Active v. Passive - The Secret to Winning the Loser's Game

This is the final post on active v. passive investing but before moving on let me briefly summarize.

• Academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest. Index funds should form the biggest part of every portfolio.
• Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
• The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.

But the cap-weighted index isn’t perfect and, depending on how much risk you’re prepared to take, you may want to tilt the portfolio towards other types of risk, or beta, such as small company or value stocks.

Again beta is a measure of overall market risk. But what about alpha? That’s the name given to any return provided by an investment over and above the benchmark index.

First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?

Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy.”

Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him?”

Much evidence is stacked against active fund management. But, say for example, in spite of everything academia has said, you still want to take a gamble with part of your portfolio, how do you choose an active fund from the thousands of funds available?

Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do.”

Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.

Like Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written. In it Graham wrote that investment is most intelligent when it is most businesslike.

In his preface to the fourth edition of the book, Buffett said: The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

Whichever route you go down - passive, active or somewhere in between - your behavior is absolutely critical - particularly at times when emotions are running high. Everyone knows the idea is to buy low and sell high, but time and again we do the precise opposite.

Many investors pile in just as the market reaches a top. Then, even worse, they bail out just as prices reach the bottom and are bound to rise again. That kind of behavior is sadly all too typical, and even the professionals are prone to it. The effect on the long-term value of our investments can be catastrophic.

So, how do we as investors curb that sort of self-destructive behavior? Well, one way is to have an automated approach to investing. So, once you’ve chosen a strategy and the level of risk you’re prepared to take, you leave your investments exactly as they are. Either once or no more than twice a year you should rebalance your portfolio to realign it with your risk tolerance. But again, this can be done automatically.

Merryn Somerset Webb from MoneyWeek says, “There are lots of styles that work over the long term. Value works, dividend investing works, momentum investing works if you get it right. All sorts of things work. But they only work if you stick with them."

It also helps to have a financial adviser to keep you on track. Charles Ellis says: “There are two main roles for an adviser. One is to help individuals understand themselves and what their real financial purposes are, and what their anxieties would be. And the second is to hold the client’s hand and encourage them to stay in it for the long term.”

Vanguard founder Jack Bogle says: “Why in the name of peace do we pay any attention to the stock market? It's a giant distraction to the business of investing.”

Of course it doesn’t help that we’re constantly hearing about the markets. There are specialist magazines. Almost every major newspaper has a money section. There are radio shows and, of course, entire television channels devoted to the latest on the markets and where the so-called experts think they’re heading.

And that, in a nutshell, is the secret to winning the loser’s game. First, choose a strategy that’s based on evidence - ideally one designed to capture the returns of the whole market - and then tailor it to your attitude to risk. Secondly, stick to your strategy through thick and thin. Rebalance your portfolio, yes, but most important of all, stay the course.

CBlakely CFP®, CTFA        02/2015

Sources: Winning the Loser’s Game – Charles D. Ellis;  Robin Powell: How to Win the Losers Game – SensibleInvesting.tv Link to the video

Finding Income Without Adding Significant Risk

The current priority at the Federal Reserve is to keep rates low to help the broad economy, especially housing and the money center banks, get healthy again. However, this has a deleterious effect over the long-term on savers and income investors. With short-term interest rates near zero and the Fed committed to keeping rates low for the next couple of years what is an income investor to do? Do you throw out your risk tolerance parameters and plow into stocks?


The short answer is no. You can maintain your risk profile while adapting to the current environment by embracing creative solutions in small percentages in your portfolio. Many solutions used in the past are probably not the solutions that will serve you best over the coming decade. Remember a successful portfolio funds an investor’s current and or future needs or liabilities, anything short of this is a failure.

For high net worth individuals the use of charitable trusts can create a satisfactory income stream. Tax breaks for some charitable trusts can help high net worth investors divest highly appreciated assets tax-free. The trust income goes to the investor and eventually the remainder goes to the charity. For the majority of investors this is not a prudent option.

There are several opportunities for investors not interested in trusts. First, mortgage backed securities funds are an option. These funds contain AAA/Aaa rated mortgage securities backed by the guarantee of Fannie Mae, Freddie Mac and Ginnie Mae. There are many low cost funds available that offer access to mortgage backed securities. The yields are in the 4.0 to 4.5 percent range.

Next, income investors might consider adding a small percentage of high dividend equities to the portfolio. One example might be adding a select dividend fund or a utility fund to your portfolio for the current income. Both types of funds offer a current dividend yield of 3.5 to 4.0 percent depending on the fund family and fund makeup.

Finally, the fundamentals within the high-yield bond market are strong. That is reflected in yields which are currently around 6.5 percent and approaching historical lows. The main risk to the health of corporate fundamentals would be a meaningful slowdown in the U.S. economy. Base case is that the economy does not come off the rails. The most probable economic outlook is for a slow-growth environment with reasonably steady interest rates. However, the economy is not robust enough, nor are yields high enough, to protect high-yield investors against certain macroeconomic shocks. Macroeconomic driven events - such as, the European debt situation, China's slowing economy, and geopolitical events in other parts of the world - will cause short-term gyrations in the funds value.


If your portfolio is predominately fixed income, adding a small percentage in each of the three types of income investments to your portfolio may actually decrease the overall risk profile through diversification. Minor adjustments can add value to your portfolio.

As always, to see the impact this strategy would have on your investments and cash flow discuss this with your (accredited) financial advisor.

CBlakely CFP®, CTFA, CMFC     05/2012

Sources: Morningstar, iShares

Diversify Your Holdings (or not - That's Cool Too)

 Should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is a good one at one end is the advice that you get from the efficient markets camp: maximum diversification across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” held in proportion to its market value. At the other is the “all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.


Which Gospel? Mark or John
These arguments got media attention recently, because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated at $2.5 billion), as an entrepreneur. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the founder of Vanguard, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about."

So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: First, how certain your assessment of value and second, how certain you are about the market price adjusting to that value within your specified time horizon.

At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:

1. Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage and it is feasible only with finite lived assets (such as options, futures and fixed income securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
2. A perfect tip: On a more cynical note, you can make guaranteed profits if you are the recipient of inside information about an upcoming news releases, but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. The problem, of course, is that you would be guilty of insider trading and may end up in jail.

At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market hypothesis), you should be as diversified as you can get.

Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over pced for a long time.

How Diversified?
Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:

A. Uncertainty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, as a general rule, your response to more uncertainty should be more diversification.


B. Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversified in your holdings.


In summary, then, there is nothing crazy about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value.


Bottom Line
Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assessment skills, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much.

CBlakely CFP®, CTFA 02/2012

Source: New York University Stern/Damodaran

Jobs and Asian Investing

The current economic downturn has been called a housing crisis, a financial crisis and a debt crisis, but now, according to nearly everyone running for office, we are in a jobs crisis. Politicians currently talk of vague jobs plans, filled with serious-sounding phrases and little real meaning.

Think about it, when has a corporate CEO ever been rewarded for hiring people who aren’t absolutely required. Most companies hire only when its workforce can no longer keep up with the demand for its products.

The government’s ability to create jobs is pretty disappointing and that’s ok. The most popular types of jobs programs involve state tax breaks or subsidies that seek to move a company from one state to another. These policies don’t add to overall employment so much as they just shuffle jobs around.

John Maynard Keynes’s view is that government can create jobs by spending a lot of money. The stimulus, however, has to be borrowed, and it has to be huge — probably something close to $2 trillion — to fill the gap between where the economy is and where it would be if everyone was spending at pre-recession levels.

Many Republicans follow the more fiscally conservative University of Chicago School, which argues that Keynesian stimulus can’t heal a sick economy — only time can. Chicagoans believe that economies can only truly recover on their own and that policy interventions only slow the recovery.

Of course, Republicans can’t say, “wait this thing out while we cut taxes and regulation.” These policies may make the economy healthier in 5 to 10 years, but the immediate impact would require firing a large number government workers.

The U.K., as part of its austerity measures, is in the process of firing about 500,000 government workers under the notion that the private sector would expand (lower taxes and regulation) and employ all those laid-off. But this isn’t happening. The British economy continues to grow slowly, if at all and few government workers have found new jobs in the private sector.
The second area of agreement is the most important: an economy is truly healthy only when its people know how to make and do things that others will pay them a decent amount for. Jobs are not the cause of a healthy economy, they’re the product.

The economy that emerges from this recession is going to be different. Without the distortion of a credit bubble, it is clear that far too many Americans don’t know how to do anything that the world is willing to pay them a living wage for (Kardashians excepted).For confirmation, look to the aptly named rustbelt and also look at the negative correlation between education and unemployment.

An economic downturn is the time to learn new skills – move forward and learn about something that can help produce a paycheck. Those who can’t find a job where they live should consider moving to places where there are more jobs than applicants.

With Europe plugging the nearly insolvent country dyke that seems to spring a new leak every six months and until the U.S. economy, somewhat mired in mud, gets unstuck, emerging economies will be a beacon to investors.

Take for instance, The Matthews Asian Growth and Income Fund, the Fund invests in dividend-paying common stock, preferred stock and other equity and convertible securities of companies located in Asia – it’s paying a 3.4 percent current dividend. Investors are becoming increasingly aware of the attractive demographics and strong economic growth that exist in the region.

Over the last 15 years the Fund has delivered risk adjusted performance (alpha) of 7.24 percent ABOVE the index. And during this period of economic volatility, the Fund was able to accomplish one of its main aims—to offer a degree of downside protection—and cushion shareholders from the worst of the sell-off.

To index is smart when the market is terribly efficient. Managers cannot consistently outperform in highly efficient markets as prices instantly change to reflect new public information. This is true of the Treasury market and may be true of the domestic large cap stock market. In inefficient markets a good manager can exploit this to the shareholders advantage. Small cap stocks and emerging markets currently fall into this category. Indexing in these markets may not be as profitable over the long-term.

 CBlakely CFP®. CTFA 11/2011

Sources: PlanetMoney – Adam Davidson, Bill Gross-PIMCO, Matthews Asia

401(k) Investors Who Use Professional Help Outperform Those Who Don't

Investors who relied on professional help in the form of managed accounts and advice earned nearly three percentage points more than those that did not, according to an analysis of eight large defined contribution plans between 2006 and 2010 by Aon Hewitt and Financial Engines. The plans covered 400,000 participants with a total of $25 billion in assets.

The study found that in those five years, workers who received some form of professional advice experienced higher returns, averaging 2.92 percentage points, net of fees, than those individuals who managed their 401(k) on their own. According to Aon Hewitt and Financial Engines’ projections, a 45-year-old participant who invests $10,000 and receives professional help will have a portfolio valued at $71,400 at age 65, compared to $42,100 for someone who doesn’t get any help.

The study also found that 30 percent of participants were using help in 2010, up from 25 percent in 2009. It also found that younger investors with smaller balances were the most likely to use target-date funds (ouch - the most expensive and worst performing funds offered in plans - usually), and younger investors with larger balances preferred online advice. For those nearing retirement, managed accounts are the favored investment vehicle.

“This research shows the concrete value of professional retirement help during a variety of market conditions, and across age groups,” said Christopher Jones, chief investment officer at Financial Engines. “The help that employers have made available is having the desired effect of keeping participants in diversified portfolios and avoiding costly mistakes.”

The study also found that 38 percent of do it yourself participants have excessive risk levels, and 18 percent have risk levels that are too low. In contract, participants using professional help maintained more diversified allocations with appropriate risk levels, and also employed a rebalancing strategy.

“Exacerbated by continued market volatility, workers not using help are clearly making significant investment mistakes,” Jones added. “Their inefficient portfolios and skewed risk-taking is hurting results—and as the numbers show, the cost is very high.” Indeed very high! High enough to make a significant difference in how you live during your retirement.

CBlakely CFP, CTFA    09/30/11
Source: excerpted from  a recent article from Money Management Executive

Useful Mutual Fund and Annuity Facts!

A study by Dalbar, a mutual fund research firm in Boston, found that in the 20 years ended December 2010,the average stock fund investor had annualized returns of 3.8 percent, compared with 9.1 percent for the Standard & Poor's 500-stock index. The average person would have been better off, much better off buying an index fund and holding it for 20 years. This again makes the case for professional management or at least index investing if you are a diy type. Why do we keep listening to Sam Waterston?

Why is it when questioned about retirement, nearly everyone prefers the certainty of guaranteed income, like a defined benefit plan, commonly referred to as a pension? But when offered the chance by buying an annuity, nearly everyone declines. Economists call this the "annuity puzzle." Using standard assumptions, economists have shown that buyers of annuities are assured more annual income for the rest of their lives, compared with those who self-manage their retirement assets. There is the term "self-manage" again. Professional advice is invaluable.
Buying an annuity can be scary, make a mistake and there is usually a large upfront penalty in the form of a surrender charge.There are psychological ramifications as well. Rather than view an annuity as insurance against living a very long life, they are viewed as a gamble, in which you have to live a certain number of years to break even. And they can be very expensive - guaranteed income for life, sounds like it should be an expensive option to me. Are they good or bad? Yes and no. It depends on your income needs and investment objectives and risk tolerance. Also, if you can, buy direct from the insurer, it's the least expensive way to purchase an annuity.

CBlakely CFP, CTFA   6/2011

sources: Dalbar, Richard Thaler - NYT