Posts filed under “Rules”
This is post number five in our series, bringing us exactly halfway through our ongoing look at the most common investor errors.
This morning, we are going to briefly look at what may very well be the most common mistake investors make: Being active investors.
Passive vs Active Management
Active fund management – the attempt by an investor or manager to try to outperform their benchmarks through superior stock picking and/or market timing – is exceedingly difficult. It has been shown (repeatedly) that every year, 80% of active managers under-perform their benchmarks.
Those are not particularly attractive odds.
Worse, most active managers typically run higher-fee funds. (all that activity costs money!). That combination — High Fees + Under-performance — are not the ingredients of a winning long-term strategy. This is why for the vast majority of investors, passive index investing is a superior approach.
-Remove the emotional component
-Take advantage of (instead of working against) mean reversion
-Garner the lowest possible fees
-Eliminate all of the friction caused by overtrading
-Keep capital gains taxes as low as possible
-Get good results over the entire long cycle
-Avoids typical cognitive errors
-Stop chasing hot managers and funds
Consider if your portfolio won’t be better served replacing some or all of your active fund managers with passive indices.
This morning we are going to ever so briefly look at mistake number four:
4. Asset Allocation Matters More than Stock Picking: The decisions you make as to your mix of assets has a far greater impact on your investing success than does your stock picking or market timing. This too has proven repeatedly in both academic studies and the real world.
I’ll save you the war story, but when I was on the Sell Side, I was a big Apple fan. When the first iPod came out, the company was trading at $15 (pre-split) with $13 in cash. I recommended Apple, the firm bought a ton at $15, and dumped most of it at $20 for a 33% winner.
Pretty smart, huh?
That was literally the worlds greatest stock — and it hardly mattered at all. The worlds’ greatest stock pickers all got crushed during the 2008 crisis. And a monkey could have thrown a dart at a stock list in 2009 and made a ton of money.
Consider this: If your allocation mix contained too little equities over the past few years, then you probably missed the 100% rally since stocks since March 2009. And a lack of bonds meant that during the 2008-09 crash, you had nothing protecting you as markets fell.
Stock picking is for fun. Asset allocation is for making money over the long haul.
Last week, I mentioned some investor errors investors make, and decided to put together a top 10 list of broad and common mistakes.
So far, we have looked at Excess Fees, and Reaching for Yield. Today we are going to ever so briefly look at mistake number three — behavioral issues in investing. (for far more details, see this collection of posts).
3. You Are Your Own Worst Enemy: Your emotional reactions to market events is yet another detriment to your results. Typically described as Fear & Greed, it is more complex than that. But for starters, Fear & Greed does enough damage.
Do you get excited about hot new companies? Do you love chatting about stocks at cocktail parties? On the other hand, do your holdings keep you up at night? Are there periods where you cannot bear to even open your monthly statements?
These all suggest that you, like most humans, are an emotional investor. This manifests itself in two ways: With heavy buying of equities at the regardless of valuation as excitement builds near the top of the cycle (most public ownership of equities occurs this way); secondly, with panicked selling, typically near major inflection points.
You can take steps to protect yourself from, well, yourself. Predetermine your exits and stick with it. Make decisions while objective, before emotional trouble hits.Set up a Mad Money account with a less than 5% of your capital. This will allow you to indulge “your inner Cramer.” If it works out, that’s great — maybe you are thr next Steve Cohen. If it’s a debacle (and the odds are it will be), it’s a terrific lesson that will serve to remind you that trading in and out of stocks like a deranged hedge fund manager is not your forte. Be thankful it wasn’t most of your retirement assets that you lost.
Your emotions are often the enemy of your financial well-being. Learn how to keep them in check, or to protect yourself from them, to become a better investor.
To start July, we are introducing a series looking at common investor errors. This is the part two of ten. Yesterday, we looked at the impact of excess fees on performance.
In the current low rate environment, many investors make the mistake of reaching for yield. That is our #2 investor error after excess fees.
The first law of economics is there is no free lunch. You would think the mathematics of that would itself be a warning as to the perils of chasing the higher yielding paper, and that it should be self-explanatory. But its not
History shows us there are few investment mistakes more costly then “chasing yield.” Fixed income is supposed to be your safe money, what you have to have back, what will cushion the ups and downs of the equity markets. Hence, you should be first concerned with return of your money, and second, the return on your money.
In other words, safety first for your bonds and preferred.
Don’t take my work for it, just ask the folks who loaded up on sub-prime mortgage-backed securities for the extra yield how that worked out for them. Some people have suggested I cut the RMBS investors some slack, as the paper was rated AAA. I don’t because they willingly violated the Free Lunch edict.
Quick war story: In 2004, I worked at a firm that was occasionally pitched products from other shops. One day, I walked into the conference room to hear Lehman Brothers offer a higher yielding fixed income product. “AAA rated, Safe as Treasuries, yielding 100-300 basis points more. I was subsequently called into my bosses office for saying:
“You guys are either going to win the Nobel prize in economics or go to jail. There is nothing in between.” (Does a firm ending faceplant count as the equivalent of the latter?)
Regardless, we know the outcome of THAT free lunch.
There are three common ways to chase yield: 1) Go out on the duration curve, i.e., buy longer dated bonds; 2) Go down the credit scale, i.e., buy junkier, riskier paper; or 3) use leverage, which amplifies your gains but also amplifies your losses as well.
With the 10 Year Treasury at 1.6%, I see lots of folks trying to capture more income using some combination of the above. Anyone who engages in this sort of ill-advised risky behavior should best understand the risks you are taking, and what that might mean if and when things go awry.
Simple rule of thumb: Never reach for yield.
What are you chasing for Yield?
Top 10 Investor Errors
1. Excess Fees
Earlier this week, I mentioned a short list of common errors many investors make, and cobbled together a top 10. Readers had a number of very astute and specific suggestions.
For my list, I wanted to keep it as broad as possible
During each of the next 10 days, I want to flesh out these ideas in some more detail. While I am traveling, I will post one per day in no particular order, starting with today.
The first error we are going to look at are high fees.
You can define fees in a variety of ways, but to me, its any non-investment spending relative to your portfolio that detracts from long term performance.
These can include:
-Mutual Fund Loads
The bottom line is simply this: High fees cut into your returns. Every academic and industry study that has ever looked at this issue has determined that fees are an enormous drag on long-term performance. Typical mutual fund or advisor fees of 2-3% may not sound like a lot, but compound it over 30 or 40 years and it adds up to an enormous sum of money.
One Morningstar study found that while 10% of mutual fund managers regularly outperformed their benchmark, net after fees that number dropped to 1%.
The hedge fund fee structure of 2% plus 20% of the profits is even more of a drag on returns. Other than a handful of superstar managers (that you likely don’t have access to), the vast majority of hedge funds simple cannot justify their costs. Speaking anecdotally, my experience has found that to be true for most of the retail stock brokers and for many of the investment advisors that work on Wall Street.
Its as true for investment advice as it is anywhere else, the wealthy get a better deal. Fees typically drop significantly on accounts over $1m, then even more over $5m and $10m dollars.
Sub $500k accounts pay the highest fees as a percentage of dollar invested. I have a few ideas I want to put into place in the coming quarters to lower these fees appreciably, especially for the accounts under $500k and $100k. I don’t believe these accounts typically get especially good service or performance, and I have a few strong ideas about how to change that structure.
Across all of my managed asset clients, my goal is to keep fees down at an average of ~1% or less. (it is not an easy target). Investors should expect to pay a little more for smaller portfolios, and somewhat less for much bigger portfolios.
What fees are you paying?
I am working on a checklist of the most common errors investors make. I have my own top 10, but I would love to hear other people think are important. Here is my short list: 1. High Fees Are A Drag on Returns 2. Mutual Fund Are Inferior to ETFs 3. Reaching for Yield is…Read More
Last week, Scott Bell posted this hilarious 2010 rant by Howard Stern — NSFW audio after the jump — it is a stream of a profanities about the casino that is the stock market, brokers who never sell, and all sorts of other fascinating commentary.
Howard Stern may have more dough than you, but his rant is instructive in what most individuals — not just HNW, but anyone — needs to learn to protect themselves from the wolves of Wall Street.
Most of these apply to anyone, a few are specific to Howard.
Advice for Working with Financial Advisors (for both HNW or not)
1. Societies, Economies and Markets Move in Long Cycles: Investors have to understand long cycles — and that half of them are not good:
Think about the post WW2 era — GI Bill sent millions of returning soldiers to school, the building out of suburbia, rise of the car culture, construction interstate highway system, civilian air service, broad electronics development — its no coincidence that 1946-66 was a long term secular bull market (good) for stocks. This investors paradise was followed by an ugly period: 1966-82 had VietNam, Watergate, Oil Embargo, Inflation, etc. In 1966 the Dow was 1000 and in 1982 it was still 1000 — 16 years, no gains (not good). The next good run was the 1982-2000 period that saw the rise of the PC, chips, software, internet, mobile, networks, storage etc. Another golden era for investing. (good). Do I need to explain 2000-2012 and counting? (not good).
If you don’t understand these cycles, you will not be a successful investor.
2. Long term doesn’t matter if you are in the middle of a bear market: Like we are today. I cannot tell you when it will end, but history suggests sometime before the next 5 years are over.
During these secular bear markets, your job is to reduce risk, carry more cash and bonds, and wait for better times. Tactical adjustments are what get you through these periods — not sitting fully invested in equities and getting shellacked. (See number 1 above)
3. Ignore pretty charts in Marketing Materials: Whatever you are shown in glossy brochures is nonsense sales bullshit. Never make any decision based on the old couple walking down the path, or a picture of boats. Its junk advertising — and amazingly, it is an effective way to capture the suckers.
Howard called it “bullshit” in the audio — and it still ensnared him. That’s how effective it is.
4. Your advisor should help to Educate you.. More than just managing your money, your advisor should help you understand what is occurring financially in the world.
They should have a working knowledge about valuation, trends, economy, sentiment and market internals. They should be able to tell you what is working and what is not and why. A good advisor can contextualize the headlines, not merely read them to you. They should be able to answer all of your questions, and when they cannot, they should honestly tell you so — and then go find the answer for you.
5. Buy & Hold is for Secular Bull, Not Bear Markets. Buy & Hold is folly during secular bear markets like 1966-82 or 2000-to-today. Simply stated, it is against human nature and therefor will not work. People get tired, annoyed and angry. Human nature is such that no one wants to lose money for 15 years. This ultimately leads to frustration and bad decision making.
Secular bear markets like the one we are in right now is not when you want to work with a buy & hold advisor (like Howard’s).
6. Caution When Too Much Wealth is Tied Up in One Stock: You would think that this lesson would have been learned after Worldcom, Enron, Lucent, Lehman Brothers and soon Facebook, but apparently not.
Anyone with a substantial amount of their personal net worth tied up in a single company needs to diversify that holding as soon as possible. We can argue if 40% or 75% is too much, but the short answer is if you are even debating it, you need to diversify your risk away from that one holding. PERIOD.
7. Build a Bond Ladder 7-15 Years Out: Ladders are bond portfolios of differing maturities (rungs) designed to capitalize on falling or rising yields. Higher yields means you build a longer ladder (15-20 years); low rates like today means you keep it shorter duration. HNW investors should have a substantial income stream from a diversified portfolio of Treasuries, A-rated Munis and investment-grade Corporates. With rates this low, the bond ladder should be no longer than 7 years.
8. Rising Bond Prices = Lock in Yield: This has been a 30 year bull market for bonds. Anyone who is HNW should have been advised to ladder a portfolio decades ago, up to as recently as 2005-06.
You can still build a bond ladder today — just don’t expect too much in way of returns. Expect higher or more normalized rates in the future.
9. Collars (XM Sirius): There are occasions when great concentrations of stock wealth cannot be sold immediately. These are what the costless stock collar was invented for. It uses stock options to lock in a range of prices, and dramatically reduce the downside risk.
Let’s say hypothetically, if you owned 400 million worth of Apple, and were getting nervous. They could sell the January 2014 600 calls for $92, use the proceeds to buy January 2014 535 puts for $89. Upside is limited to $600, but the downside is capped at $535.
This is what should have been done for Howard back when SIRI stock had some value.
10. Covered Calls: Lacking a collar, the SIRI stock is now under $2. Depending on the stock holding, income can be generated writing covered calls — selling out of the money options to pick up revenue. This is only done if the writer is happy to sell and does not believe the stock has much upside.
That’s my 10 suggestions. Each one should make you money — or at least keep you out of trouble.
As for Howard . . . He needs to get himself educated, and find some better advice — quickly.
Jeff Saut channels Justin Mamis via When to Sell: “Stocks are bought not in fear but in hope. No matter what the stock did in the past it assumes a new life once a purchaser owns it, and he looks forward to a rosy future – after all, that’s why he singled it out in…Read More
Nice piece I came across in Library of Economics and Liberty. There is not a lot to disagree with these. My one caveat about all such rules is that are a rough framework for conceptualizing the world, and are neither gospel nor a mantra. Reality does tend to intrude from time to time, making these…Read More