawyer, the fraudster’s lawyer, and the government through a program designed to deal with these situations. This book has some information about how this complex situation would play out, but I would like to have seen more.

Overall, this book is a useful guide to identity theft and other fraud, and I recommend it.

Friday, January 18, 2008

Do Financial Advisors Provide a ‘Steady Hand’?

One of the arguments for using financial advisors is that they provide a steady hand that helps keep you from making rash investment decisions that will hurt your returns. The study by Bullard, Friesen, and Sapp released in December 2007 casts doubt on this argument.

As discussed in this post, the study showed that mutual fund investors actually get lower returns than the funds’ reported returns because of poor market timing. You would think that working with a financial advisor would keep investors from making such mistakes, but apparently not. Another aspect of the study was to examine how investors working with a financial advisor fared compared to other investors.

The study’s authors summarize: “We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds.” Instead of a steady hand, we find that investors working with financial advisors actually have more losses from poor market timing. This begs the question, is the ‘steady hand’ on your shoulder to guide you, or is it in your pocket?

The steady hand argument supposes that financial advisors are actually knowledgeable about investing, and that they have their clients’ best interests in mind. I have no doubt that honest and knowledgeable financial advisors are out there, but they may be scarce.

Thursday, January 17, 2008

The Illusion of Mutual Fund Returns

You’d think that the reported return on a mutual fund would give an accurate picture of how much money the fund’s investors made. A study by Bullard, Friesen, and Sapp released in December 2007 shows that this isn’t necessarily the case.

It turns out that a fund’s reported returns only apply to buy-and-hold investors who held the fund from the beginning to the end of the reporting period. But not all investors do this. Due to the timing of investor money flowing into and out of the fund, the actual returns seen by investors are often lower.

The study found that for one class of funds, investors underperformed the reported returns by 2.28% per year! These funds are like guys on online dating sites who say they like long walks on the beach and talking about their feelings, but turn out to be beer-swilling football watchers like all the rest.

Across all actively-managed funds, investor money underperformed the reported returns by an average of 1.7%. Over 25 years, this would build up to 35% less money in investors’ accounts. In contrast, according to the study’s authors, “investors in no-load index funds experience no performance gap at all, suggesting that the smartest money is finding its way into these funds.”

But, how could a mutual fund’s investors get less than the return reported by the fund? It seems like there must be some sort of conservation law that makes this impossible. The short answer is that funds tend to have higher returns when they are small and lower returns when they are big. See this post for more on why this happens.

So, a small number of investors are in a fund while it does well, then new investors flock in, and fund performance drops. In the end, the average investor gets worse returns than the buy-and-hold investor who held the fund for the whole reporting period.

This argues for being a buy-and-hold investor when it comes to actively-managed mutual funds instead of constantly switching to the new hot fund. This post shows that investors would have been even better off abandoning actively-managed funds entirely and investing in index funds.

Stay tuned for more interesting results from this study.

Wednesday, January 16, 2008

Investing is Like Surgery?

One of the choices investors have to make is whether to handle their investments themselves or work with (and pay) a financial advisor. People have a lot to say on both sides of this issue, but I’ve heard one clever argument several times now. It goes something like this:

“You wouldn’t do your own surgery, right? So, why would you try to handle your own investments? Leave this stuff to the experts.”

On the surface, this reasoning seems compelling. The image of some guy trying to operate on his own belly is pretty amusing. Anyone who comes up with a catchy line that makes people laugh must be right.

But, this analogy breaks down very fast. Exactly who is the brilliant surgeon in the financial world? The financial planning industry would say that the average investor is not as smart as a surgeon, and I agree. Maybe professional money managers who run mutual funds are the surgeons. But these professionals as a whole don’t do any better than the stock market averages. When we take into account the fees charged to investors, index funds outperform actively-managed mutual funds over the long run (see this essay for more about mutual fund underperformance).

So, professional money managers aren’t the surgeons in the analogy. This leaves financial advisors. Fee-only financial advisors might fit here. They are usually smart people who are paid for their time to give unbiased advice rather than being paid by mutual fund companies to sell their funds. I wouldn’t exactly call fee-only financial advisors surgeons, but the analogy is close.

What about the typical financial advisor who is paid commissions out of the fees that mutual funds charge to investors? Could these people be the surgeons? I could make a joke here, but let’s just say no they aren’t. These financial advisors are more like salespeople. Just like other types of salespeople, there are good ones and bad ones. But they all have to eat, and they feel the constant pressure to sell financial products that earn them commissions.

There is a lot of money at stake, and the financial industry is willing to spend heavily on marketing. It is important to understand the basics of investing even if you choose to use a financial advisor. You need to know enough to tell whether you are getting good advice or are being taken for an expensive ride.

Tuesday, January 15, 2008

Review of “Building Wealth” by Ric Edelman, Last Part

This is the last part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here.

The audio program contains an extended pitch for long-term care insurance. See this essay for a discussion of some of the things to look out for with this type of insurance. According to a Consumer Law Page article (the web page with this article has disappeared since the time of writing), “sales agents are driven by high commissions” in the long-term care insurance business. I don’t know whether it is a good idea to buy long-term care insurance or not, but it would seem that those who sell it make good money.

Some good advice

Let’s not focus entirely on the negative side. On the positive side, the CDs were nice and round. I’m just kidding. Here are some of the good points made in this audio book.

· Make a realistic financial plan consistent with your goals.
· It’s okay to start investing with small amounts. Just keep saving.
· Avoid frequent investment changes in an attempt to time the market.
· Discuss your financial plans with your parents and adult children.
· Control your emotions when it comes to investing.
· Avoid credit card debt.
· Don’t buy stock if you have credit card debt.
· Don’t speculate in the latest hot sector or you’ll risk getting caught when the bubble bursts.
· Always have a resume ready in case you need it.
· Maintain cash reserves in case of emergency, like job loss.
· Participate in your company’s retirement plan.
· Pay attention to frequent small expenses.

Summing Up

All the problems in this audio book spoil what could otherwise have been a useful investment primer. Edelman’s speaking style is interesting and easy to follow, and his listeners could benefit from most of his advice. However, because of the self-serving aspects of his advice, I cannot recommend this audio book.

Monday, January 14, 2008

Edelman on Mutual Fund Fees, Book Review Part 4

This is the fourth part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here.

Mutual funds charge various fees that reduce investor returns. Some of these fees are paid to investment advisors for bringing business to the mutual fund. Edelman claims that fees are the least important thing to worry about when choosing mutual funds, and that “all of the academic data show that there is no correlation between performance and fees.”

I had to pause the audio program there and think about that one. The main components of mutual fund fees are the MER that is paid each year and any loads that are paid when entering or exiting a fund. It is true that academic studies show little or no correlation between loads and fund performance. But this actually means no-load funds are better. Why pay loads if they don’t lead to higher returns? As for the yearly MER, academic studies definitely show a correlation between high MERs and lower fund returns. Edelman is wrong when he says that fees are the least important thing to worry about.

An amusing part of the audio program comes when Edelman talks about whether investment fees should be visible to investors. In his experience with his financial planning firm, “we find that when people see the fees they tend to get more fussy about them.” No kidding.

In the final part of this review, we look at long-term care insurance as well as some of the good advice Edelman gives.

Friday, January 11, 2008

“Building Wealth” Book Review Part 3

In this third part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth,” we look at his views on market indices and index funds. This review began here.

A market index is a measure of how the stock market performed as a whole. In a sense, it tells you how well the average investor has fared (not counting taxes, commissions, and other fees). You can choose to get the market average performance by investing in a low cost index fund (look here for more information about index funds).

Edelman says that you shouldn’t measure your returns against market indices. This seems like a bad idea to me. If you do better or worse than an index in a given year, it doesn’t mean much, but if you do worse than the index over a long period of time, you need to examine your investing approach and consider switching to index funds.

The discussion of index funds begins with Edelman saying that he doesn’t care if you buy an index fund or an actively-managed fund. This was pretty funny because he followed it with an extended diatribe against index funds, making numerous claims about mutual funds beating index funds over various time intervals. However, his claims are contradicted by the data. For one study that contradicts most of Edelman’s claims, see pages 260-263 of Burton Malkiel’s book, “A Random Walk Down Wall Street,” and see this essay for more detail on mutual fund underperformance.

Edelman’s firm sells mutual funds, and the majority of funds give lower returns than the overall stock market over the long term because of the mutual fund fees that investors pay. Low-cost index funds don’t pay these fees to financial advisors. If investors started comparing their returns to market indices, financial advisors would have a lot of explaining to do.

Asking you not to look at market indices is a bit like asking you not to compare prices on a big screen TV. This might work well for a store that sells TVs at inflated prices, but you are better off if you check prices at other retailers.

In part 4 of this review, we look at Edelman’s views on investment fees.

Thursday, January 10, 2008

Edelman on Mortgages, Book Review Part 2

This is the second part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here.

Edelman recommends keeping your mortgage, making the minimum payments, and investing any extra money you have even if you’re able to pay off your mortgage. The main support he gives for this advice is that many of his wealthy clients keep their mortgages.

Any time you borrow to invest, you are said to be using leverage, and this increases your investment risk. It stings any time your investments drop in value, but the sting is worse if their value drops below the amount you owe.

This idea of leverage is similar to the leverage you may have used as a kid on the teeter-totter. I remember pulling my side out to make it longer than the other side so that I could control the movement even if the other kid was heavier. I could make him go way up more easily. With a well-timed hard push I could also make him crash into the ground more easily. It works the same way when using financial leverage; the ups and downs get magnified.

Keeping your mortgage maxed out for decades may make sense for some people, but is definitely not for everyone. One thing is sure, though: following this advice will give people more money to invest and will increase the size of the commissions financial advisors get, including Edelman’s financial planning firm.

This advice makes more sense for Americans who can deduct mortgage interest on their taxes than for Canadians who cannot. However, Canadians with equity in their homes who are determined to borrow to invest can read this essay on the “Smith Manoeuvre” for writing off loan interest on their taxes.

In part 3 of this review, we look at Edelman’s view of market indices and index funds.

Wednesday, January 9, 2008

Review of “Building Wealth” by Ric Edelman, Part 1

Ric Edelman is a financial advisor whose personal financial planning firm manages nearly $2 billion for its more than 5000 clients. His audio book “No-Nonsense System for Building Wealth” (Nightingale-Conant Corp, Simon & Schuster Audio) makes big promises about the financial success you can have by following his advice. He is a compelling speaker who has appeared on the Oprah Winfrey Show, but not all of his points hold up under inspection.

Edelman makes many good points such as the fact that most financial advisors don’t know much about investing, and most of the financial press is full of noise that you shouldn’t listen to. Concerning the financial press, Edelman says the following.

"Many in the financial world have their own agendas. They aren't necessarily trying to give you financial information. What they are trying to do is generate profitability for themselves."

Sadly, the same appears true of Edelman. Most of his advice is good, some of it not so good, and some of it is contradictory. But the biggest problem is that much of his advice is self-serving. Too often his recommendations are of questionable benefit to individual clients, but would improve the profitability of financial planning firms.

In this vein, maybe I should start making recommendations instead of just explaining financial matters. I recommend that you send me a lot of money. If you send enough, I promise that it will have a substantial effect on your finances (and mine).

Starting in part 2 of this review, I will discuss some of the details of Edelman’s advice.

Tuesday, January 8, 2008

Index Funds Beat Most Mutual Funds, Part 2

In part 1, I explained why the average professional money manager doesn’t get better returns than the stock market averages. Once we take into account the high costs charged by professional money managers, we find that index funds beat most actively-managed mutual funds.

However, it is possible to find analyses within the mutual fund industry that seem to contradict these conclusions. This is because mutual fund lists contain only those funds that are still active. Poorly-performing funds get closed or merged with other funds.

Wouldn’t it be nice if we could all throw out our worst performances? “Judge, I’d like to point out that that in 3 out of 5 football games I attended this year, I didn’t go streaking onto the field.”

If we calculate average mutual fund returns after throwing out bad funds, we get an artificially inflated average return that is higher than the returns investors actually received. This is called survivorship bias. In the book “A Random Walk Down Wall Street,” Burton Malkiel found that survivorship bias inflated average returns by 1.4% per year from 1982-1991. A Savant Capital Management study found that returns were inflated by an average of 1.3% per year from 1995-2004.

You might think that survivorship bias isn’t a problem because you don’t want to choose a bad fund anyway. You’d rather just choose one of the best funds. Unfortunately, the funds that have performed well aren’t guaranteed to stay that way. This is especially true of funds that performed well when they were small, and then swelled as investors rushed in looking for high returns.

The very fact that professional money managers dominate the market is what makes it possible for the average investor to use index funds to match the professionals’ average performance without paying high fees. Once we factor in the costs of actively-managed mutual funds, the evidence is clear. The average investor has received higher long-term returns in low-cost index funds than high-cost actively-managed funds.

Monday, January 7, 2008

Index Funds Beat Most Mutual Funds, Part 1

Actively-managed mutual funds have professional money managers who can do a better job of investing than the rest of us, right? That’s not what the evidence says. Studies show that the average professional money manager does not get better results than the market averages.

There are a number of reasons for this including the difficulty of investing very large sums of money and the pressure to show decent results every quarter or face having investors leave the mutual fund. The simplest reason, though, is that professional money managers control so much of the total money invested in stocks and bonds that they dominate the averages.

The US Federal Reserve’s December 2007 statistics contain a breakdown of stock holdings in Table L.213. It is not immediately obvious which line items correspond to professional money managers, but if we include just state and local governments and their pension plans, insurance companies, private pension funds, mutual funds, closed-end funds, and exchange traded funds, we find that they hold 59% of all US stocks. Expecting the majority of professional money managers to outperform the average is a bit like expecting the majority of people to be taller than average. It just doesn’t make sense.

Once we take into account the fact that actively-managed mutual funds have much higher costs (loads and the yearly MER) than index funds, we find that index funds beat most actively-managed funds. Many detailed studies confirm this, and I’ll point to two of them. One study by Savant Capital Management found that for the years 1995-2004, actively-managed mutual funds lagged their indexes in all nine of Morningstar’s mutual fund style boxes. On pages 260-263 of the book “A Random Walk Down Wall Street,” Burton Malkiel showed that mutual fund returns lagged the S&P 500 index most of the time from 1972-1998.

Stay tuned for part 2 of this discussion.

Saturday, January 5, 2008

Class Action Suit Against Canada Post

Lee Valley Tools Ltd. has initiated a class action suit against Canada Post over shipping charges. Before 7 years ago, Canada Post charged for shipping packages by weight. Then they introduced a new system where they charged for either weight or volume depending on which gave the higher charge.

The idea was to charge more for big bulky packages that take up a lot of space, but aren’t very heavy. This all sounds reasonable enough, except that Lee Valley alleges that the machine Canada Post uses to measure volume can overstate the volume by as much as 20%.

Another allegation against Canada Post in all this is that they keep any overpayments. Commercial customers have to weigh their packages and calculate the charges themselves. If Canada Post finds that the customer paid too little, they demand more money, but if the customer pays too much, Canada Post keeps the difference. Nice.

If Canada Post loses this suit, it could be very costly for them. Of course, if Canada Post loses and then finds a way to increase postal rates to pay for the losses, it’s not clear that the participants in this suit will be gaining much in the long term. I suppose principle counts for something, though.

Canada Post’s alleged wrongdoings are fairly minor compared to the things that some retailers pull:

“We don’t have any more of the $129 HD DVD players we advertised, but we have this better one for only $449.”

“Would you like to buy an extended warranty for only $79?” In most cases retailers will do anything they can to avoid losses on these warranties. They might as well be asking you “would you like to pay $79 extra for this item?”

See this post over on Ellen Roseman’s blog for more interesting customer service problems.

The difference between most retailers and Canada Post is choice. Canada Post is a monopoly protected by Canadian law. They have to be held in check or they will squeeze us for all we have. Most retailers have the constant threat of losing business to a competitor. If people don’t like how they are being treated, they can go elsewhere to buy things. If a retailer treats its customers badly, but the customers come back anyway, then those customers deserve what they get.

When the market can’t regulate the actions of a company with competition, as in the case of Canada Post, then the law must step in.

Friday, January 4, 2008

The Problem with Risk-Adjusted Returns

You may have heard of risk-adjusted returns in connection with mutual funds. The basic idea is that a risky investment may not be better than a predictable investment even if the risky investment has a higher expected return. There is some validity to this, although it is too often used to justify the poor returns of mutual funds compared to the overall stock market.

Normally, any discussion of risk-adjusted returns includes some intimidating math. I’ll explain the problems with risk-adjusted returns without needing the math, and I’ll give pointers to where the math can be found for those who are interested.

According to the theory, before comparing investments, you should do a risk-adjusted return calculation that will reduce the returns according to how risky they are. The riskier they are, the more the returns are lowered before any comparison. By “risk” here, we mean volatility, which is a measure of how much the returns vary over time. An investment that grows steadily has low risk, and another investment whose value jumps up and down unpredictably has high risk.

Sharpe Ratio

For those interested in the details of the calculations, Wikipedia has a good explanation of one theory based on the Sharpe ratio. According to this theory, the following two investments are equally desirable:

Investment A: 100% stocks
Investment B: 50% stocks + 50% government debt

The stocks could consist of a broad market index fund, and the government debt could be US Treasuries or Canadian T-Bills. Investment A has a higher expected return, but is twice as volatile, and so both investments end up with the same Sharpe Ratio.

In one year, Investment A will probably have a higher return than B. But it is also possible that A will have a significantly lower return, and it would reasonable for some investors to prefer Investment B if it is only going to be held for one year. However, over a long period of time (say 25 years), Investment A is preferable because it is overwhelmingly likely to outperform B.

This cuts to the heart of the problem with the way risk-adjusted returns are usually calculated: it doesn’t take into account how long the investment will be held. Over time an investment’s ups and downs tend to balance out somewhat. The average yearly return on an investment gets more predictable (and less risky) the longer it is held. This means that the longer you are invested, the more risk you can tolerate while seeking higher returns.

Some investments are too risky even over a 25-year period. A portfolio full of penny stocks would likely be too risky even over the course of a full lifetime. Another thing to remember is that it never makes sense to take on more risk unless you get a higher expected return. Stocks are a better bet for the long term than government debt because the expected returns are enough higher to justify the added risk.

Morningstar’s Method

Morningstar provides detailed information about both US and Canadian mutual funds. They use a different theory for adjusting mutual fund returns when they assign their star ratings (1 star to 5 stars). However, this theory suffers from the same problem as the Sharpe Ratio; it doesn’t take into account how long the investor will hold the investment.

Suppose that we have a choice of two investments: an adventurous investment that we expect to have a long-term compounded return of 12% with high volatility, and a safe investment that we expect to have a long-term compounded return of 9% with low volatility. For a one-year period, the adventurous investment might deserve to have its return adjusted down to 7% because of the risk, and the safe investment might deserve to be adjusted to 8%. This makes the safe investment preferable.

Now let’s consider a 25-year period to give the volatility a chance to balance out somewhat. Now the adventurous investment deserves to have its yearly return adjusted down to 11%, and the safe investment deserves to be adjusted down to 8.8% per year. In this case, the adventurous investment is better.

Morningstar will discount the adventurous investment by the same amount regardless of how many years it is held. The same is true for the safe investment. So, if you use Morningstar’s method, one of the two investments will be judged better for both the 1-year and 25-year cases, and one of these answers will be wrong.

All of this helps to explain the rule of thumb that money not needed for longer than 3 or 5 years can go into stocks, and money needed sooner than this should go into some less volatile investment.

Thursday, January 3, 2008

Market Timing can be Tempting and Difficult to Avoid

Wouldn’t it be great if you knew when the stock market was going to go down? You could sell your stocks, wait for a while, and buy them back when the stock market was going to rise again. You’d get rich very quickly.

Sadly, there doesn’t seem to be any magic way to know when the stock market will go down. You just can’t predict short-term swings in stock prices. But the sting of watching the value of your holdings drop 10% can make it tempting to look for signs of a market decline. Many people actually do a reverse kind of market timing. They get nervous and sell after stock prices drop, and they buy back in after prices start to rise again.

Many commentators offer the sound advice that you should keep saving money and ignore short term stock market swings. Suppose that you have taken this advice to heart. Maybe you pour savings into low-MER index funds every month without thinking about whether stocks are up or down. Even so, you will still be forced into a situation where it will be tempting to think like a market timer. Let me explain.

At some point, you will have some use for your money. Suppose that you’ve been saving for 15 years for your child’s college education, and you’ll need some of the money in 3 years. Maybe you’ve heard the sound advice that you shouldn’t have money in stocks if you’ll need it in less than three years. So what should you do?

You could sell enough stock right away to pay for your child’s first year at school, but what if the stock market is down right now? It is very tempting to try waiting for the stock market to recover before selling. You are being pushed into a market timer’s way of thinking. Just as investors find themselves thinking like traders sometimes, investors are also pushed towards market timing sometimes.

One solution to this problem is to sell a small amount of stock every two or three months that will add up to the amount of money you need in three years. So, you’re selling stock the same way you bought it; steadily, and without any market timing. As the cash builds up, you could put it into fixed income investments (like bonds) that will come due when you need the money.

It pays to think through your financial plan in advance so that you’re not forced into a situation later where you’re tempted to try market timing.

Wednesday, January 2, 2008

Investing vs. Trading, a Slippery Slope

Most commentators agree that people should be investors rather than traders. However, it’s impossible to be an investor without trading sometimes (or at least once). This is like telling people not to become smokers, but expecting them to take a puff once in a while.

Let me start by explaining what I mean by “trader” and “investor.”

A trader is someone who buys and sells stock. We usually use the term “trader” to mean those who trade stocks frequently and base their decisions on recent stock price movements rather than the health and future prospects of the businesses behind the stocks.

An investor is someone who examines businesses to try to predict their long term success in terms of revenues and profits. Some commentators stop there, and I know what they mean, but none of this analysis makes any difference unless you actually buy the stock. Investors have to be traders at least part of the time.

Let’s say that you are an investor who has found a business you would like to own because its long-term prospects look excellent. But that’s not enough to justify buying the stock. You can’t just ignore the stock market and focus exclusively on the businesses. You need to have an opinion on a fair price for the stock and compare this to the stock’s current price.

Suppose that you find a good business available at a bargain price. Now, you have to start thinking like a trader. Should you just place a market order for the stock, or should you protect yourself with a limit order? What price are you willing to pay?

Fortunately, investors who focus on businesses don’t have to become traders very often because they tend to hold stocks for long periods of time. In contrast, traders tend to pay a high price in commissions and spreads because they trade in an out of stocks far too frequently.

Even people with the best of intentions to be investors will feel the excitement (or terror!) when they put money at risk by placing a trade order. This excitement can be seductive. It’s also more interesting conversation to talk about the possibilities of short-term gains from trading stocks than it is to talk about whether some company will have good product sales over the next five years.

Unfortunately, because brokerages make money from commissions on trading, many of them encourage their clients to be traders rather than investors. The world of stock trading can be seductive, and when you’re forced to take a puff, don’t get hooked.

Tuesday, January 1, 2008

Financial Predictions for 2008

Happy new year! I have a few fearless predictions for the upcoming year.

1. Half of all financial prognosticators will correctly guess whether the stock market will go up by more than usual this year.

Of course, the other half will get it wrong. Maybe we would be better off if we ignored people who pretend to know what is going to happen to stock prices in the short term.

2. Interest rates will either go up, or down, or stay the same.

This is a safe one. Some people will pick just one of these three possibilities, but I don’t believe they know what will happen to interest rates any better than the rest of us. I doubt that even the people who set interest rates know for certain what they will do more than a few weeks in advance.

3. Newspapers will continue to print explanations for what happened in the stock market each day.

We see articles with titles like ‘markets jittery amid inflation concerns’ or ‘market rally blunted by corporate earnings pessimism.’ I rarely find these explanations useful in making investment decisions. Smart investors will yawn and ignore these articles.

I wish you a happy and healthy 2008.