We're Not All Experts

I've been working in the retirement / investment planning world for a long time now.  I don't recall anyone I've ever talked to about retirement, meaning hundreds of people, expressing much confidence in their retirement planning.  There are just too many variables, and too many programs like social security and Medicare they don't understand.

However, when it comes to talking to many of those same people about investing, there is not only confidence, but more recently overconfidence about how to do things.  Why is that?  Consider a few macro-reasons:

1) Thanks to American innovation and capitalism, the stock market goes up over long periods of time.  It also goes down, sometimes sharply, for short periods of time, but people eventually forget about that short-term pain.  So, over long periods of time, they see their money grow, and they assume this means they're great investors.  In fact, all they've really done is to stumble into one of the greatest passive investment strategies there is -- put money in stocks, and do nothing.  This works fine, until retirement, when you no longer want too much invested in stocks.

2) The proliferation of financial media outlets in the past two decades has given people many opportunities to be 'enlightened' by so-called investing experts.  Watch enough TV or read enough on the internet, and soon people are convinced that they too, are experts by simply following the unsolicited advice of these other so-called experts.  If anyone actually tracked their results, they'd be disappointed, but rarely does anyone track the performance of a media-expert.  Also, no one wants to be inconvenienced by the truth.

3) A perfect pandemic storm that includes the introduction of no-fee securities trading, a massive surge in technology stocks, and social media platforms and influencers.  Many in the new 'work-from anywhere'  crowd have only been able to do this investing thing for a short time, during a prolonged market upswing.  At this point, they think the stock market and their investments only go up.  Their confirmation bias will ultimately lead them into one of the inevitable sharp short-term market corrections.  Unlike others, this millennial-heavy group isn't likely to have the patience or discipline to keep from exiting their positions.

Investing doesn't have to be complicated, but it decidedly isn't a simple thing.  The only sure thing is, being overconfident in one's ability to do it will lead to a bad outcome.

Opposite Day(s)

The coronavirus is spreading across the continents.  The stock market and interest rates are tanking.  This is a good time for some perspective (on the markets, not on the virus).....

When stocks decline sharply, the steady flow of negative news reports drives many people to flee the markets out of fear -- and miss out on potential gains as financial markets inevitably regain their strength over the next few months and years.

Right now, we're actually going through the third(!) stock market drop of 10% or more in the past 13 months.  The other times, as well as all of the other times before that, the markets recovered and went on to new highs.  Yet people are still fearful.

So how do you keep the fear from prevailing?

Simple.  Long-term investors should do the opposite of what they want to do.  That is, instead of watching the markets and reacting, they should ignore the markets and do nothing.

It's OK to not check your investment / 401k / 403b account balance when the market is falling.  It’s also OK to not watch or listen to financial news.  In fact, turning off the financial news is the smartest anyone can do if it keeps them from making mistakes based on emotional decisions.

The real contrarians will actually do something -- they'll buy into the falling markets, and of course, sell into the gaining ones.  They're the smart ones.

Be smart.  Be brave.  Be opposite.

Correlation Is Not Causation

A few years have passed since I’ve blogged about investing.  I used to post more about it when I worked at a firm where I put myself in charge of writing a quarterly investment newsletter of sorts; then I’d basically copy and paste what I’d already written.

One of the themes of that prior investment writing I did was how there was little, if any, correlation between how the markets perform over long periods and virtually any other specific individual thing.  Investing history and statistics prove that if X happens, it does not impact the future of Y.

The best current example of this investing correlation mistake is people who want to correlate the political parties with stock market performance.  The fact is, there has never been a correlation between those two things.  [Note to those Republicans who still believe those things are related, you actually want a Democrat in office, because the stock market went up more during three democratic presidential terms than for any republican presidency.]

Another very broad example of this investing correlation fallacy involves technical trading, which is buying or selling based on nothing more than the grid lines on a chart. For some, these simple securities price charts signal a breakout up or down, ergo an investing opportunity.  It's amazing how many otherwise smart people believe in this type of technical 'strategy' when it has nothing to do with the underlying company.  It's stupid.

This all makes me think, what other things do people want to positively or negatively correlate that have no real correlation?  There are so many, but here are a few that annoy me:

* Scholastic grades and intelligence.

* Hours spent at the office and work.

* Owning a Fitbit (or other electronic health tracking device) and weight loss.

2018

Another New Year's Eve (eve) is here, so it's time for my annual review of the things I wanted to have happen in the past year, and a fresh list of things I want to have happen in the next year.  Here's the 2017 list, with comments in ALL CAPS:

-Again:  At least some progress on medical marijuana in Iowa,

THE GOOD NEWS IS, SOME PROGRESS WAS MADE.  IT'S GOING TO BE A TAD BIT EASIER FOR THOSE WHO NEED IT TO GET IT.  THE BAD NEWS IS, IOWA IS STILL NOT FULLY COMMITTED TO IT.

-Some type of institutional or legal control over fake news / social media.

FACEBOOK HAS TAKEN SOME ACTION, ALBEIT TOO LITTLE, TOO LATE.  AT THIS POINT, IT'S HARD TO GET IN FRONT OF IT, BECAUSE THE PRESIDENT LIVES IN A VIRTUAL REALTY WORLD THAT HE WANTS OTHERS TO BELIEVE IS NORMAL.

-Related to the above, more critical thinkers, fewer idiots who believe everything they hear.

THERE ARE MORE CRITICAL THINKERS ON THE LEFT, AND LET'S JUST SAY FEWER CRITICAL THINKERS ON THE RIGHT.

-GPS technology used in major sporting events, e.g. to mark the ball in football games, and for the strike zone in baseball games.

NOPE.  LOSERS.

-More working from home by me.

THIS HAPPENED, BUT TO ONLY ABOUT 25% OF THE LEVEL IT SHOULD HAVE.

-The return of popular mainstream rock bands and rock music.

THIS DIDN'T HAPPEN, HOWEVER, I SAW RED HOT CHILI PEPPERS AND JOE WALSH AND TOM PETTY (AND SCHEDULED TO SEE BOB SEGER) IN CONCERT.  SO IT WASN'T ALL BAD.

-Implementation of the fiduciary rule, and the demise of commission-based financial advice.

THE CURRENT ADMINISTRATION ALLOWED THE RULES TO GO INTO EFFECT, BUT THERE WILL BE NO ENFORCEMENT UNTIL AT LEAST 2019.  SO, NO.  AND SINCE FINANCIAL INSTITUTIONS ARE IN THE REPUBLICAN'S POCKETS, MIGHT AS WELL FORGET ABOUT THIS FOR A FEW MORE YEARS.

-The resignation or impeachment of an unqualified president -- no names, any one will do.

NOT AS CRAZY AS IT SOUNDED LAST YEAR. WILL ADD PUSH THIS FORWARD.  IT WON'T BE ANY FUN TO ASK IT FOR 2019 BECAUSE BY THEN IT WILL BE LIKELY.

For 2018 I'd like to see:

The failure of Bitcoin, not as an idea, but as an investment.

An NCAA scandal so large they will have to start allowing players a cut of revenues.

More destinations and ways to fly on Southwest Airlines.

A widespread ability to charge devices without a cord (also asked for this for 2016).

A new governor / lieutenant governor elected for Iowa. 

Let's try this -- exponential growth in the cannabis industry to the extent all states will want a piece of it through taxation.

Greater national and international awareness of CRISPR (genome editing) technology.

Smaller entree portions served in restaurants, for a reduced price.

Fewer national weather disasters, but more understanding of climate change.

The resignation or impeachment of a mentally unstable and unqualified president -- again, no names.

Saving Investors From Themselves

One of the smartest financial journalists I follow is Jason Zweig.  He isn't a media darling, but he's fairly well-known for writing a column for the Wall Street Journal, and he's also authored books and operates his own web / blogging site at jasonzweig.com.

I was looking at his blog archive recently, and came across a gem from three years ago called, "Saving Investors From Themselves."  He's writing about financial journalists, but he could just as well be writing about financial advisors.

Here's an excerpt -- if you don't want to read it all, at least read the last sentence.

I was once asked, at a journalism conference, how I defined my job.  I said:  My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly.  The temptation to pander is almost irresistible.  And while people need good advice, what they want is advice that sounds good.

In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.

It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news.  It’s also no wonder that the media has ignored those findings.  Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.

My job, as I see it, is to learn from other people’s mistakes and from my own.  Above all, it means trying to save people from themselves.  As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics:  Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.

My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it.  I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot.  Instead of pandering to investors’ own worst tendencies,  I try to push back.  My role is also to remind them constantly that knowing what not to do is much more important than what to do.  Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.

Fiduciary Rules!

Within the next few months, the U.S. Department of Labor is expected to release final rules that will impose a fiduciary standard of care on financial advisors (including insurance agents) working with qualified retirement employer-sponsored plans and individual retirement accounts.  While I'm generally against more regulations, this happens to be of the best and most overdue pieces of federal rule-making ever.

First, let’s clarify the two different rules under which financial advisors currently operate.

Suitability Standard of Care
Most financial advisors, including financial company representatives and insurance salespersons, operate under the suitability standard of care.  Generally speaking, the suitability standard simply requires the advisor to 1) know the client and their financial situation, and 2) recommend products that are suitable for their situation.

Fiduciary Standard of Care
Some financial advisors, including Certified Financial Planner® professionals, must operate under the fiduciary standard of care.  Under this standard, advisors must 1) put the client's best interest first; 2) act with prudence, meaning with the skill, diligence and good judgment of a professional; 3) provide full and fair disclosure of all important facts; 4) avoid conflicts of interest; and 5) fully disclose and fairly manage, in the client's favor, unavoidable conflicts.

While the general public often assumes financial advisors are working in the client’s best interests, in fact, most are not bound to do so.  The new Labor Department rules would change that, making the fiduciary standard the actual standard in financial advising.  It boils down to every advisor following the highest standard of care regarding investment advice and retirement planning.

Seems like a slam-dunk, right?  In truth, large financial institutions (particularly insurers) are spending millions in a lobbying effort to stop the rules from being codified.  There is only one viable reason for this:  Greed.

Big financial institutions use the fecklessness of the suitability rule to sell lots of useless financial products to trusting people who don't need them, thereby capturing huge commissions and other fees.  This is great for the company, while simultaneously terrible for everyone else.  In short, those companies value profits over people.

Let's just hope this fiduciary rule regulation is made final, and comes with the enforcement it deserves.

Be Greedy When Others Are Fearful

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."  --Warren Buffett, October 2008

This quote about investing in stocks may be many years old, but it applies like new based on the last 10 days of stock market trading.

A downturn in the investment marketplace creates a natural fear for even the most experienced investor.  When something is cutting away at our net worth, we want to stop it as soon as possible.  We want to do something.

Here’s the problem:  Leaving the markets in that environment is generally a bad idea, because it’s done out of fear.  People make the biggest investment mistakes when they’re fearful.  It’s even more powerful than greed, and there's proof.

Daniel Kahneman is a research psychologist, but he won the 2002 Nobel prize in economics for his work in an area now referred to as behavioral economics.  His research reveals that the response to a price drop generates a much stronger emotion than a response to an equal price gain.  In short, he found that most people fear loss much more than they enjoy success, and this makes fear a powerful enemy of an otherwise level-headed investor.

If we feel the urge to reduce our stock or bond allocation during a market downturn, our challenge is to recognize Kahneman’s observation.  We need to remember that we picked our asset allocation target during a period when we weren't emotional, and did it for good reason.  We must also remember that short-term market movements are of little-to-no consequence if we have a long-term investment horizon.

That said, we should do something during a big market correction -- but not leave the market.  Rather, we should rebalance to our pre-chosen allocation target, effectively buying more stocks or bonds at a time when we may fear it most.  Then later, when those markets inevitably recover, we should try to enjoy our success more!

Post #300

This is my 300th blog post since I started it around six years ago.  As with post #200, let's take a look at some of what I wrote about over the past 100 posts spanning about two years:

I wrote with more practical, real life advice for high school and college graduates.

I wrote about a variety of investment issues, client-approved of course.

I wrote about how a political lackey masquerading as a university president ended VEISHEA.

I wrote more about the best songwriters and lyrics from yesteryear.

I wrote about how pop culture should start ignoring Lolo Jones, well before pop culture came to the same conclusion.

I wrote about major cities I visited.

I wrote more about taxpayers getting fleeced, and the primary non-profit fleecers.

I wrote about how medical doctors are self-centered, not patient-centered.

I wrote about what turning 50 years old meant to me, in a mostly non-philosophical way.

I wrote about a variety of ways that people / politicians / governments refuse to accept the evolution of social issues, such as how dumb it is to oppose both medical marijuana and decriminalization of marijuana, and how dumb it is to allow 2,000+ year-old religious doctrine control all of their secular decisions.

I wrote a little bit about a lot of other things, all in the name of getting things off my mind.

No Thanks Necessary

Your investments had a great 2014, or so it appears.  Your portfolio went up over 15%, and now you want to go out of your way to thank your investment advisor.

Instead, you ought to be looking for a new advisor.  If your portfolio went up that much last year, it means virtually all of your money was invested in U.S. stocks.  In turn, that means your advisor did not focus on something that should have been of equal concern: Risk.

No doubt, U.S. stocks performed well last year -- but what if they hadn't?  History has taught us that no one can accurately predict the short-term direction of the investment marketplace.  No one, investment advisors included, knows exactly when the market will go up or down, or when to jump in or out.

So managed properly, your investment portfolio would include more than just U.S. equities.  It would include other asset classes whose returns don't always move in the same direction, nor with the same volatility, as the overall domestic stock market.  These risk-diversifying assets would include things like corporate bonds, international stocks, government bonds, and real estate.

Last year, most of these 'non-correlated' asset classes did not perform as well as the U.S. stock market, and if you had them in your portfolio, they reduced your overall return.  However, those assets also substantially reduced your risk of having a horrible year, from which it could take many years to recover.

If your investment advisor had focused on risk as well as performance, then it was mathematically improbable to generate a 15% return in 2014.  They deserve no thanks.

Good investment advisors, and you, should focus instead on risk-adjusted return.  You may not have huge shorter-term investment gains, but more importantly, you'll likely avoid huge losses.

A Working Model

In the investment business, there are three basic models that firms utilize to deliver investments and/or advice to their clients.  They don't all work well for investors.

Let's start with the commission model.  In this model, the advisor (known as a 'Registered Representative' of a 'broker-dealer' firm), is compensated for the investments that are utilized.  Many securities, including virtually all annuities and life insurance, are sold this way.  Those commissions pay the advisor an up-front, often substantial amount, which the investor ultimately repays directly or indirectly via account deductions.

Another model is called fee-based, and it's essentially the commission model with a twist.  That is, these advisors usually have licenses which also allow them to give advice for a fee, in addition to their Registered Representative licenses. These dual-licensed advisors are called fee-based, because they can provide investment advice for a fee, but they primarily continue to utilize commission-based compensation for making a sale.

The third model is the fee-only model. Practitioners of this model are licensed as Investment Advisor Representatives (IAR) of a Registered Investment Advisor (RIA).  Many of them also have attained the Certified Financial Planner® professional designation.  The term 'fee-only' acknowledges that they are only compensated by the transparent, negotiated fees (not unspecified commissions) their clients pay.

Unfortunately, most advisors aren't fee-only, even though that model makes the most sense for those seeking help.  Consider the possible conflict of interest when a commission-based advisor sells an investment product -- can the investor truly know if the size of the commission impacted the sale?  By not receiving commissions for the investments recommended, a fee-only advisor eliminates this uncertainty.

Also, since commissions are paid up-front, what is that advisor’s incentive to provide ongoing client-service?  Fee-only advisors charge a flat amount, or a percentage based on the assets they manage -- but in either case, it isn't paid until AFTER the work is done.  Since this fee is only a fraction of the commissions that would otherwise be paid, the fee-only advisor must continue to work diligently, as the client can end the relationship at any point.

I am a fee-only advisor.  I remove the conflicts of interest that could otherwise exist between investors and advisors, because our interests are the same.  That shared interest shapes how we interact, to create and maintain the trust needed to successfully work together.

(Un)American Pickers

First, a lesson on stock dispersion in investing.

Low stock dispersion means that stocks are generally moving in the same direction. High stock dispersion means that individual stocks are headed in more unpredictable directions, as has been the case so far in 2014.  While the so-called financial experts are always calling it a ‘stock picker’s market’ (because they make money on trading), they are louder about it during those periods of high dispersion.

If stocks have low dispersion, presumably an active stock picker should find it more difficult to beat a relative benchmark index.  Conversely, when stocks are acting more independent of one another, there should be more opportunity for skillful (or lucky) investors to outperform.  Of course, there is also a greater opportunity for the less skillful (or unlucky) investor to underperform.

A new study titled Dispersion:  Measuring Market Opportunity, by S&P Dow Jones, suggests there is no evidence to support the notion that stock picking is easier or better done when there is wide dispersion among individual stock returns.  In fact, the data suggest the probability that actively managed mutual funds will outperform the market (already a less than 50% chance after expenses) is no higher during periods of high dispersion than low dispersion.

It all makes sense.  Why should a greater percentage of active fund managers outperform during periods of high dispersion?  Their skill doesn't suddenly increase during these periods.

Money managers who masquerade as financial advisors have lots of marketing ploys they use when promoting their services, and saying it’s a ‘stock picker’s market’ is among the most used.   But the truth is the same as always – there’s no extra benefit to the guesswork of active management.   Use a passive, index-type approach to investing, and you’ll be farther ahead in the long run.

How To Lose Money In The Market

Do most mutual fund managers add value in their attempts to identify 'mispriced' securities? 

Based on a recent analysis of the CRSP (Center for Research in Security Prices) Mutual Fund Database returns data through 2012, we have a pretty good idea of the answer.

This CRSP report documents survivorship and performance in the U.S. mutual fund industry, and illustrates the negative impact of high fees and turnover on returns.  In summary, for the periods examined:

*Outperforming funds were in the minority
*Strong track records failed to persist
*High costs and excessive turnover may have contributed to underperformance

The underperformance among mutual funds points to an important guiding investment principle:  Choosing a long-term winner involves more than seeking out funds with a successful track record, since past performance offers no guarantee future success.  Investors must consider other variables, including a mutual fund’s underlying market philosophy, investment objectives, and perhaps most importantly, cost. 

The competitive landscape makes the search for future winners a formidable challenge. Confronted with so many fund choices – and lacking an investment philosophy to guide their search – some investors resort to picking funds that have strong track records, reasoning that past outperformers will continue to outpace their benchmarks.

According to the CRSP analysis, only about a quarter of the equity funds with past outperformance during the initial three-year period (2007-2009) continued to beat their benchmarks in the subsequent three-year period (2010-2012).  The results for funds with good five- and seven-year track records were similar – only about a quarter beat their benchmarks in the subsequent period.

So, do most mutual fund managers add value in their attempts to identify 'mispriced' securities?  This CRSP analysis of U.S. mutual fund industry performance tells us the answer is a resounding, "No!"  It’s more proof that a broad, low cost investment approach is the best one.

The Investment Wallflower

Nearly every conversation about the investment marketplace focuses on the stock market.  From the media to financial advisors to investors, the bond market has long been an overlooked wallflower at the proverbial investment dance, even though it has experienced exceptional risk-adjusted returns over many years.

However, the bond market is currently the one that deserves attention.  After a decades-long run of falling interest rates (and thus bond prices rising), bond yields recently have risen sharply, negatively impacting those portfolios with significant exposure to what many consider a ‘safe’ investment.

Generally speaking, the bond market works like this:  As demand rises for less risky investments, bond prices go up.  If you are a bond issuer, such as a government or a corporation, heavy demand means you can get away with paying a lower yield.  Borrowing gets cheaper, with a hoped-for side effect of economic stimulation.

After the 2008 financial panic, bond prices rose to a great degree because the U.S. Federal Reserve started buying billions of dollars of government-issued debt.  Without this central bank action, demand surely would fall, and issuers would be forced to pay higher rates, potentially stifling an economic recovery.

In the past several months, uncertainty about when the Fed might taper its purchases caused a broad selloff in bonds.  Yields climbed rapidly, and fixed income investors suffered losses.  Note that nothing actually changed; rather, the bond market reacted in a volatile way to the mere perception of a change.

No one knows exactly when the Fed will decrease its government bond purchases, but fortunately, we don’t have to know to have a good investment outcome.  A successful investment portfolio doesn’t come from market timing – it comes from a low-cost, risk-appropriate mix of stocks and bonds based on time horizon, with disciplined rebalancing to that mix as necessary.

Managing bond risk is no different than managing stock risk, in the sense that emotion-free decision-making is critical.  The bond market wallflower may suddenly want more attention, but that doesn’t mean you have to change how you dance. 

How To Win A Coin Toss

If you were told your odds of investing success were no better than a coin toss, how would you react?

Standard & Poor's recently published an annual year-end scorecard, called the Standard & Poor’s Indices Versus Active (SPIVA) report.  SPIVA compares the performance of active mutual funds versus their respective benchmark indices.  Not surprisingly, the results continue to favor the indices.

For the 5-year period ending December 31, 2012, 79% of actively managed U.S. equity funds failed to beat their benchmark index.  The percentage that failed for international equity and fixed income funds were 66% and 69%, respectively.  Put another way, the odds of picking an active fund that outperformed its benchmark were less than successfully calling a coin toss!

Unfortunately, these results do not fully paint the picture of active management's underperformance.  SPIVA’s return measurements do not take into account significant fees that most active mutual funds charge.  Additional costs include management expenses, commissions, and marketing fees, all of which further reduce returns.

This is another of a multitude of studies that reach the same conclusion:  Investors expose themselves to additional market risk from active managers' attempts to outperform a given benchmark – risk that is not compensated by higher returns.  Further, the higher costs associated with active mutual fund investing make the probability of outperforming the market extremely unlikely.

I have always advocated a different approach to investing, one that acknowledges what SPIVA confirms.  Specifically, allocating and owning a portfolio of passively managed, tax efficient, and low cost funds allow investors to capture the most that capital markets provide year after year.

Investors’ assets should not be left to chance.  By using a passive investing strategy, you can markedly and consistently improve the odds of investing success beyond the toss of a coin.

Post #200

Since July of 2009, I've been writing random thoughts out in this blog.  This is post #200, so just as I did with post #100, let's review some of what was covered in the last 100 posts, or basically the past two years.....

I spent a little time writing about the importance of certain singers and song lyrics.

I spent some time writing about finance and investing, which is the work I do for a living.

I spent a good deal of time writing about politics, particularly in 2012 as related to the presidential election.

I spent a bunch of time writing about people who are dishonest, how to identify them, and calling them out.

I spent too much time, but will probably spend more, writing about the moral hazards of religion.

I spent a lot of time, and will definitely spend more, writing about how taxpayers are being shafted by people in government who make selfish decisions.

Many Happy Returns

The end of the year encourages retrospectives about financial markets.  So let’s match that up with what ‘financial experts’ were saying a year ago.

In December 2011, a Barron’s panel of ten stock market strategists and investment managers predicted the S&P 500 index to end 2012 some 11.5% higher.  There was so much for these forecasters to consider – and to get right.  The euro zone crisis, uncertainties over the growth of earnings, and the U.S. presidential election and ‘fiscal cliff’ were all major concerns.

Twelve months later, markets are still grappling with many of the same issues.  However, that Barron’s panel forecast, which the magazine said was ambitious, now looks conservative – the S&P 500 index was up 16.0% for the year.  International market returns were even stronger, generally speaking.

As usual, there are a few lessons here.  First, while ongoing news headlines can cause people to worry, it’s important to remember that markets are forward-looking and absorb information very quickly.  By the time you read about it in the newspaper, the markets have usually reacted, and gone on to worrying about something else.

Second, the economy and the market are different things.  Good or bad economic news is important to stock prices only if it is different from the information that the market has already priced in.

Third, forecasting the investment market is a challenge for the best of us.  If you are going to invest via forecasts, realize that not only must you correctly predict what will happen around the globe, but also correctly predict how markets will react to those events.

Everyone should take an interest in what is happening in the world, but care needs to be taken in extrapolating the headlines into investment decisions.  It’s far better to let the market do the worrying for you, and diversify around risks you are willing to take.

In the meantime, many happy returns! 

(Un)conventional Thinking

One of the simplest and most common questions asked of investment advisors is, "What stock should I buy?"  Another frequent request is, "Where do you think the market is going?"

Although these questions ask different things, they share something in common – they are asking someone to make a forecast.  The conventional thinking is, in order to have a successful investment experience, advisors and investment managers should be able to predict the future.  Just pick the investments that will do well, and avoid all the others, right!?

Unfortunately, man versus market isn't a fair fight.  More often than not, the market is going to win.

Identifying investments that have outperformed in the past is easy, but there is no way of determining what will outperform in the future.  While some fund managers are going to ‘beat the market’ from time-to-time, a mountain of academic research tells us it’s no more than you would expect by chance.  In other words, the market always has investments that will do well, but there’s no logical way for man to determine which ones they will be.

So instead of trying to predict the future, I think about this instead:  In the aggregate, investors earn market returns before fees. Since the market reflects the collective holdings of all investors, the value-weighted average investment experience must be the market return after fees.  This is not just a theory; it is a universal truth based on simple arithmetic.

This arithmetic gives me something reliable – rather than a prediction – from which to base investment decisions.  Specifically, if I broadly diversify investments based on client risk tolerance, and keep investment costs to a minimum, I have significantly increased the likelihood of an above-average investment outcome.

Making investment decisions based on this logic certainly isn’t glamorous.  It would be much more exciting to declare which individual stocks I ‘like’ based on a hunch, and then regularly update that list.  Still, I vastly prefer our more reasoned approach.

Investors may never lose the urge to form an opinion about the future, or to ask their advisor for one.  But if those investors ask me, they should expect to hear some unconventional thinking.

Buffett's Words Of Wisdom

On May 7, 2012, CNBC conducted a wide-ranging interview with legendary investor Warren Buffett.  Below are 5 brief excerpts from that interview.  (Glad to see he agrees with me!)

BUFFETT ON CASH:  “I think cash is probably as risky an asset as you can own over time.  You're not taking risk off when you go into cash.  You are going into something that is sure to decline in purchasing power over time.  So that is the biggest risk I know is to own cash.”

BUFFETT ON HYPE:  “Retail investors should not pay any attention to the day's news.  If they're paying attention to the day's news and they're trying to buy and sell stocks based on the day's news, they're never going to be successful investors.  The idea is to buy a good business.  I mean, it's the same way as if you went out to buy a business.  You'd look around for a company, some little business that had good prospects over time, had decent and honest management and where the price made sense.”

BUFFETT ON STOCKS:  “I think equities are very attractive for the long term.  And they may get more attractive next week or next month.  But it's the same thing I said in October of 2008.  I didn't know where bottoms were going to be or where they were going to be in a year.  But equities, good producing businesses are a great thing to own over time, and they will be a great thing to own for the next 100 years.  But who knows whether they go up or down in price next week.”

BUFFETT ON TRADING:  “I'm not a fan of active trading of any kind.  I don't know how to make money trading actively.  Maybe if I did, I wouldn't be so negative on it.  As to the volume, though, there's still way too much volume in the market.  I mean, the idea that the ownership of a company should turn over a hundred percent in a year, that is not the way people behave with apartment houses, it's not the way they behave with farmland.  But they have this notion in stocks that they ought to do something every day.  The best thing to do with stock is buy stock with a good company and don't look at the price for five years or something.”

BUFFETT ON WHAT TO BUY:  “The greatest asset to own is your own abilities. I mean, no matter what happens in the economy or with currency, if you develop your own talents – I tell the college students that the best thing to have is to develop your own talents.  The second best thing is to buy into other people's talents.  You know, here's Coca-Cola, and people are going to be drinking it 10 years or 50 years from now, and they're going to be drinking more of it, and they'll make more money.  So I don't have any idea what Coca-Cola stock is going to do next week or next month or next year, but I'm pretty darn sure where the company will be in 10 or 20 years.  And people beat themselves in the stock market.  The stock market, literally, in the 20th century, went from 66 on the Dow to 11,400.  And you'd said, `How could anybody not have a good experience?'  But millions of people don't because they get excited at the wrong time, and they get depressed at the wrong time.  So you've got to put your emotions aside, you've got to give up the idea that you can decide when to buy stocks and when to sell stocks.  The time to buy stocks is consistently over time.”

Remember December

Remember December?  It was only a few months ago.  Equity markets had just finished a volatile and generally poor year.  European nations were arguing over how to deal with a mountain of sovereign debt, while the rest of the world fretted over how that debt would affect global markets.

Most market analysts expected further tough times in early 2012. Financial magazine Barron's warned, "For investors frightened by the stock market's volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort—at least in the first half."

As an investor, if you had taken that advice and left the stock market, you would have just missed one of the best short‐term equity rallies in recent history. The S&P 500 index was up 12% in the first quarter of 2012, its biggest first‐quarter percentage gain since 1998.  Broader equity market benchmarks also made record or near‐record quarterly gains.

Why the turnaround in markets so far in 2012?  The primary drivers have been signs of economic stabilization in Europe, along with signs of economic recovery in the U.S.  But the most important thing to know is that a few months ago, virtually no one predicted either of those to happen.

This brings me back to my oft‐repeated investment philosophy:  No one knows how markets will perform going forward, because that requires an ability to accurately predict unforeseen events.  Since the future is unknown, it’s best to maintain your pre‐determined asset allocation, in the most diversified and lowest cost manner available.

Market discipline works both ways, of course.  Just as it was wrong to assume the market pessimism of last year would continue into early 2012, it would not be prudent to anticipate that the rest of this year will resemble the first three months.

You can always guess, of course, but experience reveals that isn't a very good investment strategy.   Remember December?

It's Tough To Make Predictions

This is the time of the year when the so-called investment ‘experts’ make their predictions for the coming year.  While this information may be interesting, the predictions are actually much more entertaining when reviewed a year later.

Take the late 2010 Barclays Capital Global Macro Survey of more than 2,000 institutional investors.  The consensus pick for the best performing asset class in 2011 was equities, with a predicted 15% annual gain for the S&P 500 stock index.  Less than 10% of those surveyed said fixed income would be the best performing asset class.

And...wait for it...Surprise!  Fixed income was easily the best performing asset class of the year, with the Barclays aggregate bond index gaining almost 8% in 2011.  Conversely, the year-to-date return for the S&P 500 stock index (including dividends) was 2%.  On a risk-adjusted basis, the disparity is even greater.

Remember, these were the forecasts of big institutional investors – major financial institutions with armies of analysts, mountains of data, and sophisticated forecasting tools.  If the ‘experts’ can't get the broad asset class movements right, what chance do they (or anyone) have of correctly and consistently predicting the performance of individual securities?

In short, they have no chance, but year after year, that doesn't stop them from trying.

What are the lessons to take from this information?

1)  Don’t invest based on economic forecasts.  They are simply media-hyped guesswork.  Over time, unforeseen events are sure to invalidate certain assumptions used in those same forecasts.

2)  There is no substitute for low-cost diversification.  While equity markets were rocky this past year, fixed income markets provided excellent returns.  By staying diversified both across and within asset classes, and keeping investment costs to a minimum, smart investors can enjoy gains now and still be positioned to reap returns when riskier assets come back into favor.

3)  The past is NOT prologue.  As an investment strategy, chasing past returns is no better than chasing predicted returns.  Just because fixed income outperformed the equity market in 2011 is no reason to believe it will do the same in 2012.  Investors should determine their risk tolerance, and not change investment direction unless that tolerance changes.

In the end, when it comes to ‘expert’ forecasts on the direction of investment markets, it’s probably best to remember the words of Yogi Berra:  “It’s tough to make predictions, especially about the future.”