The Rules

The Five-Minute Investing Workout: Allocate, Allocate, Allocate

We’re going to be helping our busy and beginning investors by including some quick and easy workouts in the investment gym to help you boost your portfolio. Today’s workout is about one of the most important and basic tools in the investing toolbox: allocation. It’s time for a quick check-up of how your investment assets are allocated.

Asset allocation has a major influence on the performance of portfolios and retirement accounts. What do we mean by asset allocation? What we’re referring to is the percentage of your investments that are allocated into different kinds of assets: cash; bonds or bond funds; and stocks or stock funds. You might also want to consider real estate or real estate investment trusts (REITs) as a separate asset class. For this week’s five-minute workout, go to your investment portfolio or your retirement account and figure out what percentage of your investments are in these three main asset classes, leaving aside any real estate for now. Then apply a simple formula that will help you decide if you have the correct allocation for your age. This is not a cut and dried formula, but a general guideline that will give you an idea if you’re at least in the right ballpark.

The younger you are, the greater risk you can absorb over a long investing horizon, and therefore the more you should have invested in stocks and stock funds or exchange-traded funds. If you’re twenty years old, you should only have about 20% of your retirement-fund investments in bonds and cash. If you’re thirty to forty, that percentage should increase to thirty percent or so. At forty, you’ll be increasing your exposure to bonds to up to forty percent. At fifty, you should be edging closer to fifty percent. And so on. That’ the most conservative allocation. The higher your percentage in bonds, the higher your margin of safety, but the higher your percentage in stocks, the higher your potential return over the long term. 

If you find that you’re facing more risk than you realized, it’s time to think about moving some of your investment funds into bonds rather than stocks. As you near retirement, you’re not going to want to be facing sharp swings in your portfolio’s value. But if you’re playing it too safe to build a good retirement, you might want to think about increasing your stock allocation.

May 15, 2009 • The Rules

Three Investing Lessons

Bernie Madoff (pronounced made-off, as in made off with your money) appears to have surpassed Enron’s Ken Lay and Worldcom’s Bernie Ebbers as the poster boy for financial scandal. It’s been yet another train wreck for investors after watching the subprime meltdown and the masters of the universe at Lehman Brothers run for the hills. How many blows to confidence can investors take?

So does this mean that we should give up and get out the shovels to bury our nesteggs in the backyard? Or is there something we can learn from this cascade of disasters?

It’s time for us to get out our soapbox and repeat the same old themes we’ve been harping on from Day 1.

1. Don’t trust the OBN: the Old Boy Network. Look where it got such otherwise smart guys as Steven Spielberg and developer Mort Zuckerman, who should know better. Wise guys of Wall Street have developed a kind of private priesthood of expertise, in which they appear to have magical powers of investing beyond that of mere mortals. They don’t. When it comes to the market, if it looks too good to be true, it’s probably a sham. If someone looks like an investing wizard, think Wizard of Oz.

2. Don’t forget DDD: Do your Due Diligence. It’s really, really important to understand the basics of investing, and to keep up with what’s happening to your portfolio, even if you’ve turned over the management of your money or your investments to an “expert.” If that expert can’t adequately explain what’s happening to your money, move on. There are simply no valid excuses any more for turning over your money to someone without knowing the first thing about investing. This is your financial future that’s at stake.

3. Do Diversify. The best way to limit catastrophic damage to your portfolio is to diversify. Plenty of folks put their entire nesteggs in the hands of Bernie Madoff and his cohorts, who placed those investments in a mysterious black box that noone could penetrate. These folks would have done better to open an account at a discount broker and buy an array of index funds that included bonds as well as stocks. They could watch the progress of their investments easily and minimized expenses and taxes. And they could have avoided crooks. Allocation of assets is as important, and sometimes more important, than good stock picking. 

December 18, 2008 • The Rules

Bear Market Rule #1: Don’t Give Up on Your 401K

The market has been a terrifying rollercoaster ride, and many investors have simply given up. But now is definitely not the time to give up on contributing to your 401K. If you contribute regularly to your retirement plan, you have three thing going for you right now. The first is that stocks are cheap. The price to earnings ratio right now for stocks in the S&P 500 is about ten, which is the lowest it’s been in decades. Stocks may go lower, but you’ll also be taking advantage of another key investing strategy, which is dollar-cost averaging. When you invest on a regular basis, rather than in one big chunk, you dilute your risk and take advantage of buying when prices are low.

The third advantage of buying now—when you buy stocks that pay dividends—is that those dividends are going to plowed back into the stocks at cheap prices. When the value of the stock goes back up, so does the worth of your reinvested dividends. So be sure to max out your retirement plan to take advantage of the company matching funds. The “free money” that your employer pays is a kind of leverage that helps you scoop up more shares on the cheap. You’ll also get a fourth boost: the tax advantage of reducing your taxable income.

November 23, 2008 • The Rules

Our Next Important WWP Rule: Don’t Follow the Crowd

There are plenty of reasons not to follow the crowd when you’re investing. But it becomes particularly important when the market gets volatile.

We enjoyed a recent New Yorker magazine piece by financial writer Jamie Surowiecki that aimed to offer some slight comfort and counsel to investors who have been frazzled by extreme market volatility over the past few months. The image accompanying the piece is particularly apt, with two guys on a seesaw, one in market heaven, and the other in market inferno, with the positions about to reverse.

Surowiecki points out that the market has actually risen over the past month (the article is dated Sept. 1, 2008), but that it has done so in roller coaster fashion, with six days on which the S&P 500 has gone up or down by at least two percent, making for a rally and fizzle pattern guaranteed to jangle the nerves of most investors. It’s the kind of market we like to call bipolar, with days of apparent exuberance followed by ones of gloom and doom.

However, when we buy stocks, we really don’t feel either exuberant or depressed. And we doubt that many other investors do, either, unless perhaps they’ve had too much coffee or just broken up with their honey. We like to think we’re in a rational state of mind when we make those kinds of decisions. (We try to go easy on the coffee!)

A better explanation of what’s going on has to do with a herd instinct that tends to rule markets, particularly when there’s a lot of uncertainty. Much of what is happening, as Surowiecki suggests, is a function of what economists call herding. When conditions look uncertain, or potentially dangerous, humans, like other animals, herd together for protection. So when markets look unstable, the herd instinct takes over. In these cases, brokers and mutual fund managers in particular tend to follow trends and huddle together for safety: they buy when the herd is buying and sell when the herd is selling.

Studies have found that mutual-fund managers herd for a couple of important reasons. First, trend-following allows money managers to hew to the norm, so they won’t look bad when compared to average performance. It’s not so bad to be losing money when everyone else is, so long as they’re not losing lots more. Trend-following also gives them a chance to piggyback on the knowledge of their competitors. When a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. When it starts to drop, they assume, again, there must be a good reason, and the party, with the same cakes and ale, becomes a bust, with everyone leaving. So this strategy, which creates a kind of self-fulfilling feedback loop, can magnify trends. The result is more volatility, sometimes with no real rhyme or reason.

So what are investors supposed to do when the market turns into a carnival ride, like the tilt-a-whirl or roller coaster? One good way to look beyond daily volatility is to look at charts showing longer term trends.

Go to the Yahoo Finance site and type in the stock ticker symbol for the stocks you’re interested in, and for the main indexes that you can use as a reference point. For example, you can compare your stock of interest to the S&P 500 on a short-term or longer basis by calling up the chart of your stock and then comparing it to the chart for SPY, an exchange-traded fund that holds all of the S&P Index stocks. The chart for SPY, if you looked on Aug. 25th, would show you that the S&P Index has lost nearly 12% for the year, but that it has been on a gradual but VERY bumpy uptrend since mid-July. So how does your stock compare?

That ride you thought was so bumpy just might be taking you in the right direction, if you look far enough ahead. But if it’s headed straight down for a fall, it might be time to get off. Just make sure you’re not exiting just because the crowd has jumped off. (They might decide to jump on again when the weather improves!)

August 25, 2008 • The Rules

WWP Rule #3: Greed Is Contagious

Why is it that big-money people who’ve managed to lose money big-time for their clients head for Monaco, one of the most expensive places on earth, to commiserate and lick their wounds? Shouldn’t they perhaps go to a more modest destination, like Las Vegas, and pledge not to get carried away by greed and hubris? At least they could get by with cheaper lunches. Or how about Fatima, where they could humble themselves and ask for a miracle?

Hedge fund managers and mutual fund managers who met in Monaco this past week are predicting yet more ugly secrets to come creeping out of bank vaults, with a prediction of additional “write-downs” to exceed the ones we’ve already seen. How many bad mortgages can there still be out there, waiting to bite banks in the butt? You have to start asking yourself if there were mortgage hawkers were out there on every freeway in the U.S., flagging down broken-down cars on the highway to see if the owners wanted to buy a million-dollar house.

It’s gotten absurd, really. This has far surpassed the dotcom bust in stupidity born of greed. And from what we can see, the investment banks have not been alone in their greed. These things are contagious. Many fund managers who managed to escape the excesses of the dotcom absurdity appear to have remained blind to the equally visible excesses of the subprime era. Some of the most venerated mutual funds, like the Sequoia Fund (SEQUX), have been losing money just as handily as the dotcom idiots of yesteryear.

Which brings us back to the wisdom of index funds, which can’t be influenced by the “strategies” that have misguided so many hedge fund and mutual fund managers. The market will eventually right itself and recover, just as it did after the dotcom excesses, and the indexes that track the market will also recover. Those who made big bets in the wrong sectors, however, or on the wrong strategists, will not recover for a very long while. 

June 22, 2008 • The Rules

Dividends Can Be a Girl’s Best Friend

When the market gets as bearish and volatile as your worst nightmare of a former boyfriend, it’s time to remember our Big D’s of Defensive Investing: (1) Diversify, (2) Buy on Dips, (3) Do your Due Diligence, and (4) Look for Dividends. The one that many investors tend to overlook is dividends, simply because everyone seems riveted on stock price. Dividends, however, can play a big role in the stability AND return of your portfolio. In fact, dividends can be the “hidden kicker” in your porfolio, the unseen and unheralded booster to your portfolio’s long-term performance. (Yes, think of your porfolio as a performer, dancing along even while you’re sleeping.)

A major benefit of investing in well established, dividend-paying companies is that when investment markets experience short-term volatility, dividends, in many cases, can act as a relative constant in the face of fluctuating or decreasing share prices. One reason is that panicky market sentiment can influence a share price, even as the company keeps trundling on, earning as much as before or evening increasing earnings. So you’ll keep getting your dividends, which are reinvested at a lower price, meaning you’re getting a bargain that will go up when the share price goes back up. So the dividends will not only offset the drop in share price; they will increase the overall value of your holdings in the stock over the long term. This will give you downside protection for your portfolio. And good businesses can be expected to increase their dividends, increasing the return to investors each year. Eventually the stock price of a good company will rise to reflect its true market value, including the value of its dividends.

For example, let’s compare a company (let’s call them Acme, in honor of Wile E. Coyote), that experiences a fall in share price of 5% but pays a dividend with a yield of 3.5%, with another company (let’s call them Zeta), which does not pay a dividend and whose share price falls 3%. Which company would you be better off with? Acme will actually outperform Zeta, with a net loss of only -1.5%, while you’d be stuck with a 3% loss for Zeta. So even Wile E. Coyote would be smart to go with Acme.

Check out the following graph that shows you the long-term performance of dividend payers vs. nondividend payers:

April 14, 2008 • The Rules

Rule No. 1: Whatever You Do, Diversify!

We think that investing, like football, dating or other potentially risky pursuits in which scores are kept, requires a good defense. We follow what we’ve called the Five D’s, the five rules of defensive investing, from diversification to dividends. We’re going to get started with our first rule, which is: diversify, diversify, and then diversify some more! We acknowledge that this is contrary to the kick-butt, mucho macho style of investing, which involves letting everything ride on one or a few stocks. Occasionally, this all-or-nothing Vegas-style trading does make a lot of money. But we like to sleep at night. And we also think that in the long run, Mr. Market is just too random and unpredictable for that kind of strategy. Anyone remember Enron? And the day traders who lost everything in the dot.com meltdown?

We tend to agree with investment gurus like William Bernstein, author of The Four Pillars of Investing, that wide diversification and minimal expense are the keys to building good portfolios. And to sleeping at night.

Picking Horses and Playing Cowplop Roulette

When we were working at the racetrack, we noticed that the handicappers who actually made real money were the ones who spread their bets. They narrowed down their choices to the horses they considered the top contenders and then made bets that allowed them to make money if any of their choices came in, and in various order.

We noticed the same phenomenon in yet another context when we attended a state fair and entered a cowplop contest. A field had been marked out with squares, and a well-fed cow was led to the field, ready to plop on a square somewhere in the field. You could place money on a square. But it was obvious that if you really wanted to win, you’d cover as many squares as possible. We’re not saying that Mr. Market is as random in his movements as a Holstein cow – well, maybe he is. But clearly, diversification is important when you’re dealing with the unpredictable.

The Beauty of Indexes

So what’s the easiest, cheapest and most reliable way to diversify: use the indexes! There are mutual funds and ETFs that track and try to mirror any of the indexes that we mentioned in our previous gym workout: the Dow Jones, the S&P 500, the Nasdaq, and all of the Russells. There are also indexes that track bonds, world markets as a whole, and emerging markets.

If you want to equal the market, you can simply put together a portfolio of index funds and/or ETFs that give you full exposure to all kinds of stocks: large caps, medium caps, small caps; growth stocks, value stocks; U.S. stocks, world stocks, emerging market stocks. You can also buy a bond fund or a treasury-bond fund that follows key investment-bank indexes.

In our next workout, we’ll look at some different indexing strategies, from a simple three-fund strategy that has been called the lazy or coffee-house portfolio, to an array of seven to ten index funds used by top investment banks and money managers for their wealthy clients.

December 31, 2007 • The Rules