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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.

On June 10th in the first part of this series, 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.