Here is some lighter fare for a Friday. The first quote is this article referencing itself. Unfortunately, it probably applies to some of my other articles (and some articles by other financial bloggers as well). “When ideas fail, words come in very handy.” – Johann Wolfgang von Goethe This next quote from Warren Buffett explains more clearly than I ever have why most professional money managers don’t really try to beat the index. “Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)” The last bit makes me think of someone watching a video of hundreds of lemmings going over a cliff, pausing the video...

Some commentators say that while professional money managers used to provide value because stock markets were inefficient, modern markets are too efficient for money managers to make up for the fees they charge. I agree with the latter part of this claim, but I haven’t thought much about the former part. The idea is that in the “old days” there was little information available to the little guy, and professionals supposedly had a huge advantage. But, with the instantaneous spread of information on the internet, professionals no longer have an edge. For the claim about the past to be true, money managers had to be buying when stock prices were low, and selling when they were high. After all, the only way to outperform in the stock market is to sell stock for more than you pay for it. I came across a 30-year old quote from Warren Buffet showing that money managers in the past weren’t doing their job very well for at least one time period: “An irresistible footnote: in 1971, pension fu...

The idea behind asset allocation is that by carefully choosing how much of each asset class (like cash, bonds, and stocks) to own, you can get higher returns without taking on more risk. Any sub-optimal portfolio can replaced with an optimized portfolio with higher expected return or lower risk. This mantra has been preached by many commentators to the point where thoughtful investors devote so much attention to their asset allocations that they lose sight of other important considerations. But, optimizing your asset allocation gives less benefit than you might realize. An Example Suppose that Jen has a retirement portfolio made up of 40% bonds and 60% stocks. We’ll assume that the stock and bond money is invested in low-cost index exchange-traded funds (ETFs) to minimize fees. Using the figures from the paper Portfolio Optimization by John Norstad (2002-09-11), Jen can expect a compound return of 5.23% per year above inflation. What happens if we allow Jen to include cash...

Back in 1986, a study by researchers Brinson, Hood, and Beebower concluded that over 90% of the variance in pension fund returns was determined by their asset allocation decisions rather than the individual equities they chose. Investment advisors like to abuse this statistic for their own gain. What the researchers did was to replace the pension funds’ individual equities with appropriate indexes and see how much the returns changed. It turned out that they didn’t change much. When a pension fund allocated a fraction of its money to mid-cap stocks, it tended to choose a broad mix of mid-cap stocks that performed very close to the average of all mid-cap stocks. The same thing happened for other asset classes. This isn’t very surprising. Christopher L. Jones observed in his book, The Intelligent Portfolio , that investment advisors abuse this 90% statistic to steer investors toward investments that are profitable for the advisor. I didn’t recognize it at the time, but I had an...

A friend observed a contradiction between two of my articles. In one I point out that it’s important to pay attention to small amounts because they can add up . In another I argued that pennies are a waste of time . In fact, I routinely refuse pennies in change from cash transactions. So, which is it? Do small amounts matter or don’t they? It depends on how small the amount is. If you spend $10 on fancy coffee and donuts, that is wasting the equivalent of a thousand pennies. The difference between a penny and a ten-dollar bill is the same as the difference between running to first base and running a marathon. The average cash transaction will produce about two pennies in change. I average 2 or 3 cash transaction per week. So, I’m refusing about $3 per year in pennies. It would take me more than 3 years for this to add up to spending $10 on coffee and donuts once. Thirty years worth of pennies invested at 8% interest with 3% inflation would have a present value of about ...

I enjoy playing low stakes poker for fun. I’ve even tried it in casinos in Las Vegas. Part of the ritual in casino poker games is that the dealer takes a cut of a few dollars out of each pot, and the winner of each hand often gives the dealer a tip of a dollar or two. This gives a good illustration of how small things can really add up. In low stakes games the players are often very impatient. I found that I could make about $20 per hour by simply being patient and disciplined. Playing this way is boring, but slightly profitable. To win this $20 each hour, I actually lose about $180 and win $200. Of course, the winning and losing occur randomly, and it took many hours of play before I considered these average figures to be fairly reliable. The problem is that the casino’s cut and the dealer’s tip come out of the $200 rather than just the $20. My “gross earnings” are actually more like $40 per hour. Even though the cut and tip are just a small fraction of each pot, they eat up a...

According to CNN, a Ponzi scheme run by Andres Pimstein fell apart recently in Miami, Florida . A Ponzi scheme is a fraudulent investing scheme where investors are paid returns out of other investors’ principal instead of being paid from the returns of a legitimate business. Ponzi schemes fall apart when there aren’t enough new investors to pay the existing investors. The fraud grows exponentially until the pool of suckers runs out. What I find interesting about this story is the way that people are tricked into these schemes. Potential investors are offered guaranteed big returns in a short time. If this were a legitimate business, why wouldn’t the pitch man just borrow some money from a bank and keep the huge profits himself? The usual explanation for why people get caught in these frauds is that greed overcomes reason. I think that is just a partial explanation. My guess is that the people, like Pimstein, who run Ponzi schemes are charismatic. Potential investors probably lik...