More About Ric Edelman

When in my last post, I criticized some of Ric Edelman’s practices and fees, I felt a bit queasy.  Was I being unfair?

I reached my conclusions by reading the handout material and by what he said in a seminar.  I also studied his web site, which disclosed his fees.  But I did not have direct access to a client’s portfolio, so I felt somewhat tentative in my judgments.  But today’s post by Allan Roth An Interview with Ric Edelman – Is High Cost Indexing an Oxymoron? confirmed my suspicions.

Roth analyzed an Edeleman client’s portfolio, and he also spoke to Edeleman. Roth reached the same conclusions I had about the high fees, and he also questioned Edelman’s recommendation of not paying off a mortgage.  Finally he confirmed my belief that Edelman was not paying attention to asset location, since he found the same allocations in the IRA accounts as in the client’s taxable accounts.

But enough criticism.  The rest of this post is about Edelman’s book The Lies About Money, which I can recommend.  In the first two chapters he persuasively lays out the case for diversification and for not trying to time the market.  This is a very important message which many investors still do not get.  Then he explains the advantages of mutual funds.

But it in his fourth chapter, The Demise of the Retail Mutual Fund Industry, that he shines.  He essentially demolishes (active) retail mutual funds.  For starters, he discusses the frequent manager changes, the costs of active management, and the dangers of style drift.  And this is just the beginning; he discusses 25 reasons why you should not use a typical (active) retail mutual fund.

Not satisfied with that, Edelman actually put together A Mutual Fund Scandal Timeline outlining the abuses that have been alleged or proven from 2003 to 2007.  It takes him a “mere” 40 pages to summarize the questionnable practices and allegations of abuse.  If that is not enough to make you question whether your mutual fund or stockbroker is actually your friend, then nothing will.  So buy the book or get it out of the library simply for Chapter 4.

Conclusion

The financial services business is fraught with conflicts of interest, high fees, misleading ads, and general confusion for the typical investor.  Sorting through this mess is not easy.  As William Bernstein says, “Both mutual fund companies and brokerage houses know more ways than you can count of fleecing you without your knowing it.”

To be continued.

Edelman Financial: Bigger Isn’t Necessarily Better

Because Edelman Financial Services is opening six offices in the New York/ New Jersey area, I accepted an invitation to attend a seminar by Ric Edelman, the well-known author, radio host and investment manager.  The talk was held at the luxurious Hilton Hotel in nearby Short Hills last week.

Here is my review.  As a public speaker, I gave him an A+.  He was entertaining and informative, and offered a very clear piece of advice: Buy-and-hold a diversified portfolio of low-cost institutional mutual funds. Certainly, I would recommend his firm over a broker from Ameriprise, Smith Barney, Merrill Lynch, etc.

Still, I would only give him a B to a B+ as an investment manager.  I realize that it takes a certain amount of chutzpah (nerve) for a solo practitioner like me to judge someone whose firm manages approximately $4 billion and has thousands of clients – my goodness, Barron’s rated him the No. 1 independent financial advisor in 2009 – but I believe it is my responsibility to give you my opinion.  Read on, and see if you agree with my assessment.

Points of Agreement

First of all, let me state the areas of agreement.  I think his basic message is absolutely correct.  Most individual investors have so many misconceptions and make so many mistakes that their results are generally terrible.  Edelman provides a useful service in summarizing the theory, evidence, and his personal experience to educate the public on what really works.  He correctly points out that investing in safe instruments such as CDs is just about guaranteed to cause penury in retirement, because the “safe” investments don’t keep up with inflation, especially after taxes are considered.

He convincingly explains in great detail the necessity for wide diversification, proper asset allocation and rebalancing.  He also shows that listening to the media is bad for your investment results.  Good for him!

Like so many good investment managers, Edelman recommends having a long-term strategy and the importance of being invested at all times.  He was quite convincing in explaining how past performance is no guarantee of future results.  His down-to-earth “toaster” comparison was so good that I plan to use it myself when the occasion arrives.

He also explained in detail why retail mutual funds are just way too expensive.  These are not just opinions, but are based on facts.

He graphically illustrated the high cost of being “out of the market” for even a short time.  According to the data, provided by Standard & Poor’s, the average yearly return of the S&P 500 from 1994 to 2008 was 6.5% per year, if you were invested all 3,827 days.  If you missed the 10 best days, that’s right only 10 days, your return was actually 0%.  What a convincing comparison for a buy-and-hold all-the-time strategy.

So in general, I applaud Ric Edelman for being on the right track.

Where we disagree

My first criticism is that, although Edelman emphasized the long term cost that inflation inflicts on client portfolios, pointing out that over the long term inflation has been 3.2%, he says that it is “too early” to be concerned about inflation. He is “monitoring the situation” and will change his strategy when he thinks it is appropriate. In my opinion, this is a very strange approach for someone who believes that you cannot forecast the future.

Since markets react very quickly to new information, I worry that Edelman will not be able to change his strategy at just the right time. Why try to “time the market” by saying that inflation is not a concern now? To paraphrase an old Wall Street saying, “No one rings a bell to let you know when you should be worried about inflation.”

The question and answer portion of the seminar revealed a position that I take exception to.  Edelman suggests that paying off a mortgage quickly is a mistake, because clients can invest the money for a higher return.  While this is a controversial area, I believe that it is comparing apples to oranges, because mortgage debt is a certain obligation, while investment gains are variable.  As with many personal financial issues, the right answer is “it depends.”  There are too many variables in one individual’s life to hand out one-size-fits-all investment advice.  For some people, paying off a mortgage is the right thing to do, depending on their tax situation and their risk tolerance.  The peace of mind a debt-free retirement provides is valuable to some people who are no longer trying to maximize returns.

And, frankly, I am concerned that he is recommending something that will give him more assets to manage and therefore increase his fees, without mentioning the conflict of interest.

When I decided to look up Ric Edelman’s previous books, including The Truth About Money and The Lies About Money, I was surprised to see reviewers on Amazon.com chastising him for his previous rejection of index funds.  While Edelman now (appropriately) denounces actively managed retail mutual funds (because they are a rip off to investors with their high fees and hidden expenses), it’s unconscionable that it took him such a long time to realize that. 

It appears that Edelman had been attacking the notion of index funds for years.  Interestingly, he now follows a correct passive approach to investing, which is very similar to index investing.  He just isn’t willing to admit his conversion (or his past mistakes, for that matter).

In addition, I have read that Edelman doesn’t require that his advisors be Certified Financial Planners.  If true, this is a very serious shortcoming. Real financial planners address more than just investments, and while the CFP certification is not a panacea, it does indicate the seriousness to master your craft. More than passing a 10-hour test, the continuing education requirements are invaluable.

Fees and Value

Edelman Financial Services uses low-cost institutional mutual funds and ETFs, as do I.  The firm charges annual management fees of 2% on the first $150,000, 1.65% on the next $250,000, 1.25% on the next $350,000, 1% on the next $250,000, etc.  There is no additional cost for buying and selling mutual funds, which is a plus.  Another good thing is that they are willing to take on clients with modest amounts to invest, as low as $50,000.

However, while all-in costs are less than you might pay a typical stockbroker, I believe that for individuals with as little as $250,000 or $300,000 to invest, his fees are higher than those of a typical independent fee-only financial planner.

An investor with $500,000 will have to pay Edelman $8,375 per year as compared to a typical $5,000 fee to a smaller financial planning firm. An investor with $1,000,000 will pay Edelman $14,000 per year as compared to $10,000 for most boutique firms.  And many of the fee-only planning firms use the same low-cost institutional mutual funds and ETFs that Edelman does.

Conclusion

I have received mixed reviews from other financial planners regarding Edelman Financial Services.  Some call his portfolios cookie-cutter, which may or may not be a fair description.  Others have pointed out that there is very little attention paid to asset location, as compared to asset allocation. One financial planner told me that there was no effort to do tax loss harvesting, but another one said “it depends” on the client.  These are issues that many investors will not even be aware of, but the answers can influence after-tax returns.

Certainly Edelman’s services are better than working with a typical stockbroker, who might put you into a bunch of expensive retail mutual funds or sell you a variable annuity.

However, investors should understand that they are paying a premium for a celebrity’s name on the door.  And something a potential client should definitely ask is how much financial planning will be done, in addition to investment management.  The answer to that may also be “it depends.”

For a second opinion, and to help do a cost comparison, use “Find an Advisor” at the National Association of Personal Financial Advisors’ (NAPFA) web site and interview other financial advisors.

Evidence-based Investing, Part Two

“When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s almost no chance that you end up beating an index fund. The odds…are 100 to 1.” – David Swensen.

Passive investing, sometimes called index investing, is, as the name suggests, the exact opposite of active management of a portfolio.  The latter attempts to “beat the market” by various means, including selecting securities that are (hopefully) underpriced, trading holdings, and sometimes, by getting out of (and eventually back into) the market entirely.  Passive investing, on the other hand, employs a consistent strategy of buy and hold.  The $64 billion (adjusted for inflation) question is which approach is better?

The evidence proves that active fund managers actually under-perform their relevant benchmarks.  Specifically, over a 10-year period, approximately 75% to 80% of all mutual funds fail to “beat the market.” Attempting to be one of the 20% to 25% who succeed is known as “playing the loser’s game.”

And the longer the period under consideration, the worse the odds become. A study published in 2008 found that from 1975 to 2006 only one in 166 mutual funds outperformed the stock market.  That was 0.6% of the total. 99.4% failed to outperform the market.

Keep in mind that mutual funds that use active management charge more in management fees.  First of all, they have higher operating expenses, because they spend more money on research and on active trading.  And by claiming that they can outperform their peers, they can charge more, so they do.  But as an investor, you start with a handicap if the mutual fund you are using has higher expenses.

I don’t doubt that some of the active managers sincerely believe that they can deliver on their promises.  But logically, and statistics proves this out, they can’t all be above average.  So buyer beware.

Another consideration is that active management generates short-term profits, which are more highly taxed than long-term capital gains.  So, even some investment managers who think they can add value by actively managing a portfolio decline to manage a taxable account.  They believe that, after taxes, an actively managed portfolio will always underperform a passively managed portfolio.

Given the stakes in determining whether you can ever “beat the market” it’s not surprising that so much has been written on the subject.  And since we are talking about 50 years of research, it isn’t easy to summarize the evidence.  So I’ve chosen one (somewhat facetiously titled) article, How to Beat the Market in Three Easy Steps, which I think is well-written and which will give you a flavor for the logic and practical implications of passive investing.

Here are some quotes from the article by Karl N. Huish, Esq., CFP®

To be an active investor, you must say, ‘I am right, and most of you are wrong.’

One huge challenge is separating talent from luck.  Wall Street is filled (and overflowing) with bright, capable fund managers, with gold-plated MBAs and Ph.Ds in economics, mathematics, computer science and physics.  IQ tests and education resumes will not be enough to distinguish the true geniuses from the merely intelligent.  Most of these funds are advertised by top-flight marketing companies.  How do we dis­tinguish the sheep from the goats?

Can past performance help us?  This is the miscon­ception upon which many investors stumble.  It turns out that [surprise!] past performance is not indicative of future performance. A recent large study (3,700 public and corporate plans, representing $737 bil­lion invested) found that manager hiring and firing decisions made by retirement plans, endowments and foundations was a complete waste of money and time: the fund managers performed better than the market before being hired, but underperformed the market af­ter hiring.  In other words, their market-beating per­formance was luck, not skill.

David Swensen is the manager of the Yale University Endowment, which is the highest performing endowment fund over the past 20 years.  To many he is considered the greatest current institutional investor – a modern mastermind. … He stated the fol­lowing:

‘When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s al­most no chance that you end up beating an index fund. The odds…are 100 to 1.’

Mr. Swensen – the best in the business – isn’t very con­fident about beating the market rate of return, as re­flected in an index fund.  How confident are you that you or your advisor can identify those active funds that will – taking all costs into consideration – outperform the passive alternatives?

What Does the Research Say?

Well, what about the data?  It turns out that David Sw­ensen is just about right.  In a 2008 published study, Professors Laurent Barras, Olivier Scaillet, and Russ Wermers used the most advanced statistical testing in science (using tests from computational biology and astronomy), to drill down into the performance of active mutual funds for a 32-year period, from 1975- 2006.  The researchers found that, on a pre-expense basis, 9.6% of mutual fund managers showed genuine market-beating ability. But after expenses were de­ducted only 0.6% of fund managers outperformed the market.”

Conclusion

My Investment Philosophy is based on the belief that a passive approach is the best way to invest my clients’ money.  I follow that same strategy for my own portfolio, as well.   I am not convinced, however, that using simple index funds is the best strategy, largely because of their trading inefficiencies.

But that’s the topic of another post.

I Told You So!

“Stock picking and market timing are expensive, risky, and ultimately futile exercises.” – William Bernstein.

As you may recall, on Friday, March 6th I wrote that it was a mistake to be scared out of the stock market.  The stock market actually hit its bottom on the next business day, Monday, March 9th.  Since then, prices have soared, not in a perfectly straight line, true, but the increases have indeed been spectacular.

What does that mean?  That I can predict stock market prices?  No, absolutely not.  That remains an “unacquired” skill.

What it does mean, though, is that I follow a buy and hold philosophy, because getting out of and into the stock market again and again is a losing strategy, simply because you are not going to do it well.  One benefit of working with a fee-only financial advisor is avoiding the emotional swings that accompany volatile stock prices.

Please read my March 6th post, Nobody is Buying Stocks?  in which I mocked the total negativity that was seemingly everywhere in the media.  I pointed out just how overblown the language used at the time was:

“With so much uncertainty, investors are parachuting out of companies…”

“No one is taking a back-seat approach. Everyone is just selling.”

“It’s like an unending nightmare.”

Please take a moment to read the entire post (if you haven’t already), but here is the conclusion if time is pressing:

“No one knows what tomorrow will bring, but unless capitalism ceases to function, stockholders will be rewarded in the long term for owning stocks and for taking risks. Yes, there is risk in owning stocks, as we have recently experienced. Since we’ve already seen the risk, how about staying around for the reward?

An old Wall Street proverb is that “Nobody rings a bell at the top or the bottom of a market.”

Are you waiting for that bell to ring?  Don’t.”

As I pointed out, since March 9th stock prices have soared.

Understand, though, stock prices can go down again.  In fact, I can  guarantee that.  Once again, I am not clairvoyant, and I rarely make predictions.  But, I have counseled a buy and hold strategy for many years. There is no evidence that anyone can get in and out of the market at the right time and improve on a buy and hold approach.

Heaven help the person who got out of the market earlier this year.  The March 6th post quoted financial advisor Bijon Mishras who said, “I want to wait for a firm turnaround, and be as safe as possible.” I wrote, “Whoa, Nelly. Remember this quote and see how it turns out.”  So, Bijon, is now the time to get back in?

On March 16th I wrote a series which started with Is Buy and Hold Not Working? Part 1.  I said that timing the market was impossible, “The evidence shows that most investors get it wrong over and over again.”

“Historically, stock markets have had sharp increases following a bear market.  The difficulty is identifying when that move is for real.  Bear market rallies, bear traps, etc. tend to keep investors gun-shy, so a sustainable bull market rally will only be identifiable in hindsight.

Nevertheless, individuals who keep their investments in cash or Money Market funds will miss out on most of the move.”

Conclusion

I’ll stick with what I said on March 27th, “Given what does not work, what is the recommended approach?  In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.”

A good advisor should help you do that and also avoid the “big mistakes” of buying high and selling low.  Is that worth the annual amount you pay a fee-only advisor?  I certainly think so.  Do the math.

Read more

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.

What Should Investors Do Now?

“No one knows anything.”

“There is a science to investing.”

Given the market volatility and the steep declines of the last year or so, which quote would you agree with?

My answer is that I agree with both statements.  Here’s why.

Absolutely no one can successfully predict the short term direction of the stock market, the value of the dollar or gold, the movement in interest rates, etc., etc. When it comes to investing, there is no magic formula. There are no gurus who can foretell the future and help you “beat the market.”

On the other hand, there are approaches that work very well in the long term. For example, there is a fundamental relationship between risk and (expected) return. Ignore it at your own peril.

And you can learn from the past; you can devise a sensible strategy. Most of all, by following a long term buy-and-hold approach with a diversified portfolio that is matched to your risk tolerance, you can avoid the big mistakes of being too optimistic or too pessimistic.

For a thorough presentation on the intellectual underpinnings of a buy-and-hold approach and what investors should consider as they move forward, I highly recommend the video, What Should Investors Do Now? by Weston J. Wellington of Dimensional Fund Advisors.

This multi-part presentation includes “an examination of capital markets, the effects of recession and government policy on stock prices, how the current market stacks up to previous downturns, and the reasons why our core beliefs have not changed in light of these events.”

If you hold an MBA in Finance, you’ll find this video to be a valuable review of capital markets and portfolio management. If, like most people, you’re merely an ordinary investor, one just trying to figure things out, this will be an extremely useful introduction to the evidence that supports a sensible  long- term approach to investing.

So, grab a cup of coffee or tea, then sit back and enjoy the show. It is over an hour long, but you can view it in segments.

Watch it here.

Actively Mismanaged Funds

“Active managers can and often do outperform for short bursts of time. But once you extend the time horizon, the probability of that outperformance continuing significantly diminishes.” – Srikant Dash, Standard & Poor’s.

A previous post sought to debunk the notion that anyone can consistently outperform the market by superior stock selection and/or stock trading, better known as active management. It’s worth continuing an examination of this approach, because so many investors, through their investment advisers, are essentially chasing a chimera. They are trying to beat everyone else by choosing mutual funds that have done well. This approach has been shown, time after time, to fail.

I concluded with this statement: “It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible.”

Actively Mismanaged Funds by Scott Woolley in the April 13, 2009 Forbes Magazine reinforces my conclusion.

Here are the relevant quotes:

For years William Miller’s name appeared atop lists of the world’s most successful stock pickers. His Legg Mason Value Trust outperformed the S&P 500 every single year for a decade and a half through 2005, an astonishing streak regularly cited as evidence that a smart fund manager can consistently beat the market. Customers flocked to this hot hand. Assets in the fund climbed to $12 billion, representing $200 million a year in management fees for Legg Mason. (Emphasis added.)

That’s when the gravy train came screeching to a halt. Value Trust’s 6% gain in 2006 was only half as good as the market’s. The fund has lost money ever since, including a 6.7% decline in 2007, 55% in 2008 and 20% through February of 2009. Each of those numbers was worse than the broader market’s return.

Another way to look at Value Trust: Investors paid Miller and his underlings $2 billion in management fees to destroy wealth.

Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they’re worth a premium because they’ll rescue you from nasty bear markets while “dumb” index funds abandon you to a mauling.

The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.

Especially humiliating lately is the performance of the largest funds, including Fidelity Magellan, in Peter Lynch’s day the grand master of actively managed vehicles. The fund lost 52% in the past year.

While Magellan has been a disappointment to investors, it has done very well for its manager, Fidelity Investments (in which the family of billionaire Edward Johnson owns a large stake). The fund’s 0.73% annual expense ratio on $41 billion in average assets added up to $295 million in fees last year. Investors could have stuck their money in Fidelity’s Spartan 500 Index at one-seventh the cost and earned more over the past one-, three-, five- and ten-year periods.

 Humans, …are hardwired optimists. To our detriment as investors, we tend to overestimate our ability to pick winning stocks and stock pickers, like Bill Miller. (Emphasis added.)

The other problem is that funds are often sold rather than bought. The sellers are in it for commissions. Those are easiest to skim off actively managed funds that charge fat fees in exchange for the prospect (but not the probability) of knocking out the lights or the protection offered by “professional management” in troubled times.

Franklin Templeton’s ads boast that its flagship Growth Target Fund has “weathered the ups and downs of the market for over 50 years.” That included some rough sailing in 2008, when Growth Target, a supposedly conservative mix of stocks and bonds, lost 31% of its value and lagged its index by six percentage points, according to Morningstar.

American Century enlisted pedaler Lance Armstrong to evoke his successful battle against cancer as a template to “provide for a secure financial future.” Ultra, American Century’s largest fund, lost 41.7% last year, lagging the S&P 500.

Investors are learning

The crash is making investors rethink their faith in funds that try to beat the market. Last year they yanked out $222 billion while adding $18 billion to their index holdings, according to Lipper. That left $3.2 trillion with active managers at year’s end, compared with $672 billion in passive mutual funds and exchange-traded funds.

That shift from actively managed funds to passively managed mutual funds and exchange-traded funds is definitely a move in the right direction.

Is Buy and Hold Not Working? Part 3

“Being a buy-and-hold investor today makes as much sense as it ever did. The point of sticking to sound, fundamental strategies, after all, is to keep you from making big mistakes in moments of crisis. And abandoning the market now could turn out to be a very big mistake.” – Jeremy Siegel.

Roger C. Gibson, the author of Asset Allocation: Balancing Financial Risk was recently interviewed by Morningstar Advisor to offer his perspective on the turbulent stock market of the last year. Gibson is an expert on portfolio construction and investment management. His observations are worth considering.

No Place to Hide in 2008

Morningstar’s data base includes approximately 4,000 mutual funds that invest in either stocks or real estate (U.S. or international). All but one had losses in 2008.

“Of 1,730 bond funds–both taxable and municipal–68% lost money, which surprised us. Those that didn’t were (U.S) government or short term bond funds.”

“I’ve never seen losses like 2008, but it wasn’t something completely unthinkable. And when you have absolutely horrible, panic-driven significant losses, they’re usually not just confined to a particular asset class. In 2008, panic fed on itself.”

Volatility

Gibson tabulated the number of days the Standard and Poor’s 500 gained or lost 5% or more. Between January 2008 and August 2008, there were no 5% days. Between September and December there were 18 days when the market moved 5% or more, or one out for five! This is unprecedented volatility.

It is quite amazing how investors have become accustomed to 5% fluctuations in a single day. According to Gibson, “Over the last 50 years, these kinds of moves probably only happened once a year and, already, investors have almost gotten numb to this volatility.”

What can we learn from 2008?

“During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.”

Regarding asset allocation and diversification, “Strategic asset allocation isn’t broken and never promised to sidestep a year like 2008, but what it will do is make the portfolio as a whole have less average risk. That’s mathematically driven. And it will cause a portfolio to have a higher compound return than the average return of its asset classes. That said, it doesn’t mean you can’t get into a scary environment.”

Conclusion

In previous posts, I have written about the futility of trying to predict the near term direction of the stock markets. It just can’t be done successfully on a continuous basis, neither by you, on your own, nor with the help of a market strategist. I’ve also written about the near impossibility of improving your overall results by pulling out of the market and waiting until you think it’s a better time to invest. Finally, I have outlined the evidence for the failure of market selection – finding underpriced securities.

Given what does not work, what is the recommended approach? In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.

To be continued.

Is Buy and Hold Not Working? Part 2

My last post addressed the proper response to a stockbroker’s claim that the “Buy and Hold” approach to investing has not worked. My answer was, “compared to what?” I explained that, in determining when you should and should not invest in stocks, the probability is low that you’ll guess right.

By the way, have you noticed that the question of whether “Buy and Hold”  works only comes up after a steep market decline? Why doesn’t it ever come up when stock prices are hitting new highs?

Since we have covered the issue of when to buy, up next is what to buy, or more specifically, what approach to use in investing for the long term.

Active Investing

A perennial debate (actually, only since the 1970’s, but you get the drift) among investors is which is better, active or passive investing. Wall Street (stockbrokers) must convince you that active investing is superior, or they have little to sell. Their sales pitch is usually that their experts can do better than average. Think about it. All stockbrokers and active money managers say the same thing. How is it possible that they all claim to achieve better than average returns? Do they live in Lake Wobegon?

What they are claiming is that, through superior stock selection, they can outperform the market. The strategy is for an investment manager to buy something that is underpriced and will do well. After it has outperformed, sell it and then buy something better. This approach is certainly good for the stockbroker, who earns a commission on each and every trade, or the mutual fund company, which can charge higher fees for active management.

But there is no evidence that anyone can actually do it profitably on a consistent basis. Let me rephrase that a bit, there is no evidence that a stockbroker can do it consistently and profitably on behalf of an investor. Certainly, the stockbroker consistently profits from the commissions he earns while actively trading on an investor’s behalf.

Regarding mutual funds, remember that active trading has costs; the cost of research, trading, and taxes, for a taxable account. Therefore these mutuial funds have to overcome the higher costs before their investors benefit at all from active management.  That is true in good times and bad. In fact, many actively traded mutual funds have had a really rough time in this bear market, underperforming stock indexes.

For a witty (though somewhat wonkish) take on the active versus passive debate, consider a transcript of Rex Sinquefield’s opening statement in a debate with Donald Yacktman at the Schwab Institutional conference in San Francisco, October 12, 1995.

For a more recent comment on the issue, one professional investment management firm that manages billions of dollars and uses the asset class mutual funds of Dimensional Fund Advisors, summarized it well.

“Let’s be very clear: this bear market has been witness to the spectacular failure of active management. Index funds have handily outperformed active managers in a market where conventional wisdom would have you believe the active approach would add value. When (you) read that now it is more important than ever to be tactical, it begs the question that if active management didn’t help you avoid this bear market, then why would you expect it to outperform going forward?”

Conclusion

When an active investor attempts to identify and buy a stock or bond that is underpriced, what he or she is really saying is that everyone else is wrong. That’s because the current price is the best estimate of what everyone thinks it should be. It’s true that prices can be wrong, and that they can and do eventually change, but the question is whether you, or anyone else for that matter, can identify and take advantage of any mis-pricings in advance of their correction.

The same applies when choosing a successful mutual fund investment manager. It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible. You may find that sometimes (about 25% of the time) a mutual fund has beat its benchmark. Unfortunately, you cannot identify such winners in advance.

To be continued.