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Investment Pornography, Part 1

Caught your attention, didn’t I?  Please don’t be offended by the title of this post, and please don’t snigger over it.  This is serious business, after all. Also called “Financial Pornography,” investment pornography consists of (1) alluring magazine cover headlines promising juicy riches, (2) articles featuring exciting ways to capitalize on supposed opportunities and (3) outlandish claims and predictions that may, in fact, be bad for your financial health. Finally, it has no redeeming value whatsoever (except that it is good for a laugh).

When I go to conferences held by Dimensional Fund Advisors, one of the best run and most respected mutual fund companies, the lecture known affectionately as “Investment Pornography” generally gets the most attention and the most nodding heads of recognition. The presentation consists of articles from popular finance magazines followed by a quick analysis of what actually happened. Punchline: They were spectacularly wrong, time and time again.

Future posts will cover articles that are way too optimistic and were written simply to get you riled up enough to buy a magazine, newspaper or investment newsletter. Today’s topic is of the other kind of Investment Pornography, the alarming article that promotes fear. This is the other side of the outlandish approach to getting your attention.

Sympathy and Recognition

I feel sorry for a journalist who covers the stock markets. A writer typically takes the financial news of the day (which is, more often than not, pretty muddled), and tries to make some sense of it by quoting various people who at least sound as though they know what they’re talking about.

The fact is that sometimes stock prices go up and sometimes they go down, and sometimes they don’t do anything. And no one can predict what is going to happen next. That’s why it’s best to be a buy and hold type investor. But, really, who would read that story over and over? Would you?

So although writers try to be accurate, relevant and interesting, they frequently stray into making predictions. In my opinion, trying to predict the future is futile, and can be downright dangerous. Sometimes a writer will positively mislead you and convince you to do something you will regret.

Fear Mongering

A year ago, on March 6, 2009, I took the New York Times to task for fear mongering at (possibly) just the wrong time. By coincidence the stock market hit its actual bottom a year ago on March 9th, the next business day. Read that post for an egregious article that, if followed, would have cost you dearly.

While, in general, I love the New York Times’ reporting, here is a recent example of fear mongering from the January 25th article, Volatility and Politics Spark Fears of Market Correction, by Javier C. Hernandez.

Here are some questionable quotes with my comments:

“Brace yourself for another wild ride on Wall Street.” (Sounds scary, doesn’t it?)

“Worries about the strength of the global recovery and proposals from Washington to clamp down on banks have sent fresh jitters through financial markets, prompting chatter among traders that stocks could be poised for that rare but alarming phenomenon: a correction.” (Rare and alarming? Not really; it happens more often than you’d think.)

“Over three tense days last week, stocks tumbled nearly 5 percent; the Dow posted triple-digit losses on Wednesday, Thursday and Friday, ending the week at its lowest level since November.” (So? Five percent declines are quite common and mean nothing. Three days should definitely not make anyone “tense.”)

“Some analysts believe the downward momentum may continue.” (True, but other analysts don’t.)

“A confluence of all those headwinds creates a perfect storm of uncertainty on a market that had already been a bit vulnerable to a pullback,” said Quincy M. Krosby, a market strategist at Prudential Financial. (“Perfect storm”- nice phrasing; I sure hope that it didn’t convince you to abandon a well-thought out plan, though.)

“A severe decline in the market is far from assured. There are no certainties on Wall Street, and stocks have been known to bounce back after similarly turbulent periods.” (Thank you, thank you, thank you! I couldn’t have said it better myself.)

“In the near term, an unusual degree of uncertainty may bring more losses to the stock market.” (Yes, and then again it may not.)

Fast Forward Five Weeks

By contrast, after the market had gone up, the New York Times had this March 5th article: Markets Find the Upside of the Jobs Report also by Mr. Hernandez.

What a difference five weeks makes! Now, after the stock market has gone back up, we read “better-than-expected snapshot of unemployment in the United States lifted Wall Street on Friday, reinforcing hopes that the job market — and the broader economy — might be gaining strength.”

Here are more quotes with my comments.

“The fact that unemployment is not getting worse is great news for the market.” (First of all, it is possible that statistically the recession has already ended. Second, the unemployment news tells us only what has already happened, not necessarily what the stock market will do.)
…

“In light of that uncertainty, the question for Wall Street is whether the upward push can endure.” (You are free to guess what the stock market will do short-term, but no one knows.)

…

“The major indexes have recovered from their losses in January, and they are in positive territory for the year. Last week brought strong gains, with all three indexes ending the week more than 2 percent higher.” (Good thing we didn’t bail out and sell after reading that January 25th article, hmm?)

Enough

I am not picking on the New York Times. It is a must read for me every day, for its reporting and also for its opinion columnists. In truth, if I had to give up either reading the New York Times or watching TV, it would be a difficult choice.

And the New York Times is certainly not alone in its fear-mongering role; almost without trying, you can easily find dozens of predictive articles in most, if not all, national publications.   Money magazine has had many silly articles that would have cost you big bucks.  SmartMoney is frequently not-so-smart.   Business Week and Forbes should be ashamed. Time magazine is well known for its lurid front covers of Depression-like photos.

My advice is to ignore such articles, because they are in fact “Financial Pornography.” They attempt to, and often succeed in, getting people riled up, by either pandering to fear or greed. More likely than not, they are heavily influenced by what has already happened.

If they correctly predict what the markets subsequently do, it is merely a coincidence, in my opinion. Save your time and your money. Pay no attention to sensational articles with worrying predictions, or ones that identify sure-fire investments for that matter. By the time you read the story, any relevant facts are already reflected in today’s prices. It is too late to consider what you read to be useful, actionable information.

Do not be influenced by short term fluctuations or worrying articles. It is much better to have a plan and to stick with it.

Learning from Investment Mistakes, 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.” Jim Peterson, vice president at the Schwab Center for Financial Research.

My last post discussed the basic stock-bond allocation decision. This is a technique that many investment advisers use, but it is not the way most people approach investing. Most people are looking for an idea, a story or concept that they can build upon to make a winning investment, something that captures their imagination. They want to be a part of the next big thing, discovery or cure.

From time to time, a friend or acquaintance will tell me his or her investment philosophy. Years ago, one such friend offered the advice that you should “buy what you know.” That, of course, assumes that familiarity translates to good investment analysis. Unfortunately, there is no evidence that this is always the case.

Take, for example, people in Rochester, N.Y., who over-weighted their portfolios with Eastman Kodak and Xerox – more’s the pity for their retirement accounts. I submit that where you live (or where you grew up or where you work) should not be the guiding factor to which stocks you buy. Suppose you had lived in Houston and bought a ton of Enron stock or lived in Charlotte and invested heavily in Wachovia Bank stock?

Another past story line I’ve heard was “buy dominant technology companies with market power” as in Cisco, Microsoft, and other highflying tech stocks. That bit of advice was proffered in 2000, incidentally, just before all those “dominant technology companies” tanked.

More recently, a friend said that he liked GE, simply because Warren Buffett had invested in it. (And Buffett must know what he is doing, after all.) Fine, but Mr. Buffett’s company bought preferred shares with powerful guarantees and plenty of sweeteners; a much better deal than you or I or any “ordinary” investor will ever get buying GE common stock on the open market.

Some people follow trends, buying what “is going up” (which really means buying what has already gone up; granted, a small difference in interpretation, but a big difference in results). A good example of this is gold, which I have been asked about recently. (I’ll write more about gold in a future post.)

And, naturally, I’m also approached by the pessimists, who talk only of deficits, higher taxes in 2011 or 2012, third world debt, possible terrorism, etc., etc.

What is to be made from all these divergent concerns and predictions? In my opinion, not much. Hot tips and stocks with a good “story” or narrative are not necessarily going to reward you as an investor, because you cannot get the past performance that you have already witnessed.

Conclusion

My approach has always been and will continue to be this: If you are an investor, then you should invest. You should not allow yourself to be influenced by the news – good or bad – or by what your friends are doing or not doing. Investing is about cost control, having a globally diversified portfolio (preferably one holding thousands of securities), and taking the amount of risk that is right for you.

It is simple, but it is not easy.

To be continued…

Learning from Investment Mistakes

What, if anything, have we learned from the recent steep stock market decline?  One lesson, I hope, is that planning and designing a portfolio that is appropriate for you and that you can live with is very important.  Read on to learn about an approach that may help you decide on the right portfolio design for you.

The Stock-Bond Decision

When meeting with clients, I emphasize that choosing a basic stock-bond mix is a very important first step in effective and productive portfolio design. Unfortunately, I sometimes encounter people who have allocated their portfolio at either extreme – 100% in stocks or 100% in money market accounts/bonds.  Very few advisors would ever recommend either approach.

Although the stock-bond decision may appear simple, it can have a profound impact on your wealth.  Studies have proven that nearly 90% of a portfolio’s long-term results are directly linked to asset allocation, and the right stock-versus-bond mix should be your first deliberate and strategic decision.

The Rationale

Because neither I nor anyone I know can predict the future, I believe in having a diversified portfolio that includes both stocks and bonds.  I “dial down” total risk by adding fixed income to the stock market mix.  Quite simply, the greater the bond allocation relative to stocks, the less risky the portfolio, but the lower the total expected return.  On the other hand, the greater the stock allocation relative to bonds, the higher the portfolio’s expected return, and the higher the associated risk.

So, how do you confidently allocate between stocks and bonds?  One method is to use model portfolios to illustrate the risk-return spectrum over time. For simplicity and clarity, the highest risk portfolio holds 100% in a stock index, while the least volatile portfolio holds 100% in high quality bonds. Between these extremes lie other stock-bond allocations, such as 80/20, 60/40, 50/50, 40/60, and 20/80.  Comparing past results side by side is illuminating and quite helpful in the decision making process.

Certainly, relying on historical performance is not foolproof, because past results are not a guarantee of future performance.   But if you compare the average annualized return and volatility (standard deviation) of each model portfolio since 1970 (for example), you have an idea of what relative risk you can expect and whether or not you can accept the potential loss.

Lately, I have found that showing how portfolios did in 2008 is very helpful in illustrating the risk-reward tradeoffs.  Analyzing just that specific year shows that diversification neither assures a profit nor guarantees against loss in a declining market, at least in the short term.

For example, a portfolio with a stock allocation of 80% declined 30% in 2008, while a portfolio of 60% stocks “only” declined by 21%.  Many people can live with a 21% decline, knowing that markets do rebound and the long term outlook is positive.  On the other hand, suffering a 30% loss (or more) could have tipped some investors into panicking and getting out of the stock market entirely, much to their chagrin today.

Refining the Stock Allocation

After establishing the basic stock-bond mix, I turn my attention to refining the stock allocation.  Depending on an investor’s individual profile, I may overweight or “tilt” the allocation toward riskier asset classes that have a history of offering average returns above the market.

Research published by Eugene Fama and Kenneth French reveals that small cap stocks have had higher average returns than large cap stocks, and “value stocks” have had higher average returns than growth stocks.  By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.

The final step in refining the stock component is to diversify globally.  By holding an array of equity asset classes across domestic and international markets, you can reduce the impact of underperformance in a single market or region of the world.  And lest you worry about the global recession, last year developed and emerging markets grew at a rate higher than domestic markets, by 27.7% and 74.1%, respectively.

Conclusion

Over short periods of time, returns on stocks are quite variable; in other words, in any year we don’t know whether stocks will produce good results or not.  But, over a longer period of time – and this has been historically proven – stocks provide higher average returns than low-yielding bonds.  That’s why I generally recommend that investors with a long investment life ahead of them focus on achieving the higher long-term returns through investment in stocks.  As your time horizon or risk tolerance changes, you can reallocate your portfolio’s risk more in favor of bonds.

Summary

The stock-bond decision drives a large part of a portfolio’s long-term performance. During discussions with clients, I have found that examining different stock-bond combinations can help them visualize the risk-return tradeoff as they consider the range of potential outcomes over time. Once a mix is determined, it can guide more detailed choices of asset classes to hold in the portfolio. And, as one’s appetite for risk shifts over time, the allocation decision can and should be revisited.