Wisdom from the masters
By Paul Merriman, FundAdvice.com
Monday, April 21, 2008
Sometimes the most powerful wisdom comes in compact packages. A great quotation can sum up a lifetime of experience in a few words, giving us all valuable lessons. Sometimes a quote itself can tell the whole story. But often the meaning must be teased out of it. Here are some of my favorite examples.
"Rule #1: Never lose money. Rule #2: Never forget Rule #1."
- Warren Buffett
On the surface, what could be simpler than this? Just don’t lose money. But what does this really mean? Is Buffett suggesting investors avoid buying anything that might lose money? I have personally promised that anybody who invests in stocks, either directly or indirectly, will eventually lose money. I hope the loss will be temporary, but investors who react quickly to losses by selling their holdings lock those losses in, making them permanent.
Warren Buffett is the famous CEO of Berkshire Hathaway (a company that in many ways resembles a mutual fund because of its wide investment holdings). That company has lost considerable money from time to time on its own investments. So has he violated his own rules?
In my view, this quote is about the difference between being an investor and being a speculator. That difference has to do with the probability of getting a return on your investment. An investment is something that has a high probability of generating a positive return. A profit, in other words. A speculation includes the possibility of a positive return, but also a relatively realistic probability of no return or even a loss.
Buffett has become good friends (and co-philanthropists) with Bill Gates, co-founder and chairman of Microsoft Corp. In the days when Microsoft was a new darling of the stock market, Buffett took a pass on buying Microsoft stock, saying he didn’t understand the technology behind it. (Relatively few people did, and relatively few of us still do even today.) Technology stocks tend to fall into two camps: Overwhelming successes like Cisco and Google and Microsoft, and eventual duds like most of the early makers of automobiles and computer hardware. Therefore, technology stocks tend to be speculative. I think that may be what’s behind this quote from Buffett. What do you think?
"If you spend 15 minutes a year studying the economy, that's 10 minutes too many."
- Peter Lynch
I wouldn’t be surprised if Warren Buffett agrees with this sentiment from the famous manager of Fidelity’s Magellan Fund in its early years. I also agree that for most people, 15 minutes a year trying to figure out the U.S. economy is not the best use of their time. If you’re an economist, or if you’re studying economics, of course it makes sense. But if you’re an investor, there’s no payoff that I have ever been able to identify.
The comment could come from any of thousands of analysts who don’t worry about the market on a day-to-day basis. They see their job as identifying companies that are likely to do well in the future.
My approach is to identify asset classes (groups of hundreds and thousands of individual companies) that are likely to do well in the future. Regular readers can probably recite them by heart: U.S. large-cap stocks, U.S. large-cap value stocks, U.S. small-cap stocks, and so forth. I have much more confidence in those asset classes than I do in any individual stocks I might choose.
"The investor's chief problem, perhaps his worst enemy, is likely to be himself."
- Benjamin Graham
Ben Graham, considered to be the father of modern security analysis and value investing, was a mentor and teacher to Warren Buffett. Legend has it that Graham awarded a grade of “A+” only one time, and it went to Buffett.
I completely agree with this quotation. If textbooks, research and the “right answers” were enough to make people successful investors, we could all be billionaires. The right answers are out there, fairly easily available to anybody who looks for them. Yet most people fail to achieve a high level of investment success.
Why is that? One big reason is psychology. You know you should buy low and sell high. But doing that doesn’t feel comfortable, and if you’re typical you have a hard time doing it. There’s a Grand Canyon of difference between understanding what you should do and actually doing it. I’ve devoted a chapter of my book “Live It Up Without Outliving Your Money” to the psychology of successful investing. One of the things I show is that your own emotions are among your biggest hurdles.
As investors we tend to trust too easily and place that trust in the wrong hands. We want to believe that anybody we know and like would naturally have only our best interests at heart. As a result, we get taken advantage of too many times.
We want to focus on success and skip over the potential dangers. We feel safer doing what everybody else is doing, even though that is very often the wrong thing to do. We believe we – or the experts we have identified – are smarter than average, so we refuse to settle for the returns of the markets. Instead we ratchet up our level of risk in order to “prove” our superiority. Far too often, this backfires.
"Don't look for the needle. Buy the haystack."
- John Bogle
Imagine the countless hours of stock-picking and fund-picking research you could save if you were willing to buy “the haystack” of investing, essentially the whole market. If you actually enjoy sorting through a haystack looking for the elusive pins that everybody else has missed, that’s fine if you regard it as recreation. There’s always a chance, however slim, that you’ll find a really nifty needle. But don’t kid yourself into thinking that picking a few stocks amounts to serious investing.
If you are so highly competitive that you must frantically search for the needle, all I can do is wish you luck. You’ll need it, because you’ll have the company of hundreds of thousands of other investors who think they can hunt better than you can. If entertainment and excitement is what you want, you may find it in the hunt. I just hope you’re also prepared for disappointment.
Those of us who buy the whole haystack expect to outperform most of those frantic seekers. We expect to do it with less risk, less stress and less expense. If your ultimate aim is to get the best return for the amount of risk you take and effort you spend, the haystack is the way to go.
Fine tuning your asset allocation
Fine tuning your asset allocationBy Jeff Merriman-Cohen, FundAdvice.comMonday, November 13, 2006
One of the most fundamental decisions faced by every investor is how to allocate a portfolio between stocks and bonds (or the way we do it, between equity funds and bond funds). Some investors prefer a total equity portfolio for its superior growth prospects. Others invest exclusively in fixed-income instruments, preferring to completely avoid the risks of the stock market. But most people seem more comfortable somewhere in between those two extremes.
Yet the question remains: how far should you go in one direction or the other? One good approach is that of our Worldwide Balanced Portfolio, which splits all investments equally between stocks and bonds, U.S. and international, large and small, and value and growth. We believe this gives investors excellent representation in all the major markets. It’s also very easy to understand. No matter what part of the investment world is "hot" at the moment, such a portfolio will take advantage of it.
Of course not everybody wants to split things 50/50, and there is a wide range of other possibilities. You will see some examples in this large table of performance figures. The table shows the results of 36 years of buy-and-hold investments allocated between stocks and bonds in 10-percent increments, from all bonds (on the left) to all stocks (on the right). In the final column, you’ll see the annual performance of the Standard & Poor’s 500 Index, a standard equity benchmark that most investors agree is tough to beat.
At first glance, this table looks pretty daunting. It contains 432 annual performance figures, each one representing what investors got, or would have gotten, in a particular year using a specific allocation strategy. In addition, we include another 72 figures, six at the bottom of each column, summarizing the results of each strategy. But if you let me walk you through this table, you’ll find it can be an excellent tool for deciding how to allocate your assets between equity and fixed-income securities.
WHAT IS THIS TABLE?
The table shows the results of investments made in a particular group of asset classes and asset class mutual funds that are not available to the public except through registered investment advisors (including Merriman Capital Management). The funds are managed by Dimensional Fund Advisors (DFA), a company whose work is based on some of the finest academic research ever done on investment returns. This research, the indexes, and the optimum way to put them together are described in The ultimate buy-and-hold strategy.
To refresh your memory, this strategy uses no-load mutual funds to create a sophisticated asset allocation model with worldwide diversification balanced between large-cap and small-cap stocks with an emphasis on "value" stocks. Every fund tracks a particular market segment, just as a number of public mutual funds mirror the Standard & Poor’s 500 Index.
In The ultimate buy-and-hold strategy, we started by discussing an allocation of 60 percent of assets to equities and the other 40 percent in fixed-income funds. You’ll see the results of this allocation in the column in the large table marked "60% Equity."
Looking back at the large table, if you trace the numbers in that column from the top, you’ll see the year-by-year performance of the 60/40 strategy from 1970 (up 2.1 percent) through 2005 (up 8.0 percent). Continuing downward, you’ll see that this strategy produced a compound rate of return of 11.6 percent; its standard deviation, a measure of volatility in which lower numbers mean lower volatility, was 10 percent. To put that 10 percent figure in context, scan over to the far right-hand column and you’ll see that the S&P 500 had a standard deviation of 17.2 percent. This means that this 60/40 split of stocks and bonds carried approximately 58 percent of the volatility of the overall U.S. stock market.
While you’re at it, put one finger on the "Annual Return" line (this is a compounded rate of return) of the 60/40 column and another finger on the same line of the Standard & Poor’s 500 Index column. You’ll see that the Ultimate Buy-and-Hold Strategy 60/40 combo improved the performance of the U.S. stock market by 0.5 percentage points, or 4.5 percent – while reducing the volatility by more than 40 percent.
THE BEST OF TIMES, THE WORST OF TIMES
If you’re with me so far, you know how to read this table, and you’ve probably scanned a few of the other columns as well. But before we go on, look at the bottom five lines of each column. These figures show, in percentage terms, the biggest losses you would have sustained for each allocation. These are the worst month, the worst quarter and the worst one, three, and five-year periods. Note that these are not calendar years. For these lines in this table, any "worst" period could start at the beginning of any month. These figures are useful because they show the losses you must be willing and able to tolerate in order to carry through your strategy. This isn’t pleasant territory, but you’ll be far better off to spend some time with this topic than to just concentrate on the fabulous returns you might get. In real life, you’ll never get those returns if you don’t stick with the program you select. And you won’t stick with the program if the periodic losses push you out of your comfort zone. When that happens, you’re likely to bail out and sell your holdings at the worst possible time, when things look bleak and you’ve sustained some significant losses. You’ll have a tough time recovering, both financially and emotionally.
The reason we put so much attention on measuring and managing risks is that this is exactly where so many investors get tripped up. Spend some time thinking about how much of your portfolio you are really willing to lose in a month, a quarter, or a year. Run your fingers back and forth on those bottom lines and search for a combination of losses you think you could tolerate. That, in fact, is what the table is all about: giving you a way to find the column, and hence the asset allocation, that’s right for you.
WHAT THIS TABLE TELLS ME
When I study this table, one of the first things I notice is the difference between the 100 percent equity portfolio and the Standard & Poor’s 500 Index. If you’re looking for high return and low risk, you can see that the diversified all-equity portfolio was clearly superior to the S&P 500, with a 27 percent improvement in compound rate of return (14.1 percent vs. 11.1 percent) and a lower standard deviation to boot.
This gives me dramatic evidence of how important it is to diversify with non-correlated investments. The all-equity portfolio combines multiple asset classes, every one of which by itself has a higher standard deviation than the S&P 500. Yet when you combine them, they offset each other and produce a lower composite standard deviation.
Here are two other things I notice in this table. Using the portfolios in the table gave an investor a chance to approximately equal the return of the S&P 500 with only a 50 percent exposure to equities; and even with 100 percent in equities, the diversified portfolios still had less volatility than the Standard & Poor’s 500 Index.
If you are looking only for the highest performance on this table, you’ve found it in the all-equity diversified portfolio, and that’s a strategy we recommend to clients who can tolerate the risks. We think those risks are very reasonable for that performance. But 14.1 percent a year may be more than you need to meet your goals. And the risks may be too high for you, especially that 35.1 percent loss in the all-equity portfolio in the worst 12-month period during these 36 years.
Based on many years of talking to clients and polling people who attend my workshops, I have concluded that most retired people regard a return of 8 to 12 percent, compounded annually, to be satisfactory. And most people say they are willing to lose 10 percent of their assets in any given year (though certainly not year after year!) to achieve such a return.
SEVERAL GOOD OPTIONS
The good news is that there are several combinations in this table that exceed those specifications. On the conservative end, the 20 percent equity portfolio produced a compound annual return of 8.8 percent, and its largest (and indeed only) calendar-year loss was only 1.6 percent. You’ll find higher returns (and higher yearly losses) in the 30 percent and 40 percent equity portfolios. Note that the 50 percent portfolio had a compound annual return of 11 percent and a maximum calendar-year loss of 9.4 percent. That 9.4 percent loss in 1974 followed on the heels of a 7.5 percent loss in 1973. But for comparison, look what happened to the S&P 500 Index in those two years: down 14.7 percent in ’73 and down another 26.5 percent in ’74.
You’ll also see that the standard deviation of the S&P 500 was twice as high (17.2 percent) as that of the 50 percent equity portfolio (8.4 percent). You might also note that the standard deviation of the 30 percent equity portfolio, which produced a respectable CRR of 9.6 percent, was only about one-third that of the Standard & Poor’s 500 Index.
Here’s how to make this table a useful tool for you individually. Start by writing down two numbers: the target return that you need (after you add one or two percentage points to give yourself a margin for error) and the largest one-year loss you are willing to tolerate. Then start with one of those figures and scan the table to find an allocation that gives you what you need.
HOW MUCH DO YOU WANT?
Investors typically say they want the highest possible returns. But when you suggest they put all their money in pork belly futures contracts or bet their life savings on Microsoft stock, they quickly change their tunes. Still, if you are like most people you want as much as you can get. So start with the all-equity column and work your way to the left until you find a column where you can tolerate every risk item, including the worst 12-month period, and the worst periods from 36 to 60 months. When you find that column, you have an idea what percentage of equity allocation might be right for you.
Some risk-averse investors won’t want to tolerate the bad times associated with the allocation that will give them the returns they need. If you really need at least a 12 percent return, for example, you may still find the risks of the 70 percent equity portfolio are too high for you.
What should you do if you need the returns from a column that has too much risk for you? Your first impulse might be to go for the high return and ignore your gut in regard to the risk. But I think that would be a big mistake. If your needs straddle two columns, choose the one that has a level of risk that’s right for you.
There are two main reasons for this. First, remember that the figures in the table are not predictions of the future, only results from the past. And the past is a more reliable indicator of risk than of returns. For any given combination of assets, the pattern of volatility will be more constant and more predictable than the pattern of return.
Second, it is never acceptable or advisable to manage a portfolio in violation of your risk tolerance. Year after year, decade after decade, we see that people who do that are the ones who bail out of their investments near the bottom of a market cycle. They become bitter and cynical about investing. Worse, they often stay out of the markets for many years, sometimes even permanently, for fear of being burned again.
LISTEN TO YOUR GUT
If there is only one lesson you take from this article, I hope it is this: Never ignore your emotions or your "better judgment" in order to chase higher returns. It’s just not worth it. When we talk to clients who need or want higher returns than their guts will allow, we spell out a few options, which of course they already know about. If, as we often recommend, you settle for a lower return in order to take on less risk, you may have to work longer before you retire. Or you may have to spend less and save more. You may be able to increase your tolerance for risk with education. But for most of us, risk tolerance or risk aversion is a character trait that’s part of who we are, not subject to much change. So unless you are certain that you are comfortable with higher risk, listen to your gut.
Saturday, April 26, 2008
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