Yes, Virginia, bubbles do exist.  Years ago my professors downplayed the importance of speculative bubbles, but I think the evidence is clear.  In the last 15 years I would argue that we have had (at least) four separate bubbles.  Two of those bubbles have already popped, and of those I am sure there will be no disagreement.  Bubble #1 was technology stocks (remember all of the dot-com companies?) of the 1990s and bubble #2, housing prices, which from 2001 – 2006 went sky high, simply because people fell in love with the sure-fire benefits of owning them. 

Now, I cannot prove it yet, because prices are still high, but I believe we have had a bubble in gold, and to some extent, silver prices.  (I wrote about this last November.)  The phrase “as good as gold” has a long history and a certain charm, but I would not bet my own money, nor my clients’ money for that matter, on whether gold will continue to do so well. 

A Bond Bubble?

I believe that we have also had a bubble in bonds.  Admittedly, bonds have done extremely well in the past, but you don’t win a race by looking backwards.  Are too many people flocking to the supposed “safety” of bonds?  We will see.

Diversification works, but not always.  It is foolish to concentrate your investments in a narrow selection of securities.  Because we cannot predict the future, we diversify.  But in a crisis, when investors are panicking, most assets fall, in lock step.  

There have been some exceptions; we can count on cash to be stable, and money market funds have been a safe, if not very profitable, bet.  U.S. Treasury bonds usually rise when other riskier assets are falling, but even this may change at some point in time.

A fairly quick recovery of the economy usually follows a recession, but not if it is caused by a financial crisis. This is something Carmen Reinhart and Kenneth Rogoff demonstrate in their book: This Time Is Different: Eight Centuries of Financial Folly. We are living through a very slow recovery, which should not surprise us, given the financial crisis that started the Great Recession.

Decisions by the Federal Reserve are very important but not a sure thing and, certainly, not always the right thing.  The Fed can influence interest rates, the economy and people’s expectations.  They can slow the economy down when it is overheated, and they can give it a boost when the economy is not growing, but there are limits to just how much they can accomplish. We will learn more about this in the next few years, as events are still unfolding and history is still being written. And, speaking of history, it has shown us (witness the Great Depression) that the Fed’s decisions are not always the right ones. The hope of course, is that they, and other central banks, have learned from past mistakes.

Those in the know, don’t always know.  Economists are not very good at predicting anything useful: the growth in the economy, interest rates, exchange rates, stock prices.  Top management of a publicly traded stock may be buying their company’s shares like there is no tomorrow, but they can be wrong.  Hedge fund managers who have had spectacular results can make bets that turn out spectacularly wrong.  Investment “experts” are right some of the time, but are wrong frequently.  (See this post.)

Investor behavior is more important than investment returns.  To get the long term returns that stocks have delivered over time, you cannot periodically panic, sell your stock investments, and “go to cash.” If your strategy is to “get back in” at a safer time, you will undoubtedly miss the rebound in stock prices. (If you were out of the stock market in 2003 or 2009, you cannot get those large returns back.)  Just because the media and your friends are telling you how terrible things are, don’t go along with the “end of the world” story.  (See this post.)  If you do panic, you will almost certainly hurt your results. 

Conclusion

I am thankful that I learned Micro Economics, Macro Economics and Monetary Economics from some wonderful professors.  Knowing what incentives drive producers and consumers and how markets work is very helpful. But it is not enough. 

In graduate school, I loved studying Modern Portfolio Theory.  MPT was so new that we read the original groundbreaking work, before it was even in textbooks.  But I am always looking for practical ways to implement it. 

Understanding risk premiums and historical returns of various investments is useful, but it is not sufficient.  Mathematical models are helpful, but they are not foolproof.  To me Portfolio Optimization is a useful framework in theory, but not very practical in application.

We should always remember that people and events are not as predictable as we would like to think.  Economics is a social science not a physical science. Psychology frequently plays an important and changeable role.  We should not forget that our crystal ball is always cloudy.  

To many people, investing can seem a bit like a game of chance. Tracking the daily fluctuations in the equity markets can make it difficult (some might say impossible) to make any sense of investing.

Turn on the television to learn about the stock market, and too often, what you will find is talking heads.  They are no help; they are misleading, because they generally  speak only of the short term. These TV stock market commentators are always predicting future prices for stocks, bonds, currencies, etc.  It doesn’t matter if they disagree (which they regularly do, since it makes for more interesting conversation) or whether one or another turns out to be correct or way off. You never hear how their predictions turned out.

A Better Way

Modern Portfolio Theory (MPT) is a very different approach to investing. It does not depend on predicting the future or analyzing individual stocks. It is based on decades of academic research. In fact, several individuals have won Nobel prizes as a result of their discoveries related to the way securities markets work. MPT has also influenced the way many pension funds and college endowments are invested, including Yale’s.

Think of Modern Portfolio Theory’s message as the opposite of what Wall Street wants you to believe, which is that their analysts have the secret to successful investing through superior stock selection.

For a good solid introduction to the practical implications of Modern Portfolio Theory, you can view Henry Blodget’s recent interviews with Ken French, Professor of Finance at the Tuck School of Business at Dartmouth College.

The first video is Buy and Hold Versus Timing the Market.

The second video is Stock Picking Versus Index Investing.

Each video is about 5 minutes long.

Dimensional Fund Advisors

Ken French is not merely a prolific academic researcher; he is also the Director of Investment Strategy for Dimensional Fund Advisors (DFA). DFA applies academic research on capital market behavior to the practical world of managing investment portfolios. The firm maintains close ties with the University of Chicago and other research centers for financial economics.

DFA’s approach is firmly rooted in the belief that markets are “efficient,” and that investors’ returns are determined primarily by asset allocation decisions, not market timing or stock picking. DFA has no economists forecasting business cycles or interest rates, no investment strategists shifting allocations between stocks and bonds, and no analysts seeking “underpriced” stocks.

With $140 billion under management, Dimensional Fund Advisors is the leading provider of structured investment strategies in the world. DFA funds are carefully constructed to capture the returns of a well-defined asset class that has historically provided investors with a substantial premium for the risks those investors took.

DFA funds are only available to institutional investors and through a select group of fee-only financial advisors who subscribe to the passive asset class investment philosophy.

Along with other select funds, I recommend DFA funds be included in my client portfolios.

It’s a nice change of pace to have something positive to say about an investing article from the mainstream media. Believe me when I say that finding and commenting on misleading articles can be exhausting.

Well, Forbes’ recent article on Portfolio Calculus For Your 401(k) is nothing short of a breath of fresh air. It is a well-written article which offers a succinct explanation of Modern Portfolio Theory and its practical application to investing in a 401(k) plan.

There is no hype, no promises to “beat the market.” Just good sensible advice. AAII Staff is credited as the article’s writer; AAII being an acronym for the American Association of Individual Investors, a non-profit organization that educates its members about investing and financial planning issues.

The article recommends four very sensible steps to creating a well-balanced 401(k) portfolio.

1. Determine Your Risk/Return Preference
2. Form a Diversified Portfolio
3. Select Mutual Funds
4. Rebalance Periodically

I could not agree more with the process outlined; the first three steps are quite intuitive, and need no further explanation beyond that in the article. Not so with the last step.

Rebalancing

As the article explains, from time to time, you need to “readjust” your portfolio to restore its original balance. Because of market forces, the relative values of the components of your investments change over time. That’s the reason why you diversified your portfolio in the first place (or at least, why you should).

The rebalancing solution may be difficult for many investors for two reasons. First because you may have to sell off some of your “winners” and buy more “losers.” From a psychological standpoint, this may be an unusual and counterintuitive decision for many investors. But merely by virtue of market dynamics, “winners” cannot always be “winners” and “losers” will not always be “losers.” Second, if you have more than one investment account, you will have to decide which one to rebalance and when to do it. This can depend on the options available in your retirement account, cost of transactions, tax considerations, restrictions, etc.

It may not be easy, but periodic rebalancing of your portfolio is essential if you want to prevent it from getting “out of whack.”

Your Entire Portfolio

While the singular aim of the article was to explain what to do with a 401(k) allocation, similar considerations can and should apply to all of your investments. In fact, I believe that you should set up  your entire portfolio at the same time that you are making decisions about your 401(k).

Asset Location

When setting up a portfolio, one factor not sufficiently mentioned, though, is asset location — how you distribute your investments across taxable and tax-deferred accounts, e.g., 401(k) or IRAs.

The goal is to divide your investments in a way that will defer taxes and ultimately provide the best after-tax returns.

Under current U.S. tax law, long-term capital gains and “qualified” dividends are taxed at 15 percent for most taxpayers, and most other investment income (nonqualified dividends, interest and short-term gains) is taxed at marginal rates of up to 38 percent.

Not only are different kinds of income taxed at different rates, but income from tax-deferred accounts isn’t taxed in the year it is earned – instead, all contributions and earnings are taxed when the money is taken out.

While this seems complicated, we can simplify to some extent. In general I recommend that you hold tax-efficient assets like stock index mutual funds in taxable accounts. Tax-inefficient holdings, such as fixed income funds and Real Estate Investment Trusts should be held in tax-deferred accounts, whether it is a 401(k) plan or an IRA.

Conclusion

For any investor, this Forbes article is more than worthy of earning a place among your browser’s bookmarks. Bear in mind, though, that for some investors actual implementation of rebalancing and asset location may pose a challenge.

“There is no free-lunch in investing. Higher rewards are associated with higher risk.” – Burton Malkiel.

As I mentioned in a previous post, Benjamin Graham’s The Intelligent Investor was extremely influential, not just to me, but to a lot of investors. Distinguishing between speculation and a decision based on careful analysis was certainly a breakthrough. Although his analysis was logical and thorough and his recommendations practical, I do not recommend following his approach.

Author Jason Zweig said, “Graham was not just one of the best investors of all time; he remains far and away the greatest thinker about investing who ever lived.”

Challenging the Master

Given that praise, how can I dare disagree with his approach? Well, Graham was heavily influenced by the Great Depression and its aftermath. Stocks were in such disfavor that they were selling at extreme bargain prices. That’s no longer true.

While many of his ideas do stand the test of time, they were established before the development of Modern Portfolio Theory. MPT is, in effect, a second revolution superseding Graham’s analytical approach.

Risk and Return

Graham disagreed that returns and risk are necessarily related. Instead, he believed that intelligent effort can tip the odds in your favor. Furthermore, he believed that skill can increase returns. I believe that risk and return are inextricably linked and that skill is unlikely to change that.

He maintained that an investor could learn to analyze a company and arrive at its “real” value. He further claimed that, if a stock was selling below its calculated “real” value, then an investor was sure to make a profit. More recent research suggests that, while “value stocks” have had periods of high returns, it is because of their higher risk. It is exceedingly difficult (some would say impossible) to find mis-priced securities, i.e. bargains, on a consistent basis.

Moreover, Graham advocated that one could profitably invest in companies that were “out of favor, because of unsatisfactory developments of the temporary nature.” In a situation such as that, he recommended that investors keep exclusively to large companies. Had he been privy to the research that was to be done two decades later, no doubt he would have acknowledged that small value companies generally outperform large value companies.

Diversification

Regarding diversification, he recommended a minimum of 10 different stocks and a maximum of about 30. If you were to restrict your investments to one asset class, say large cap stocks, 10 to 30 stocks might be enough for diversification.

But, you may wonder, what about small cap stocks, or foreign stocks from developed countries? When Graham was writing his magnum opus (remember, published in 1949), these stocks were thought to be too risky to even consider. In my opinion, in the current era, they should be included in a well-diversified investment portfolio.

And what about emerging markets stocks and Real Estate Investment Trusts? These investment instruments did not exist when Graham was writing, nor perhaps, were they even envisioned.

Security Analysis

Rather than a buy-and-hold strategy of a globally diversified portfolio, Graham recommended:

1. Buying in “low” markets and selling in “high” markets
2. Buying carefully chosen “growth stocks”
3. Buying “bargain issues” of various types
4. Buying into “special situations”

He admitted that it was difficult to implement this policy. Currently “difficult” would be considered an extreme understatement. Impossible would be more accurate.

To Be Fair

It is certainly unfair to crtiticize Graham for not knowing things that no one could have known at the time he was writing. However, the point is that if you only read The Intelligent Investor, you have done yourself a disservice. There are several other books worth considering, and I will cover them in the future.

For a more up to date view, read the 2003 edition of The Intelligent Investor, with Jason Zweig’s extensive commentaries on each chapter. These are a very valuable contribution in their own right. He provides extensive research, charts, and tables that update the book, at least through the period right after the Dot-Com bubble burst. He seems to take delight in quoting various Wall Street luminaries who were totally optimistic in 1999 and 2000, and who were totally wrong!

To be continued …