Don’t Buy Stocks, Part 2

“Individual investors tend to invest in a small number [of stocks] and they don’t know how to construct a portfolio.  Professional portfolio managers control risk.” – says Jim Peterson, vice president at the Schwab Center for Financial Research.

In the June 10th post, I wrote about the dangers of buying stocks in companies you think you know well, and I extolled the virtues of diversification.  One reader posted a comment saying that he believed that owning 30 to 35 individual stocks was “sufficient” diversification.   I’m not so sure.

Today’s Hot Tip: Don’t Buy Stocks! an article by Howard Gold, written in 2008, reinforces my arguments.  He interviewed several professionals to make his point.  Here is a summary of his article.

William Bernstein, a money manager and the author “estimates that because of close correlations between markets, even 100 carefully chosen stocks can’t match the diversification of holding just a couple of index funds and ETFs that cover the global market.”

If you’re still not convinced, just how much work are you willing to put into picking stocks?

According to Gold, “even individuals who have good stock-picking skills rarely can do the necessary research to post consistently good results over time.”

He quotes a study by the Schwab Center that “tracked the portfolios of Schwab clients who had $5,000 in household equity and whose accounts were either at least 95% individual stocks (including foreign shares and ETFs) or 95% open-end equity mutual funds.

The survey, taken over 2005-2006, produced stunning results:

The fund investors substantially outperformed the stock pickers, with less than half the risk and after all expenses.

Though it covered only two years—and the investors may have held other assets at other financial institutions—it did take in a huge number of the 3.5 million clients of Charles Schwab, about as good a sample of the US investing public as you can find.”

Doing Your Homework

“You have to have tremendous energy to devote to the stock-picking process,” says David Swensen, chief investment officer of Yale University. “Individuals don’t have the time or the resources.”

In his book “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen advises individuals to stick to a set of broadly diversified index funds.

“If you try to manage your own money and invest in your own stocks, and you don’t…do every single piece of homework necessary, you won’t beat the market, and you’ll probably lose money,” says one well-known investing guru.  “If you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks.”  (Emphais added.)

Who said that?  Vanguard founder John Bogle?  No, it’s Jim Cramer, who pounds the table for individual stocks amid the booyahs and silly hats on his weekday Mad Money show on CNBC.

“Investing is fun for a lot of people, and if they want to try their hands [at stock picking], they should go for it,” says Peterson. “Just make sure that the majority of your portfolio is diversified.”

Gold’s observation is that the rest of us should “get our thrills and chills elsewhere.”

Conclusion

You can only achieve real diversification by investing in both stocks and bonds.  Moreover, within each category, you need to have many individual securities to be truly diversified.

Suppose you believe that your portfolio should include the following asset classes: large-cap U.S. stocks, small-cap U.S. stocks, large-cap international stocks, small-cap international stocks, stocks from emerging markets, and Real Estate Investment Trusts.  How can you possibly achieve this diversification without hundreds of individual securities?  In my opinion, you can’t, which is why you need mutual funds.

The portfolios I construct for my clients typically have mutual funds with thousands of securities.  That is diversification.

Roth IRA Basics

Roth, Roth, Roth.  Everyone, it seems is talking about Roth, and if you haven’t, rest assured – you will.  Over the next few months, you will probably hear a lot about Roth IRAs because of a change in the rules that will take effect in 2010 regarding converting a traditional IRA into a Roth IRA.  That subject is just a little too complicated for most people, so let’s take a quick look at some of the fundamentals.

Roth Basics

If saving for your retirement is one of your financial goals (and it should be), you might want to consider investing in a Roth IRA.  You should know that some people earn too much to qualify; here are the limitations:

In general, if you file as a single, you can make the full contribution provided that you earn no more than $105,000; if you’re married and file a joint return, that maximum is $166,000.  It’s actually a bit more complicated than that, but if you’re interested in learning the nitty gritty, here is a link explaining how to calculate the amount you can earn and still contribute to a Roth IRA.

Investment Choices

As with a traditional IRA, you can invest in a number of things: Certificates of Deposit, stocks, bonds, mutual funds, etc.

Advantages

With a Roth, all earnings on your investments escape taxation completely. This is unique.  All other investment vehicles are either taxed currently or tax-deferred.  By tax-deferred, I mean that you don’t pay any taxes until you take the money out.  Examples of tax-deferred investments are 401(k)s and 403(b)s, as well as traditional IRAs.

Other benefits of a Roth IRA include avoiding the early distribution penalty on certain withdrawals and eliminating the requirement to take minimum distributions after age 70½.

Disadvantages

So what’s the catch?  The primary disadvantage of a Roth IRA is that you don’t get a tax deduction when you contribute to it, as you do with other retirement options.  Your personal situation will drive what is more important, tax-free growth or a current tax deduction.  But that decision to go with a Roth will also depend on the assumptions you make about what your tax bracket may be when you retire.

Another disadvantage of a Roth, albeit a minor one, is that you have to go out of your way to use it.  What I mean by that is you have to actually open an account with a bank, brokerage firm or mutual fund.  With a 401(k) or 403(b), you just pen your John Hancock to some forms at work and you’re good to go.

Aside from the (in)convenience aspect, psychologically it is easier to save though an employer sponsored plan, simply because you never see the money; it comes right out of your paycheck.  And, of course, many employers match your contribution either in full or in part, which you ordinarily wouldn’t want to miss out on.  That is, after all, found money.

Limits

What’s the maximum you can contribute to a Roth IRA?  The same amount as the traditional IRA.  For 2009, it’s $5,000 if you’re younger than 50 years old; otherwise, it’s $6,000, and both spouses can make contributions to a Roth.  You should be aware that contributions are a “use it or lose it” proposition; in other words, if you fail to take advantage of this year’s contribution, you can’t do it retroactively.

Summary

For a quick summary of your choices, Understanding the Roth IRA has a useful table comparing the various options.

Conclusion

In general, a Roth IRA is a very smart choice in saving for retirement for many people.  To make the right decision for you, discuss the question with your financial planner or accountant.

A Stroll Down Memory Lane

“The deeper one delves, the worse things look for actively managed funds.” – William Bernstein.

Despite the title, this post is not about nostalgia, about the simpler times of pillow fights, water balloons, and The Lone Ranger.

It is about the education of an investor: me.

My last post discussed the risks of investing using individual stocks.  My point was that you simply cannot get enough diversification that way; therefore, you have unnecessarily increased your risk.

If you’ve been reading my posts, for example here and here, you have probably noticed that an underlying theme of this blog is my conviction that the right way to invest is to use mutual funds, specifically those that follow a “passive” approach.  I have believed this for 40 years.

How did I come to this belief?  Forgive my stroll down “memory lane,” but I actually went through something of a conversion process.  You see, back when I was in school I decided that I wanted to become a securities analyst.

Being a securities analyst meant that I would become a specialist within a particular industry and, through rigorous and comprehensive analysis, I would choose the “good” companies to invest in within that industry.  By the way, when I said “school” I meant high school; even at the tender age of 17, I had already set my path to fame and fortune (at least, in my own mind).

My plan, all those years ago, was to attend a liberal arts school and study Economics, because I thought that was the discipline that would be most useful to me.  I figured that I would major in Economics and then go on and get my MBA in Finance. Was I a precocious, or merely delusional, 17 year old?

Well, I graduated with an undergraduate degree in Economics from Lafayette College, and in an exit interview with a career counselor, I was asked what my future plans were.  I was steadfast in my conviction that I was going to get an MBA in Finance and then work on Wall Street.  Even four years of studying Economics and Accounting had not changed my plan.

But a funny thing happened on the way to Wall Street.  What I learned in graduate school changed my mind and also my career path.

Perhaps my professors were that convincing or the theory and evidence were just too persuasive. For I learned that, because of competitive markets, it was nearly impossible to identify undervalued stocks and therefore “beat the market.”   I recall one professor, George Benston, remarked that you could beat it (the market) with a stick but not as an investor.

Who believed such things in the 1960s?  Followers of the Chicago School of Economics; in my case, at the University of Rochester.  This is not the time to discuss the relative merits of the Chicago School, but suffice it to say that such economists as George Stigler and Milton Friedman were held in very high esteem at the U of R.  In particular, Friedman was considered a “minor” deity (and I’m not so sure about the “minor” part).  To diminish the hero worship I remember that Benston irreverently but still affectionately referred to Friedman as “Uncle Miltie.”

The Finance I studied in the 1960s was so new that it was not covered in any textbook.  Instead, we read primary documents (journal articles) by such pioneers as Harry Markowitz, William Sharpe, and the team of Modigliani and Miller, known as M&M.  These were the people who would later win Nobel prizes in economics.

One professor, Michael Jensen, had just written his groundbreaking Ph.D. dissertation on the performance of mutual funds.  Eugene Fama was his thesis adviser.  Jensen actually coined the term “Alpha,” which is a measure of excess returns achieved by investment managers.  More formally it is a statistical estimate of “how much a manager’s forecasting ability contributes to the fund’s returns.”  When you hear someone on TV talking about “creating Alpha” you now know where that term came from.  I’d bet that 90% of investors don’t know that.

But the punch line is that Jensen learned that mutual fund managers could NOT create Alpha, i.e. they could not “beat the market.”

His research was published in the Journal of Finance in 1967 and here are his conclusions:

The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.  It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free).  Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.  (Emphasis added.)

Since 1967, there have been many, many follow-up studies and, they have confirmed his basic finding that active investment managers cannot “beat the market.”  Neither can stockbrokers or “experts” on TV.  And reading articles about hot mutual funds or “10 Stocks to Buy Now” is a waste of time.

If mutual fund managers and pension fund managers– some of the so-called experts – cannot use securities analysis or trading strategies to “beat the market” why would you, an individual investor, even want to try?

Now there’s the real lesson that 90% of investors do not know.

Don’t Buy Stocks, Part 1

Did the title get your attention?  You’re probably wondering, am I changing  my approach and now making a stock market prediction?  Have I turned bearish (pessimistic) as so many people are?  No.  Plain and simple.

What I want to do is save you from the potential losses caused by buying individual stocks.  Sadly, this is not merely an academic discussion, since I have known many people who have been crushed by losses in individual stocks.  It upsets me to know that the devastation could have been avoided.

Buying individual stocks certainly gives you something to talk about over drinks with your friends.  But I don’t believe that the cocktail chatter advantage means you should actually buy individual stocks.  I don’t invest in individual stocks for myself, and I don’t recommend it for my clients.

People always have their reasons as to why their favorite stock is just “great.”  Some have done their research and have created a model that predicts that the stock that they are going to buy will double in the next four years.  Others have been following the same company for decades and are convinced that now is the time to buy.

Usually they’re talking about well known companies, such as General Electric, Johnson & Johnson or General Motors.  Did I get you?  I made that last one up.  In actuality, no one has ever told me that he was planning to buy General Motors.  That’s good, because looking back, we now know that GM, even though it was once considered a solid “blue chip” stock, was not in fact such a smart investment .

And there’s the rub. Looking back, it is crystal clear that we should’ve bought Microsoft when it first went public.  We should’ve bought Google.  Anyone with the time and inclination can do the research and figure out which stocks they should’ve bought.  But it’s not so easy going forward.

For one thing, there’s an excellent chance that whatever you have learned that convinced you that a particular stock is a good buy is already known by everyone else.  Therefore, the current price already reflects the brilliant insights you so cherish.  But another reason is that stocks are inherently risky.  If you are not using mutual funds to achieve diversification, but only buying a few stocks, you’re adding to your risk, unnecessarily.

Chances are you’re buying the stock of a company that you know quite well. If you live in Seattle there’s a good chance that Microsoft and Starbucks are in your portfolio.  Great.  And if you live in Rochester, New York there’s an excellent chance that you had Eastman Kodak and Xerox in your portfolio. Not so great, we now know.

In Atlanta, many people have invested in Coca-Cola.  By the same token, people in Houston had invested in Enron.  Where you live, and what you are familiar with, are not good reasons for investing.

Neither is loyalty.  Maybe your grandfather gave you some stock before he died and told you never to sell it.  I’m sorry, and I mean no disrespect, but don’t listen.  That stock with a family pedigree could be the next General Motors.

Or maybe you used to work for a great company and you have accumulated a lot of stock in your former employer.  But were you lucky enough to have worked for Exxon or unlucky enough to have worked for Citigroup or Bear Stearns?  Why let luck play such an important factor in your investment success?

By now you get the idea.  I’ve probably been way too repetitive.  But this is a really important concept.

As Nick Murray, author of Simple Wealth, Inevitable Wealth, says “Diversification is the conscious decision never to be able to make a killing, in return for the priceless blessing of never getting killed.”

To be continued.

In Praise of Netflix

I really, really like Netflix.  It can’t be beat for its convenience and economy, and I have watched many very good movies that I easily would have missed.  With over 100,000 DVDs in their library, there are certainly more than enough to choose from, no matter what your preference.

Netflix started out several years ago by touting its no late fees arrangement. I suppose from a marketing point of view, it’s a brilliant concept.  They must have figured out that a great many consumers were unhappy paying a late fee to a local video rental store; in the grand scheme of things, returning borrowed movies is low on the agenda, and these fees can really add up.  With Netflix, though, there are no due dates or late fees, ever.  When you’re done with a movie, you simply drop it in any mailbox using a prepaid return envelope.  As I said, the convenience can’t be beat.

I also like that you can create a wish list of films that you would like to watch, and as you return one DVD by mail, another one from your list is shipped out to you.  I usually receive the new one in 3 days.  It’s that easy.

But for me the best part is that Netflix uses technology to become a wonderful referral source for movies I might like.  How this works is that, after you’ve watched a movie you grade it from one to five stars; in this way, Netflix “learns” what you like and don’t like.  That facilitates recommendations.  For example, if I click on Little Miss Sunshine, a 2006 comedy, and ask for “Movies Like This,” Netflix will recommend Sideways and Juno.  If I click on Amelie, Netflix will recommend Priceless, another Audrey Tautou movie.

In addition, Netflix has a section called “Movies You’ll Love” which are suggestions based on your ratings.  In any case, Netflix will predict how well you will like any given movie, based on your previous ratings.  There are also brief descriptions of the movie plot and you can also read reviews by several film critics.

They have a very large selection of just about everything: hit movies, musicals, international flicks, documentaries, silent movies, and TV series.  If you don’t get HBO, you can still watch In Treatment with Gabriel Byrne. Don’t get Showtime?  You can still watch old episodes of Weeds.

Do I sound like a commercial? Only telling you the good stuff?  Okay, there is one glitch that I’ve occasionally encountered; from my experience, about 5% of the DVDs are damaged.  If you run across a problem like this, you can request a replacement disk, which will be sent out immediately.  So for me, it is an occasional annoyance, but not a deal killer.

I recently received an e-mail saying that if I forwarded it to friends, they could try Netflix for free for one month.  I’m not going to willy nilly send an email to everyone in my contacts list, but if you’re interested in trying Netflix out, send an e-mail to me at rstreit@keyfeeonly.com, and I’ll be happy to forward the message to you.  Their offer expires June 15th.

FYI, the cost of a monthly plan depends on how many DVDs you have out at one time, but vary from $4.99 (2 movies per month) to $16.99 for 3 DVDs at a time with unlimited renting.

As I mentioned, there are some really good movies that I would have missed or even bypassed without their recommendation.  This is only a partial list, because there really are too many to post:
Antonia’s Line, Ballets Russes, Billy Elliot, Elsa & Fred, The Girl in the Café, My Mother’s Castle, Miss Pettigrew Lives for a Day, Raise the Red Lantern, Smiles of a Summer Night, and Together.

And, no, in case you were wondering, I’m not getting a commission from Netflix for referring this great service.  So, why am I doing this?  For two simple reasons: first, because we all need a little less stress in our lives and second, because I really like Netflix.

Beyond a Simple Will

Most people understand that it is important to have a will which spells out the way they would like their property to be distributed after they die.  Nevertheless, many people are uncomfortable (to say the least) contemplating their own mortality, so they put off taking care of even writing a basic will.  That’s quite understandable, but in most cases, it’s a mistake.

I think it is imperative that you confront your fears and put something in writing, especially if you have minor children.  Having a will and naming a guardian is nothing short of mandatory.  My experience is that many people, who definitely know better, have not taken care of this responsibility.  That’s quite sad.  Parents spend so much time and energy in ensuring the successful viability of their children’s (long term) future in terms of education and comfort, but fairly little in considering who will care for them (in the short term) if the worst thing that could ever happen happens.

Whether you should take a step beyond just a simple last will and testament and also use a trust is the subject of a June 3rd article in The Wall Street Journal, Deciding if Your Kid Is Trust-Worthy, by Stacey L. Bradford. She raises several pertinent considerations in estate planning.

The subject of trusts can be intimidating, but it is well worth your time to become acquainted with the issues. Fortunately, Bradford explains in plain English “why parents may want to consider estate-planning tools beyond a will.” Here are some relevant quotes.

Even middle-class folks can benefit from trusts when it comes to estate planning. That’s because children under the age of 18 can’t directly inherit more than a small amount of money. If you have more than that to leave to your minor child and make no provisions in your will, a court will appoint a property guardian to manage your child’s assets until he reaches 18 or 21, depending on the state.

That property guardian may be a complete stranger who won’t understand your values. Perhaps more important, the guardian could add one more layer of bureaucracy to an already complicated situation. When your child needs money, the guardian may have to make a formal request that then goes through the court system. It can be a real headache for your kids to get funds when they need it, and it’s not an arrangement that’s always in their best interests.

One way around the court system is to set up a custodial account for your kids through your will. In that case, you get to name the custodian, and he decides how the money is spent. Once your son or daughter is legally considered an adult, he or she inherits the money outright. The problem with this setup is that your kid might blow through the money and have nothing left over for college or grad school.

For many parents, setting up a trust is a better alternative that allows them more control over how their money is spent once they’re gone. If you have the means and want your child to go to private school, for example, include that in the trust document. A trust can also delay the age at which your kids get their hands on the money.

While setting up a trust is a bit more complicated than a custodial account — it requires a lawyer’s assistance, for one thing — it also provides more financial security for your children and is therefore worth considering. Ideally, you should set up a trust when you draft your will. But you can always add a trust later as your estate gets more complicated or your assets grow.

Here are a few questions to ask yourself to determine if a trust is right for your family:

Do you anticipate leaving your children more than a modest sum of money?

Do you want to have some say in how your children’s money is spent?

Would you prefer that your children not inherit the money when they turn 18 or 21?

Do you want the money to be used for a college education?

Bradford also discusses choosing a trustee and how your guardian and trustee will work together.

Even after reading just these excerpts that I posted here, you will know enough to ask the right questions of your attorney. Reading the article in its entirety or the book on which the article is based, The Wall Street Journal Financial Guidebook for New Parents, couldn’t hurt either. By the way, in my opinion this book will be valuable for parents who are not so new and even grandparents.

And, of course, it is absolutely imperative to work with a knowledgeable lawyer who specializes in estate planning issues. Trusts are highly complicated and simply not a do-it-yourself project.

What you spend upfront on the lawyer fees will be saved many times over, if the need ever arises.