Don't Quit Your Day Job...

How Do You Know You’re Ready For Active Investing?

PK — Wed, 16 May 2012 05:45:27 +0000

My Fantasy Portfolio Returns vs. S&P 500 at Updown.com

If you read my recent article on my returns as an active investor, you’ll note that for years I invested in mutual funds before ever putting a single dollar into an individual stock.

I mean, what gives? At what point did my confidence (ego?) allow me to make the leap from a passive investor to an active investor?

Thousands of Pages of Reading

I tend to over-analyze a lot of things (do you read this site?). Since the day I started investing I knew that eventually I would have at least some of my portfolio in individual stocks. I started investing as a low emotion, low information investor years ago, and put all of my investments into stock mutual funds in my 401(k). Here is how I got that idea:

Me (on phone with my father): Dad, what’s a 401(k)?
Dad: A section of the tax code and a retirement account. Do you get a match?
Me: Yeah, 4%.
Dad: You’re young, so contribute at least up to the 401(k) match, and if you get interested in this stuff you can eventually move it.
Me: Sounds dumb, but okay.

Of course, he was the smart one, and I was just a naive intern at the time.

That summer was when I “became interested in that stuff”, and I started to devour everything I could read. Most of my research at the time involved buying books, and I still have my dogeared copies of and later . Of course I read all the Bogle books at that time, and basically anything related that I could get my hands on. One book, however, was not like the others… by Benjamin Graham.

Buy Individual Stocks? You don’t say…

At the risk of sounding like some of the earlier books in the King James Bible, Graham begot Graham and Dodd who begot Buffett, who begot Lynch who begot others, on and on. From that point until today, I have pretty much only read books on investor psychology, derivatives, and investing in individual stocks (and other securities).

The hardest part was not jumping into the markets until I thought I was ready. I had all of this book knowledge, but like Matt Damon in Good Will Hunting “There [was] nothing [I could] tell [you] that [you] can’t read somewhere else.”

Obtaining Practical Knowledge With None of The Risk

Years after I had started investing (and yes, years after I had started reading about individual stocks) the Internet investing community had matured to the point that some web sites held stock contests. I finally was able to put my knowledge to the test – but, alas, most contests had a short term view of the markets. It wasn’t until web sites started offering longer view portfolios that I started caring. One such portfolio tracking tool was at Morningstar, and I still have some of my early test portfolios saved on my username.

The Updown Portfolio I have above is the only portfolio I still touch, fantasy wise, because I like to compete with some of my friends head to head and let it track my trades for me. The graph above is from November 2008 through today and shows roughly a 121% annual return (take that, S&P 500). Even though, as you saw in my last article, I couldn’t quite touch that in real life (to say the least) I still highly suggest you spend at least a year or two with a fantasy portfolio before taking the plunge. Even if you do well in fantasy, note that:

Just like with a game of poker with no real money on the line, you will take unnecessary risks when you don’t have money on the line. This may make your returns unrealistic.
1-2 years usually means you’re only trying your strategies in one type of market. It takes decades to test a strategy with confidence (if it’s a mechanical system, Google back-testing to try your luck).
Luck can also explain excess returns…

Taking The Plunge!

If you’ve got the depth of knowledge you can build from reading books and the internet and some of the experiential knowledge from fantasy portfolios? You’re as ready as you’ll ever be. Of course, I caution you to start small with a portion of your portfolio which it wouldn’t be the end of the world if you somehow lost (I’m 38 months in and individual stocks are a bit less than 20% of my net worth).

If you’ve done all those things? Welcome to the world of investing in individual stocks. Good luck!

Do you invest in individual stocks, if not, will you ever? When did you buy the first of your portfolio? What proportion of your portfolio is dedicated to individual stocks?

Who Will Rate the Raters? The Analyst Crisis on Wall Street.

PK — Mon, 14 May 2012 05:41:00 +0000

We here at Don’t Quit Your Day Job are sometimes a cynical crew. We have a keen sense of the absurd and love to share the most egregious absurdities with you. You see, there is a position on Wall Street called a Financial Analyst – and those Analysts are trusted to do a very fundamental job: break the investment prospects in various companies down into one of 5 categories. There are positive categories (like buy or overweight), neutral categories (like market perform, market weight or… neutral) and negative categories (like sell and underweight). Different firms have different ratings, but all ratings fall into one of those three bins.

“Quis custodiet ipsos custodes?” roughly translated means either “who will watch the watchers?” or “Who will guard the guards themselves?”. Usually the phrase is employed to point out instances of police brutality, but it is relevant in this situation as well. Financial Analysts have an important position – millions of market participants rely on their words and changes in analyst ratings can move the market for a particular stock. The main problem with analysts? Their incentive structure – analysts tend to be employed by large Wall Street firms. Those firms have lines of business other than recommending stocks to investors – issuing new stock or bonds, general financial services, initial public offerings and various other categories of financial work. Therein lies the conflict of interest: putting a negative rating on a firm might get your financial company blacklisted from doing business with the firm in question. So, even though there may be a universe of stocks which nobody should invest in, Analysts are constrained during their ratings because the firm they are employed by is still interested in getting business from those very companies!

Analyst Equity Ratings (Wall Street Journal / FactSet Research Systems)

The Drift of the Negative Rating When It Comes to Stock Ratings

“Don’t shoot the messenger” is another good quote that comes to mind when discussing this issue. However, it applies to Analysts that go against the grain and downgrade a company. Sure, there is some market reaction due to the downgrade itself, but for an Analyst to actually make a downgrade there is usually a very good reason to make the call. One of the more famous calls in recent years was from Meredith Whitney, when she wrote a bearish note on October 31, 2007 about Citibank. However, as reported in the Wall Street Journal (and her own words), it wasn’t even a difficult call to make. The jury is still out on her second most famous call – a negative report on Municipal Bond defaults which hasn’t (yet?) been accurate.

Like Whitney said, deciding that a firm’s prospects were negative was the easy part. Navigating the politics of a downgrade was the hard part. Consider her Municipal Bond call – the ‘company’ that issues Municipal Bonds is usually a government, or at least government backed. Note that after her call that municipal Bonds were weak she was actually asked to appear before a Congressional Panel – talk about powerful dissuasion to say anything negative about Munis!

Good, Good, Good, Good and Okay Stock Investments

Realistically, some investments will always perform better than others. A combination of market trends and smart management ensure some companies will be winners… and some will be losers. This leads us to the analytical aspect of this piece – how many companies should have a negative rating?

It’s an impossible question to answer. The ideal number of negative ratings is obviously non-zero. Since the drift rate of stocks has been historically positive, it’s likely that there should be more positive ratings than negative ratings. However, in practice, the bias against negative ratings is incredibly strong. From the Wall Street Journal, which excerpted Mike Mayo’s book Exile on Wall Street, (Mike’s Book’s subtitle: “One Analyst’s Fight to Save the Big Banks from Themselves”) comes this disturbing statistic: of the 29,469 Analyst Ratings tracked by FactSet Research.. only 1,212, or 4.11% were negative.

Here’s my point: don’t listen to stock Analysts when you make investments. Their incentive structures dies them to the firms they track, rather than the investors who listen to what they say. So, readers, what’s your opinion of Financial Analysts?

The DQYDJ Weekender (Week of 5/7/12)

PK — Sat, 12 May 2012 18:41:04 +0000

New Blogroll Link!

Through some stupid oversight, I didn’t have Burbed in my blogroll. That situation has been rectified. If you want to share my appreciation for overpriced Bay Area homes (one of which I am typing this from!), click through there, or read this sarcastic piece on Mountain View keeping new houses away.

Links Featuring Us!

The Carnival of Financial Camaraderie (This Week, seems to have gone up early)
The Carnival of Financial Camaraderie (Last Week)
The Carnival of Wealth
The Totally Money Carnival
The Carnival of Personal Finance
The Yakezie Carnival
Financial Uproar
The Free Financial Advisor

Links We Liked!

Nelson at Financial Uproar is no stranger to these roundups, so treat him like he’s been here before and read his article on 15 vs 30 year mortgages. Apparently, I need to write one now…
Neither is 101 Centavos, for that matter. For you young’uns, read some career tips for the corporate world (or in general!)
Dr. Dean at the Millionaire Nurse Blog explains why it’s so awesome to talk about yourself.
At Make Love, Not Debt, I don’t know how I missed this piece on payday loans and some bad luck.
At Boomer and Echo, an article on chasing dividends (specifically: why not to chase dividends).
At Untemplater, Sam from Financial Samurai wrote a post on taking a sabbatical… and potentially never coming back (!).
JT at Money Mamba knows that sometimes credit card debt is actually a good deal…

Happy Mother’s Day!

S&P 500 Return Calculator

PK — Wed, 09 May 2012 04:51:02 +0000

One issue you run into a lot when you are discussing optimal savings strategies is the inability of people discussing their returns versus the S&P 500 to produce a fair comparison. They will say, for example, that the S&P 500 index was at the same level as it was at some time in the past – so therefore investing in the index was a waste of time.

It’s time to correct this nonsense. I have taken Robert Shiller’s data on the historical S&P 500 index and created a dividend reinvestment index going back to 1876 (from PK: as of this posting, through April 2012. Email me if there is newer data and I haven’t updated yet). Enter your starting month and year and ending month and year and the calculator will tell you:

S&P 500 Index Return - The total price return of the S&P 500 Index. So if it is at 1000 on the start and end date, this will be 0.
S&P 500 Index Annualized Return - The total price return of the S&P 500 index (as above), annualized. This number basically gives your ‘return per year’ if your time period was compressed or expanded to a 12 month timeframe.
S&P 500 Dividends Reinvested Index Return - The total price return of the S&P 500 if you had reinvested all of your dividends.
S&P 500 Dividends Reinvested Index Annualized Return - The total price return of the S&P 500 if you reinvested dividends. Again, it will annualize the return given above.
Inflation Adjusted (CPI)? - Whether the calculation you did is using CPI adjusted values provided by Shiller, or showing return before inflation. Hit the checkbox above the buttons to turn on or off the inflation adjustment.

The S&P 500 Dividends Reinvested Price Calculator (With Inflation Adjustment)

Methodology

Professor Shiller lists his methodology on his site – all values internal to this tool use the values he provided.

To calculate the ‘dividend reinvested’ price index, I take the dividend yield reported in any month of Shiller’s data and divide by 12 to get an approximate count of dividends paid out in the month. Using that number, I calculate how many ‘shares’ of the S&P 500 index I can buy, and run a cumulative count from 1876 to 2012. Is this completely fair? No, but it would be nigh impossible to go back and calculate exact S&P 500 payout dates and figure out what the index was trading at on that date. Deal with it.

Also, transaction fees and management costs aren’t included, which would come out of a ‘real’ investor’s return.

Implications

Does it mean a lot to include reinvested dividends? Well, yes. Consider the following – in July 1999 Shiller’s data has the S&P 500 at 1380.99. In April 2012? 1398.08. If you only used the price return of the S&P 500 you’d appear to have made a 1.238% gain, when, dividends reinvested, it was more like a 4.525% gain. It seems shabby, but the effect is much more pronounced over longer periods of time. Consider from January 1950 until April 2012 the return was 8,182.464% for the index price and a whopping 11,514.307% for the dividends reinvested index. In short? Since 1950, roughly 29% of your gains would have come from reinvesting your dividends. Still think it’s shabby?

Is this a useful tool? Anything else you’d like to see added?

Is It Possible to Beat The Stock Market?

PK — Mon, 07 May 2012 06:37:40 +0000

You recently completed a very verbose series here at DQYDJ on investor psychology, the failure of the Efficient Market Hypothesis, and how to improve on buy and hold. If you survived all of that, you’re probably wondering: “hey PK! You mentioned in the EMH article that you trade stocks on valuation. How do you know that you’re doing the right thing?”

Good point dear reader, and to tell you the truth, until I ran the numbers this weekend I wasn’t quite sure. However, lucky for you (and my ego) I have now run the numbers and am ready to share my investing history.

A Little Personal Background

Unlike some of you, I can actually point to the date I traded my first individual stock: (because it wasn’t an incredibly long time ago) March 3, 2009, a little bit before I started this website. It’s not that I’m new to investing, it’s just that for the beginning of my investing career I stuck to mutual funds. Even today, individual stocks make up less than 20% of my net worth.

I started investing by reading a bit about the Efficient Market Hypothesis and by, of course, completing the most important text on that subject, . Yes, the mutual fund portion of my portfolio is still set by what I learned from those days.

Since I only have 38 months of individual stock investing history, my value strategies have really only been tested by two types of markets… the massive bull market which started around when I did, and the side to side trending market of the recent past. The point? My strategies (and my emotions) haven’t been tested by a true bear market – even though I did continue to invest heavily in stock mutual funds during the Great Recession.

Enough Caveats!

So, did I beat the market from 3/3/2009 until 5/4/2012?

My return (annualized): 29.93%
S&P 500 Return (annualized): 26.37%

So I’ve been able to generate 3.56% of excess returns per year over the last 1,158 days. It’s not Warren Buffett’s track record, but hey, maybe I’ll have to invest more in individual stocks in the future (and sell some of those mutual funds). At least I’ll impress this guy:

Maybe so, but who’s to say I wouldn’t have invested differently had my whole portfolio been on the line?

Methodology

I know that I’d irreparably ruin DQYDJ’s reputation if I didn’t show you how I calculated the return. The short answer is: use your trading history to set up a spreadsheet in Excel (or OpenOffice or Google Documents) and run XIRR on your cash flows. Here’s a graph of my inflows and outflows since 3/3/2009 (and yes, I did spend my dividends in the beginning, so you can see them as very small outflows). Inflows are negative (depositing money to buy stock), outflows are positive (withdrawing money). The “last” outflow is the current balance – 100% (it doesn’t mean that last Friday I pulled out all my stock, it’s just the value of the portfolio as of Friday at the market close).

As for the S&P 500, this analysis is biased towards it. Most people use the price return of the index – but that would discount dividends and share options. I used the S&P 500 total return index, which happens to include reinvested dividends. On 3/3/2009 it closed at 1126.18, and on 5/4/2012 it closed at 2366.39, for a 26.37% annual return. See the problem? You can’t invest directly in an index, so your actual return would be less due to management fees and transactions. Oh, and you may have spent the dividends. I’m just saying!

Do you think I’m lucky or good? Is it better to be lucky or good? Is it actually unlucky to be lucky when you first start something risky? Will I regress to the mean? Should I sell my mutual funds and only buy individual stocks from here on out?

The DQYDJ Weekender (Week of 4/30/12)

PK — Sat, 05 May 2012 15:09:05 +0000

Hey! You reading!

Listen to us on our Podcast at The Free Financial Advisor.

Links To Us!

Links We Liked!

Control Your Cash talked me out of a work from home opportunity.
JT at Money Mamba explains that, no, it’s not always better to buy a used car. Shocking!
Tim at Faith and Finances details the differences between subsidized and unsubsidized loans.
I completely approve of the very detailed post on Walmart over at 101 Centavos.
Congrats to Corey at Passive Income to Retire (among other sites). Continue the hard work!
Have you ever seen a house with a seven figure price tag flipped? Bring that irrational exuberance back with Burbed!
Interested in California now? So was Ironman at Political Calculations, who has an interesting post on California’s GDP versus the nation’s.
Len Penzo says birth order doesn’t matter. He’s right – and neither does astrology… Treat them as entertainment!

Anything Else?

We’re beat! Too much writing about Buy and Hold. If you haven’t yet, read the series in order:

“What Kind of Investor Are You?“
“The Efficient Market Hypothesis is Flawed“
“If Buy And Hold Doesn’t Work… Then What?“

We’ll back up that writing with some hard numbers soon enough.

If Buy And Hold Doesn’t Work… Then What?

PK — Fri, 04 May 2012 05:19:54 +0000

Since you’ve now read my treatises on Investor Psychology and the Flaws of the Efficient Market Hypothesis, we’re finally ready to discuss what we originally set out to discuss – how to improve on buy and hold investing, Rob Bennett’s controversial ideas on “valuation informed indexing“, the concept of the safe withdrawal rate, and the state of buy and hold investing.

How Can Buy And Hold Investing Be Improved?

As you know, buy and hold investing has its roots in the Efficient Market Hypothesis, an idea that currently quoted prices of securities perfectly reflect the actual valuation of stocks, bonds, and other assets. To sum it up in a single phrase, they suggest that “if you can’t beat them, join them”. With buy and hold investing, you accept the market’s returns, minus some small cost for management fees and transactions.

P/E10 vs. 20 Year Returns (Wikipedia)

In most cases, unless you are willing to put the time in to learn about valuation of individual stocks and all of the other knowledge that comes along with it, buy and hold is a great idea for the vast majority of investors. In fact, only high information investors with a mechanical buy/sell system should even consider leaving the relative safety of the buy and hold arena. As I stated in the last article – the vast majority of individuals (and 2/3 of mutual fund managers!) underperform the market.

However, what if you could take the low time investment of passive investment, and combine it with some sort of valuation metric which gives a decent idea of how to allocate between two asset classes? For example, say you normally split your investments with 60% stocks and 40% bonds and fixed income. If stocks can be shown to be somehow undervalued,could you increase this to 70/30 or 80/20? How about if stocks looked overvalued – could you reduce your holdings in stocks and increase your holdings in bonds?

What if you did this across multiple asset classes – looking at the valuation of that asset versus a historical valuation, and under or over-weighting that asset in your portfolio by extension? Well, at the risk of boring the low-information investors by applying too much thought to this method – there has to be something to this.

Nearby, you’ll find an application of Robert Shiller’s (who is more well known for applying valuation to real estate prices in the Case-Shiller index) method of taking the price to earnings ratio of the S&P 500 over the previous ten years and graphing it against subsequent returns. You’ll note that as P/E10 increases, average returns for the S&P 500 fall, with better returns coming with lower valuations.

Valuation Informed Indexing

Enter Rob Bennett and John Walter Russell’s Valuation Informed Investing, or VII. Russell, before his death, released a chart which showed the coefficient of determination (square of the correlation) of 10 year returns and PE/10 having a (somewhat high) .47. For reference, a value of 1, or 100%, would mean two values perfectly track each other, while a value of 0 would mean no relation. To give one example, the Vanguard ETF [[VV]] attempts to track the MSCI US Prime Market 750 Index. It’s R-squared is 99.92%, implying that the two move in almost absolute lockstep.

So even though P/E10 isn’t as predictive as say an ETF tracking an index, it seems to have decent predictive powers. We have to ask one more thing: are the variables related? The fallacy we are worried about is post hoc ergo propter hoc – basically, saying that a correlation doesn’t automatically prove a relationship. (Read more on fallacies in investing here). However, my personal belief is that value methods have proven themselves to be a rather reliable indicator of future returns – even if they don’t eventually move markets with absolute predictability.

So, in essence, VII uses this P/E10 (and usually on the S&P 500, where the most research has been done) to decide when to invest in the S&P 500, and when to move to safer assets. Wade Pfau, writing for the National Graduate Institute for Policy Studies, evaluated a mix of 100% stocks or bonds using a methodology originally advanced by Fisher and Statman in 2006. He showed that yes, using a P/E10 of 16.4 (historic median) to set 100/0 stocks/bonds or 0/100 stocks bonds outperforms buy and hold investing over the long run. Other research by Pfau and Robert Shiller seems to point to a few valuation methodologies which can, surprise, surprise… beat buy and hold (100% stock holdings) even when using the traditional CAPM models for risk. Of course, note that if you are anywhere close to retirement (even using buy and hold) you should move to a less extreme allocation of stock (like 60/40 or 50/50 split with fixed income investments).

Safe Withdrawal Rates

Rather than rewriting a great piece of financial writing, I’d direct you to fellow financial writer Todd Tresidder’s writing over at The Financial Mentor. Todd has already written up a post on the history of safe withdrawal rates, and you would be poorly served by me duplicating the tremendous effort he undertook.

The key points of his article are that the “Magic 4%” withdrawal rate that most financial advisers quote is bunk, and is likely only valid for American portfolios due to a confluence of good luck over the last couple of centuries in America. I’d tend to agree here – he cites Wade Pfau heavily in the article, and Pfau even posted this example of safe withdrawal rates for another first world economy over the last century – Japan.

Remember, all of the ideas we just explored don’t just inform our asset allocation – they also can be used to predict what a safe withdrawal rate is when you are drawing down your retirement funds and savings. Your biggest risk in retirement is outliving the resources you have acquired, so you want to know how much you can take out early in retirement so you don’t have to cut back drastically near the ‘end’. A good place to look to get an idea of your ‘length’ of retirement is on the Social Security Actuarial Life Table, which will give you the odds they expect you to live a certain length of time based on your age. Your mileage (or age!) may vary…

If all of this research is to be believed, you should consider valuations when you go to take out funds in retirement. If stocks are insanely overvalued, you might be better served by both switching from stocks and taking out less than the so-called magic 4%, while if they are undervalued you might find yourself able to take out a lot more.

Other strategies which might make sense?

Set a minimum withdrawal percentage, say 1.5 or 2.0%. Only increase it if your total funds lost with withdrawal are less than some benchmark, say 6%. Your funds may drop 10% one year, so you only take out 1.5%. Another year, they increase 10%, so you take out 4%. They drop 2.5%? You take out 3.5%. Rinse and repeat.
Take out a percentage of current funds. The 4% number is only a risk if you base it on your original funds and the market drops.
Recognize the 4% number, and go with something less – like 3. Note that 4% implies you need to save 25 times your annual draw. 3%? 33.3 time. So this method means small movements towards conservatism mean massive increases in resources are needed.

The State of Buy and Hold Investing

Shots are being fired across the bow of the buy and hold ship, but many people… the low information investors for certain… should probably continue to sit tight and monitor the developments. In extreme conditions – like really frothy valuations and insanely cheap stocks, maybe you should consider shifting away form or towards more stocks in your portfolio.

For the high information investors? You should probably read as much on these topics as you are comfortable with. Those of you with ETFs and mutual funds, you should start to fold these concepts into your methodology and start to watch the overall valuation of stocks in your portfolio. Those of you who deal strictly with individual stocks should already have implemented some style of valuation to your buy and sell decisions.

I’m curious to dig into some methods of evaluating the entire market – P/E10, regular price/earnings, dividend yield, earnings expectations, even implied closing prices (my specialty!) or some combination thereof (or something not mentioned here). Perhaps if all of this is interesting or controversial enough, I’ll do some of my own informal studies as well, and try to figure out if some are better than others. I’m hoping it is.

What do you think of all of this information? Are you reconsidering your style of investing? Are you going to use valuation to determine the allocation of your mutual funds? How do you think age should factor into your allocation?

The Efficient Market Hypothesis is Flawed

PK — Wed, 02 May 2012 05:28:45 +0000

Are you an active or a passive investor? As with all things in finance (such as the type of investor you are), there are shades of gray, but you can basically break down investing strategies into one of those two categories.

On the one hand, you have the passive investors, the buy and hold guys (and gals). Usually this crew has a portfolio strategy, like a 60%/40% stock/bond mix, a “Coffeehouse” portfolio, or some other sort of indexing scheme. Expect it to be well thought out, back-tested, and generally a decent fit for you low information investors I discussed in my last post.

On the other hand? ‘Frequent’ traders, who are traders of individual stocks and people who are using instruments more complex or volatile than ETFs and Mutual Funds.

Information Warfare

Buy and hold has a huge following – and the truth is, it should. As my co-writer Cameron recently noted, over the last 10 years the S&P 500 returned 8.4% while the average investor saw 1.9% returns. The vast majority of investors shouldn’t bother with anything more than a passive portfolio – “set it and forget it” is an awesome strategy that won’t keep you awake at night worrying too much about recent volatility. Although the massive diversification of most buy and hold schemes means that while you capture large swings in the market, you won’t capture the outsized returns which are possible with individual stocks. Balance that against the greater risk of outsized drops and you recognize the power of passivity. If you read the previous article I wrote on investor psychology, anyone in the low information category should seriously consider this style.

Even though buy and hold likely commands the most followers, there are tons of passionate investors of an active persuasion. The tools of the trade in active investing include technical analysis, valuation, momentum trading and all sorts of sub discipline which inform the purchases and sales of individual securities (and sometimes other asset classes like ETFs). Active traders move in and out of the market more often than passive investors, and even though they are a minority of investors, they capture a majority of press. It makes sense though – that minority makes the majority of trades – they move the market on a day to day basis, even if their passive friends set the foundation.

The Efficient Market Hypothesis

In the passive corner, the strongest evidence there is that what they are doing is optimal is the theory known as the Efficient Market Hypothesis (and its various offshoots, such as CAPM). Basically,the Efficient Market Hypothesis says that there can be no edge in the market, that investors are all perfectly rational, and all investors working off public information can’t profit except from inside information (and even then, maybe not), and that all stocks are equally well priced. There are various degrees of strictness of the theory, but the main point is that the market works like a .

Passive investing’s spokesmen will point to sheer randomness and luck whenever they are presented with evidence of someone beating the market over a long period of time. Consider the following… assume you have a 1 in 2 chance of beating the market in any given year. If that is true, you can see that the odds of you beating the market quickly reduce over a period of years. However, in a universe where there are 150,000,000 investors investing randomly, getting the ‘coinflips’ right 25 times in a row still leaves 4-5 ‘investors’ who we will now treat as gurus based on sheer luck. Therefore, we should discount anyone who seems to be lucky, not skilled, over a long period of time.

At this point, a note: In my last article, I gave you a list of people who actually did beat the S&P 500 over a long period of time. Let me repeat some of them here: Benjamin Graham, David Dodd, Warren Buffett, Irving Kahn, and Walter Schloss.

Why did I pick those specific investors? Some of you already might recognize that they were either teachers or students of Ben Graham and David Dodd’s value methods, authors of the famous book (and its companion ). Keep that in mind for the next section.

Three Strikes Against the EMH

I don’t consider myself an active investor. Whenever I buy a stock I try to figure out valuation (what it ‘should‘ be priced) to calculate a potential upside. When a stock is close to fairly valued? That’s when I sell. This process of buy and hold isn’t quite the same as passive portfolios as it requires I keep an eye on a number of metrics, but since my holding periods are generally measured in years I don’t exactly consider myself an active investor. I don’t belong in either camp.

That said, I can’t accept all of the things stated by the EMH. Assuming rationality is a wonderful way to come up with a framework for how the markets work and to approximate the movements of the market, but extrapolating one rational being’s decision making to an entire market (where it’s possible that the most active investors are the least rational) is too much to swallow. Let’s talk about three reasons the EMH falls short:

The Efficient Market Hypothesis assumes that all markets reflect the fair value of all stocks quoted, discounting all publicly available information. Since at one point before the currently quoted price there was a different price, in order for the current price to be accurate some trader had to have captured the difference in prices in order for the current price quote to be accurate. He or she may have bought or sold stock to increase/lower the price, but since the price moved, someone must have profited off of it. Simply, a market participant forced the move to the current price, so someone captured the difference from fair value.
The EMH’s ‘weak’ formulation allows for the occasional flash crash like 1987′s black Monday, but no great answer has emerged as to how, in a rational market, bubbles form and pop. In what efficient market could an asset have wild swings in price from day to day in the virtual absence of news? On a smaller scale, why do markets tend to overshoot on surprise bad or good news, only to rebound in the opposite direction? Examples abound in the latter category – BP during the recent oil spill, Alcoa during the tobacco lawsuits, even banks during the recent recession (although some of that bank mojo, but not all, is government intervention).
Just above I laid out the odds of investors beating the market over long periods of time. How have 5 value oriented investors – when we said 5 completely random investors would be expected, perhaps, from odds alone – beat the market over such a long period of time? Note that Graham started teaching value investing in 1928 – so you’re talking about his methods prevailing over an absurd period of 84 years at this point (a far cry more than 25 years). Having proponents of the same theory all outperforming the market is the third strike for the EMH.

What Could Beat the Random Walk Style of Investing?

If you agree that the EMH is flawed, you’re probably wondering ‘what can possibly beat random walk investing’? That’s simple, it can be one of three things:

A leading indicator of future performance which hasn’t yet been recognized. The ultimate example is the price/sales ratio, first popularized by Ken Fisher of Fisher Investments fame.
An asset class which is more likely to be overlooked, misunderstood or ignored by the market. The ultimate example of this would be small capitalization stocks. The definition varies, but generally large funds will avoid buying stakes in smaller stocks (they don’t want to ‘accidentally’ buy voting control, or they have institutional controls preventing it). Another recent example would be mortgage backed securities – where a number of investors found a way to make a killing while the market tanked.
A methodology which requires work or a personality trait which isn’t present in other investors. This is where value investing falls into the mix – since fund returns are measured on a quarterly and yearly basis, an individual investor can out-wait a large fund, which has to impress investors quarter after quarter. Value investors might under-perform for years only to gain many years worth of returns in a few months – any funds attempting that sort of strategy would be closed well beforehand. Another example is activist investing and private equity, where extreme amounts of work can lean down a company and cause it to reevaluate things, improving outlook at a firm.

Do You Have Any Specific Evidence to Support This?

The most famous example is probably Robert Schiller’s, when he graphed the P/E10 (the average price to earnings of the S&P 500 over the rolling ten year period) versus earnings. That graph clearly shows a negative correlation with high valuations and returns… in essence, valuation works on the market as a whole to inform decisions on how and when to invest.

I mentioned Private Equity. Is there any evidence activist investing and private equity beats the market? Well, yes, again there is plenty of evidence. (As a side note, I don’t know why Mr. Arends is so angry about this study – the PE firms are putting up their capital and doing lots of work restructuring these firms, so you’d hope they can capture some excess returns).

How about small caps beating the market? Here’s what I’ve got. I could dig around for other asset classes too, but you can use Google just as easily as I can. As for people making money on misunderstood asset classes, like say, by shorting mortgage backed securities? I’d go with Michael Lewis’s .

And valuation methods which aren’t yet widely known in the larger market? Do a bit of reading on Ken Fisher and you’ll see that as his PSR became well known its predictive value started to fall – an important point for anything that can fall into category 1 above.

All of that points to one conclusion: there is a way to beat the market. It may be temporary, it may be difficult, and it may take patience – but there has to be a way.

Do you consider yourself an active or a passive investor? What do you think of the Efficient Market Hypothesis? Can market be ‘beat’? What’s your strategy for investing?

What Kind of Investor Are You?

PK — Mon, 30 Apr 2012 07:00:24 +0000

The other day our friend John at Married With Debt hosted a guest post from Rob Bennett of Passion Saving. You might remember John from our collaboration on the relative taxation of Presidents Obama and Bush. Rob, on the other hand, is a bit of an enigma in the Personal Finance world. On the one hand, he has very interesting theories on safe withdrawal rates and buy and hold investing based on market valuations. On the other hand? He weaves a tale which makes the stories of Alexander Litvinenko and Gareth Williams seem somehow tame by comparison. I’m not going to touch that further than describing it (Google around if you care), but there is precedence for disruptive financial theories causing anger. Let’s tackle the merits of Rob’s arguments, shall we?

No Comment. (Wikipedia)

Divide Yourselves Into Groups…

I really hate fence sitting, but if you get to the end of my arguments you’ll recognize I spilled lots of digital ink just to sit on a virtual fence. Bear with me as it’s going to take a couple articles to spell everything out.

A Bit On Investor Psychology

Even though I’m about to (slowly) explain why I’m undecided as to an exact course, note that people often complain when I make things too black and white (or binary, if you prefer). I get it – there are various shades of gray. I mean some of this article to be self-assessment, so categorize yourself in the correct way and draw your own conclusions on where you sit.

The way I see it, there are four types of investors: High Information/High Emotion, High Information/Low Emotion, Low Information/High Emotion and finally Low Information/Low Emotion. Here’s how they break down:

High Information / High Emotion:You’re an investor who pours through the research, has read all the books, digests as much as you can on the internet and looks over financial reports. However, when it comes time to trade you can be too quick with the trigger – a glance at your trading history reveals panic sells, piling into rising stocks, and maybe some brief flirtations with momentum investing and technical analysis (likely with poor results). Basically, you know a lot about the market but your emotions get the better of you on the transaction side.

High Information / Low Emotion: Like the HI/HE investor, you devour all the information that exists on stocks and valuations and alternative investments. You can hold court in any conversation about investing strategies and know your way around a balance sheet. Unlike your HI/HE buddy, you are very deliberate when it comes to buying and selling – only making moves when you can verify something using certain valuations and never selling based on emotions.

Low Information / High Emotion: You get most of your investment ideas through conversations with friends, tips heard at various places of business, and by reading “Top 10 Lists” of stocks. You’re very into the stock market, but don’t know much about valuation, hedging, and probably wouldn’t be able to keep up on an analyst call. However, you care deeply about retirement, tend to have certain parts of your portfolio tank, and are quick to want to move to cash in a downturn.

Low Information / Low Emotion: (I’d be surprised if many of you read this article!) You don’t know much about the stock market, mutual funds, or securities, and the funny thing is you don’t care much. You may or many not participate in a 401(k), but you can’t tell a Roth IRA from a 529 (and will walk away from someone trying to ask about them). Hi, from the rest of us above, please try to get your emotions up to ‘medium’. Thanks.

Did you identify yourself there? Good. Find which of the four categories you best fit into, because it makes a huge difference to the investments you should pick. From my anecdotal experience, I would say that most people fall into category 3, Low Information/High Emotion investors. They worry lots about having a retirement when they are too old or sick of working, but they are much better at their day jobs than investing. None of these categories are meant as an insult – the truth is, for LI investors, you probably made a conscious or subconscious decision to not increase your financial knowledge.

“You’re Unique. Just Like Everyone Else.”

Great. I just proved to you that different people are different. Here’s the point of that little exercise:

“Different Investors Require Different Approaches While Investing.” -PK

You’ve now categorized yourself in one of the four categories above, or at least found the category which is closest to describing you. Now you can figure out the general style of investing which is right for you.

Low Information / Low Emotion: If you can’t light a fire under yourself, you should at least try to get inspired long enough to make sure you’re getting all of the investment perks available to you through work: 401(k)s, Stock Purchase Programs, Share Grants, Options, and all other forms of ‘free money’. Ask a trusted smart coworker (or if your plan comes with advice, ask there) where to put your allocations. Also consider a Roth or Traditional IRA. Thanks for reading – we’ll see you in ten years when you’ve amassed a lot and are curious about the next step. You’ll be fine.
Low Information / High Emotion: First off, try not to worry too much about the general ups and down of the market, your real estate, and mutual funds and bonds. If there is a total 100% drop in a huge asset class like the stock market we’ve got bigger problems than our retirement savings (haha). For you, you’re best off putting some layer of separation between you and your funds. Consider a Financial Adviser or a passive strategy and a simple portfolio with some sort of stock/bond mix. Yep, buy and hold is usually a good option for an investor like you. Try not to worry too much about volatility – the market may have lost its value in the recent recession, but hey, it’s almost back.
High Information / High Emotion: Congratulations! You have what it takes to delve into investing a little deeper; you just need to keep your emotions in check. Use your considerable knowledge of valuations to determine a good investment mix for yourself. Think serious about avoiding individual stocks or options – know that while your knowledge is considerable, you should use some mechanical system to choose your entry and exit points. Stop losses (trailing or otherwise), limit orders, and certain option trading strategies are perfect for you – just try to keep your itchy trigger finger on your mouse away from the buy/sell screen on your brokerage window! If you can’t? Consider staying away from individual stock and bonds. You can still apply your knowledge to other forms of investments…
High Information / Low Emotion: Call it what you will, but you know this personality type when you see it – smart and indifferent. If you find yourself in this category? Congratulations. You’re set up to be a good investor. Your biggest issue is cockiness – you might have an track record which looks good, but if you blow up you’ll tend blow up hard. Limit your bet sizes, watch your arrogance while trading, and always keep learning. Of all the classes it’s most important that you never get stuck with certain biases… always keep reading and absorbing new information into your repertoire while investing.

So, About That Buy And Hold Stuff?

Isn’t it crazy the diversity in personalities represented in the stock market? We all see some aspects of ourselves in the above investors.

If you divide yourself into either of the low information categories, I would suggest sticking mostly to buy and hold principles. If you dabble too much in speculative investments or individual stocks and bonds (or worse, IPOs,futures, derivatives and options!) you’ll quickly find yourself falling behind the curve financially. Remember: on a long time frame, specifically over 20-30 years, stocks have almost always outperformed bonds. Over a career, you’ll be okay even if you give up a little bit of that maximum return. Just make more by concentrating on your job, okay?

So, high information people, still with me? The odds are, yes, you can probably optimize your portfolio to a high degree – and potentially achieve better returns than you are receiving currently. For a high information investor who is willing to put in the work, look to Warren Buffett (duh), Ed Thorp, Peter Lynch, Ben Graham, David Dodd, Irving Kahn, and Walter Schloss. Heck, even Bill Gross. I’ll get into that – and the Efficient Market Hypothesis – in my next post.

So, wait, but don’t hold your breath… I’ll get back to safe withdrawal rates and buy and hold soon.

What type of investor are you? Do you agree with my assessments? What sort of things do you do to cover for your weaknesses?

More Investor Psychology

The DQYDJ Weekender (Week of 4/23/12)

PK — Sat, 28 Apr 2012 16:31:05 +0000

Podcastin’

If you haven’t heard my dreary baritone rambling about stuff slightly less nerdy than on this site (and if you have please click-through anyway) go listen to this week’s Worst of the Free Financial Advisor podcast. I promise it is interesting enough to listen to while reading financial links!

Sites Linking In!

Articles We Liked!

The Financial God had a nice piece on Automated Cars. If you’re fascinated by inane things like traffic, read about traffic jams some time. You’ll learn all sorts of cool stuff like ‘accident ghosts’ which allow traffic jams to persist for hours after a crash is cleared.
Free By 50 had an analysis of home energy costs by square footage and date of construction – showing the movement to better efficiency didn’t really start until the 80s. We own a mid-70s house with a number of features which give us confidence in the builder (cement board under the vinyl/foam insulation, R-30 blown in attic insulation in the Bay Area(!), …) and think we’re a little better off than the average 70s house.
At Married With Debt, a guest post analysis of buy and hold investing (from Rob Bennett) which devolved into… something… in the comments. I’ll be following this up as I have a lot to say!
Domninique at Your Finances Simplified has thrown down the credit limit gauntlet. Just because you have it doesn’t mean you have to use it, people. Also, if you can handle an App-O-Rama and better signup bonuses come back to credit cards? Responsible people can follow in his footsteps!
I should have linked it last week, but Bret at Hope to Prosper stopped doing his own taxes. Cheers for stepping up from TurboTax Tim!
Len Penzo also isn’t a fan of the penny!

Déjà vu

Remember a few months ago we complained about SOPA and PIPA, two poorly considered internet bills which would have had a ridiculous chilling effect on free speech on the internet (and that’s not hyperbole…)? Keep your eye on CISPA, which just moved through the House of Representatives. Roughly, one section in CISPA grants automatic immunity for any organization or corporation to volunteer private information to another entity or Government agency. Read the CNet FAQ on CISPA for more details.

Why does this matter? Well, the word ‘notwithstanding’ means that any information which is digitized can be passed along for ‘cyber security’ reasons. What is ‘cyber security’? Your guess is as good as mine – that phrase isn’t well defined. Doesn’t it seem like a pretty blatant violation of the fourth amendment? Expect more of this crap winding through Congress until we actually, you know, vote a few of these idiots out.

On a lighter note, this Onion article is pretty hilarious. Enjoy your weekends!