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