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 Bank Mistakes

“The key to successful investing is to get the plan right and stick to it. That means acting like the lowly postage stamp that does one thing, but does it well: It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well-developed plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.” – Larry Swedroe

What can investors learn from the mistakes of investment banks, such as Lehman Brothers and Bear Stearns? That question is what Larry Swedroe addresses in his article: Anatomy of a Crisis: Lessons Learned From the Credit Crunch.  Swedroe believes that one should not judge a strategy “solely on the outcome.” Nevertheless he identifies the “major strategic errors” investment banks made.

First, they “bet the house” by using too much leverage, meaning the company would go bust if these bets lost. Highly leveraged institutions must be right all the time because even if they are correct in the long term, they may not weather a short-term storm. This is a lesson these institutions should have learned from the 1998 experience of hedge fund Long-Term Capital Management (LTCM).

Second, they failed to effectively diversify risks, placing too many eggs in just a few highly correlated baskets (such as residential and commercial real estate).

Third, they forgot that even if assets have low correlation, risky assets have a nasty tendency to have their correlations turn high at the wrong time.

Fourth, they treated the unlikely (housing prices falling sharply) as impossible. They also forgot that just because something had not happened does not mean it cannot.

Fifth, they failed to understand that liquidity can be illusory: there when you don’t need it, but “gone with the wind” when you do.

Lessons Investors Should Learn

1. Investment banks and active managers (including hedge funds) cannot protect investors from bear markets. All crystal balls are cloudy … If their money managers could protect you, why did Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to run into the arms of Bank of America to prevent the same fate? …
2. Never take more risk than you have the ability, willingness or need to take.
3. Diversify broadly, and don’t concentrate labor capital and financial assets in one basket. Many employees of once-great companies lost not only their jobs but also much of their financial assets because they made this mistake.
4. For fixed-income assets, stick only with government bonds and the highest investment-grade bonds. Anything else (such as junk bonds and preferred stocks) can have the risks show up at the wrong time.
5. We live in a world of uncertainty (the odds of events occurring cannot be measured), not a world of risk (the odds can be measured). Thus, stocks are high-risk investments, no matter how long the investment horizon. That is one reason for the large equity risk premium.
6. Treat neither the unlikely as impossible, nor the likely as certain. And, if something has not yet happened doesn’t mean it cannot or will not.
7. Make sure your investment plan incorporates the high likelihood of crises. The only way to avoid them is to not take risk, and thus accept Treasury bill returns. While bear markets are painful, there is no good alternative to buy and hold except to avoid risk. Timing the market is a mug’s game.

As further evidence against the folly of market-timing efforts, a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (a fancy term for market timing) found that not one had benefited from the efforts.

Is It Different This Time? Part 1

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.

Scary Headlines

Lately, it seems that all we have been reading and hearing about are falling real estate values, failing national banks, global brokerage firms in dire straits, and stock prices plummeting in markets all over the world. This is no fun, no fun at all. Surely, we are in big trouble. You may believe that our current financial problems are “unprecedented.” For a different view, though, read on.

Needed Perspective

Dimensional Funds Advisors Vice President, Weston J. Wellington, offers perspective on how the current market downturn compares to past bear markets. His short, 17-minute presentation Is It Different This Time?  shows how resilient markets have really been.

Video highlights include brief discussions of past articles from Time, Newsweek, Fortune, and Business Week, which shows how past crises and bear markets were covered. What is surprising is how often the word “unprecedented” gets used.

photo credit: sorian

Investment Lessons from a Big Dog: No New Tricks

“By following a disciplined policy of maintaining a well-diversified set of portfolio exposures, regardless of market zigs and zags, investors establish the conditions for long-run success.” – David Swensen.

I recently attended a meeting hosted by a very large financial services company about their approach to investment management. This presentation was given to a group of financial planners in Northern New Jersey, and the goal was to identify those planners who would like to outsource the money management portion of their practice.

This company manages almost $200 billion in assets for pension funds, wealthy individuals, not-for-profits, and financial institutions. They had a marvelous bound handout with great graphics. And they used some very impressive terminology such as Distribution-Focused Strategies and Total Return Investing.

However, after listening to their sales pitch and reading through the propaganda, I remain unconvinced that they are doing anything that innovative, at least when compared to that which an experienced financial planner already does. Because using them would only add an additional layer of fees and not provide any significant value, I was not interested in using their services.

Their presentation, though, brought up several valid points that you should consider in managing your own affairs or when finding a financial planner. Summarizing the key points to consider in creating a portfolio:

• Your Goals
• Your Time Horizon
• Your Risk Tolerance

All of these are inter-related, and it is important to remember that the real risk is not meeting your goals.

In creating and managing a portfolio, the basic factors are the same for everyone:

• Asset Allocation
• Costs
• Tax Management

Keeping these basic, yet profound, concepts in mind will serve you well over the long term.

The Total Return Investing concept is actually valid and quite useful, and worth explaining. What is implied from that term is that investment decisions should be based on total returns, not just interest and dividends. Many people looking for an amount to replace a paycheck in retirement, for example, often focus only on the yield of their portfolio. This translates to dividends and interest income.

There are three reasons, though, why the Total Return Investing strategy is at a disadvantage.

First, while interest and dividends appear to be something you can count on, only about 20-25% of stocks actually pay dividends. If you excluded the rest merely because they don’t pay out dividends, you are excluding the majority of companies.

Second, dividends are not always secure; they can be reduced or eliminated. Loading up on stocks that pay a high dividend can be riskier than you thought.

Third, when investors realize that the projected income is not going to be “enough” to meet their goals, they frequently “reach” for yield by either buying riskier bonds that promise to pay higher returns, or they buy longer term bonds, which ordinarily pay more in interest. Unfortunately, as we have seen recently, if you buy riskier bonds you may suffer a substantial loss, rather than get a higher yield. And if you buy longer term bonds, you will lose principal if and when interest rates go up.

Fourth, you are not likely to keep up with inflation, if you concentrate too much on current yield. To keep up with inflation, you need to own equities.

I am not suggesting that you should avoid bonds in your portfolio, only that they are usually not sufficient for most people.

As I said, these concepts are standard operating procedure for experienced investment managers. I just thought that their importance bore repeating.

photo credit: mahalie

The Education of an Investor, Part 1

“Experience is the toughest kind of teacher — it gives you the test first and the lesson afterwords. Perhaps, by learning a bit of history, you can assimilate the lesson vicariously without bearing the costs.” – Burton Malkiel

I’ve been an ardent reader and believer in “How-To” books since, as a teenager, I read The Education of a Poker Player by Herbert Yardley. It was one of the first books published which addressed poker from a mathematical perspective. What an eye-opener, because it proved (to me, at least) that there is a huge difference between a professional with a well thought out strategy and someone who merely played poker by relying on hunches and the appearance of Lady Luck.

About the same time, I also read How to Play Winning Checkers by Millard Hopper. While not exactly an investment book, it was useful nonetheless, especially if you were willing to practice until you had your winning strategy down pat.

Based on personal experience, it is definitely possible to improve your game by reading “How-To” books.

The concept of learning how to win at a game gives rise to these two real world investment questions: Can someone actually “play” the stock market? Is investing just a “game” or is it something else entirely?

My perspective on this goes back decades (all right, a lot of decades) to when in high school, I first started reading books on the basics and fundamentals of finance and investing. I was intrigued enough to include the biographies of several very successful financiers such as J.P. Morgan, Bernard Baruch, the Rothschilds, etc. Of the many books I read on investing, these three titles stood out among the rest:

I had no idea that these books would one day be considered investment classics. At the time, I read them because the titles attracted me. I read them passionately, often nodding my head in agreement, or shaking my head in wonder at the collective brilliance. And after all these many years, they all continue to be available for sale, albeit in new and updated editions.

Now, there may be selective memory at work, but I cannot remember the titles of any of the other books, the ones which, apparently, did not become classics, merely used book store fodder.

How many and which books about investing should you read? Obviously, that depends on what you have already read, where you are starting, and what your investment goals are. For a beginning investor, though, a good book to start with would be Mutual Funds For Dummies by Eric Tyson.

For more advanced investors, there are several books you might consider, which I’ll discuss in future posts. Stay tuned.