Thursday, April 28, 2011

Are Stocks Overvalued?

By Larry Swedroe

The S&P 500 Index has returned more than 100 percent since bottoming out March 9, 2009. The strength and the speed of the rally have brought the usual debate on whether the market is once again overvalued, with some arguing that prices have risen to extreme levels of overvaluation. Those making such statements often point to two metrics:

As an example, the investment firm Smithers & Co. announced that the market is overvalued by about 70 percent using either Tobin’s Q ratio or the CAPE.

At the very least, these kinds of statements cause stomachs to flutter. At the most, they cause investors to abandon well-thought-out plans. Valuations, of course, matter. The higher they are, the lower future expected returns will be. However, I don’t believe that valuations are at extreme levels, or that buy-and-hold investors should worry or consider altering their asset allocation.

Consider that the current forecast for 2011 operating earnings for the S&P 500 companies is about $94. At the time of writing, the S&P 500 was trading at about 1,330, or a P/E of about 14 based on that forecast.

Admittedly, that’s a forecast of full year earnings, and this is only April. In addition, forecasts tend to be too optimistic. However, even if we assume that earnings will come in at just $83 (11 percent below forecast), the P/E would still only be about the historical average of about 16. This doesn’t seem to be an extreme level, especially in light of the fact that the current rate on riskless Treasury bills is zero.

One other thought is worth considering. The market is forward looking, not backward looking. And the current 10-year period used to calculate CAPE includes not just one period of economic weakness (the recent recession), but two. This provides another reason to be wary of using this metric to make any investment decision.

Wednesday, April 27, 2011

Risks Worth Taking

By Jim Parker

A wise man once said that to profit without risk and to experience life without danger is as impossible as it is to live without being born. That all may be true, but which risks are worth taking and which are not?

The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.

Then there are the "big decisions" like selecting a degree course, choosing a career, finding a life partner, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.

In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.

Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.

In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.

Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.

To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.

Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.

In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.

To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.

Wednesday, April 20, 2011

Portfolio Endurance

By Bryan Harris

The need for retirement planning doesn't end with the onset of retirement. A new retiree's focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life—and through different economic and market conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor's control while others are not. Let's briefly consider them.

Asset Mix

Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks.2 Consequently, the larger the equity allocation, the greater a portfolio's expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most investors should have an equity component in their portfolios, with actual weighting depending on one's time frame, risk tolerance, and spending flexibility.

Spending Level

Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

  • Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio's value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
  • Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.

Investment Time Frame

Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.


Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Exhibit 1: Basic Tradeoffs in Portfolio Survival

Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.

1. Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable," AAII Journal 20: 16–21. Also see: Bengen, William P. 1994. "Determining Withdrawal Rates Using Historical Data," Journal of Financial Planning 7: 171.

2. From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term government bonds and 3.0% inflation. Sources: Standard & Poor's Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook®, Ibbotson Associates.

3. Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable," 16–21.

Tuesday, April 19, 2011

American Funds - Does it Add Value?

By Larry Swedroe

When we discussed whether AllianceBernstein provided value to investors, I was asked about American Funds. Let’s see how the company has done.

With $973 billion in assets under management at the end of last year, American Funds is the second largest fund group in the nation behind Vanguard. It’s one of the most popular choices of active investors, and for some pretty good reasons. First, its fees are relatively investor friendly (at least for an active manager). Second, it doesn’t rely on “star managers” who can pick up and leave. Instead, it relies on a team of managers. Third, it tends to stick very close to its knitting, avoiding style drift which causes investors to lose control over the risk of their portfolios. And finally, it became one of the largest companies because its track record was good.

The company also devotes considerable resources to research, noting on its Web site that it has more than 200 investment professionals (speaking more than two dozen languages) traveling the world.

So let’s see if all those resources and efforts have led to outperformance against passive alternatives. We will compare the returns of nine of the American funds to the returns of similar index funds from Vanguard and similar passively managed funds from Vanguard and DFA. The period is the 10 years ending April 11.

It should be noted that the average return of American’s U.S. large-cap growth/blend funds was 4.8 percent, and the average return of the firm’s U.S. large-cap value funds was 4.7 percent.

If we assume investors earned the average return of American’s funds in each of the four asset classes, and equal weighted the four asset classes, the American Funds investor would have earned 7.7 percent. An investor in the four DFA funds would have earned 8.1 percent. In the three asset classes that Vanguard had similar index funds, both American and Vanguard returned 7.7 percent. In neither case do we have evidence of overall out-performance.

While the American Funds may have outperformed in the past, accounting for their sterling reputation, one of the problems for active managers is that their very success contains the seeds for their own destruction. Asset bloat increases the already difficult hurdles active managers have to overcome to add value. They either incur greater market impact costs as they trade larger positions, or they have to diversify more, turning into a closet index fund.

Perhaps it’s the evidence presented above that explains why American has experienced greater outflows (more than $80 billion through February) than any other family over the past two years.

Monday, April 18, 2011

Jam Today or Jam Tomorrow?

By Weston Wellington

Until recently, twenty-nine of the thirty constituents of the Dow Jones Industrial Average paid regular cash dividends to shareholders (Disney makes a single annual disbursement while the others distribute on a quarterly basis). Cisco Systems Inc. of San Jose, California, was the lone holdout, having never paid a dividend in its twenty-one-year life as a public company.

Cisco was founded in 1984 by a husband-and-wife team of computer scientists who were frustrated by their inability to communicate by email between separate buildings on campus. A device to allow different computer networks to share information was the firm's initial product. The company hired its first employee in 1986, held its first staff picnic in 1989, and sold shares to the public for the first time in February 1990, having recorded $27 million in revenue the previous year. Today the firm has over 70,000 employees and over $40 billion in annual revenue.

Last month the company announced its first cash dividend, with a disbursement of $0.06 per share to holders of record as of March 29, 2011. Cisco's stock price at the time of the announcement was $17.14, which works out to a projected annualized yield of 1.4%.

Although this news received little attention, we think it is worthy of reflection since it illustrates a key principal of a free market economy. Entrepreneurs come to the capital markets with business ventures in need of funding. Investors supply equity capital to those ventures in return for a share of the profits. Risky ventures with little prospect of an immediate payoff must offer the possibility of a large future reward as an inducement for investors to fund such projects. For Cisco shareholders, how long was the wait and how big was the payoff?

The investor who purchased 100 shares of Cisco at the initial offering price of $18 in 1990 received no cash return from the enterprise over the subsequent twenty years. But the 6-cent initial dividend will provide that same shareholder with a cash return of $1,728 per quarter or a projected $6,912 per year. Relative to the initial investment of $1,800, the annual cash return for the initial Cisco investor is 384%. As financial theory would suggest, Cisco's stock price has factored in this dividend-generation ability, which explains why the original 100 shares (now 28,800 shares after 9 stock splits) have a current market value of $508,320.

Suppose we had limited our eligible investment universe over the past twenty years to firms paying cash dividends. We would have excluded Cisco Systems, Kohl's department stores, software developer Oracle Corp., heart-valve maker St. Jude Medical, Starbucks coffee shops, and many others. We would have included dividend payers such as photography giant Eastman Kodak, discount retailer Kmart, and auto parts maker Dana Corp. We might have drawn comfort in the knowledge that all three of the latter group had paid dividends for many years (Dana since 1936, Kmart since 1913, and Kodak since 1902) and had been singled out for special praise by the authors of a widely read management book, _In Search of Excellence. _Alas, a successful past offers no assurance of a prosperous future; Kmart and Dana subsequently filed for bankruptcy, while Kodak shareholders have seen their cash dividends eliminated in 2009 and the share price shrivel by over 90% since year-end 1990.

The five firms presented in the table below have all recently initiated cash dividends after many years as a public entity. Clearly, this list represents some degree of selection bias: If we could predict which of today's new ventures will survive for the next twenty years and begin paying dividends, our success rate in identifying huge winners would be greatly enhanced.

The moral of the story? We should not use this exercise as a motivation to identify the next Cisco Systems or St. Jude Medical. But when we exclude firms from our portfolio that pay no dividends today, we may deprive ourselves of the returns associated with the biggest dividend generators of tomorrow. A broadly diversified strategy that includes both dividend payers and non-dividend payers will ensure we enjoy the potential rewards of both.

Current market value and indicated annual income associated with purchase of 100 shares at initial public offering price

CompanyIPO DateIPO PricePrice
Cisco (CSCO)02/16/90$18.00$17.6528,800$508,320
Kohl's (KSS)05/19/92$14.00$54.20800$43,360
Oracle (ORCL)03/12/86$15.00$33.5432,400$1,086,696
St. Jude Medical (STJ)02/09/77$3.50$52.2619,200$1,003,392
Starbucks (SBUX)06/26/92$17.00$35.773,200$114,464
CompanyInitial DividendDividend RateAnnual IncomeYield on
Purchase Price
Cisco (CSCO)03/29/11$0.06/qtr.$6,912384%
Kohl's (KSS)03/07/11$0.25/qtr.$80057%
Oracle (ORCL)06/12/10$0.06/qtr.$7,776518%
St. Jude Medical (STJ)03/29/11$0.21/qtr.$16,1284,608%
Starbucks (SBUX)08/02/10$0.13/qtr.$1,66498%

Thomas J. Peters and Robert H. Waterman Jr., In Search of Excellence—Lessons from America's Best-Run Companies (Harper & Row, New York, 1982).

Google Finance, (accessed April 8, 2011).

Yahoo! Finance, (accessed April 8, 2011).

Cisco Systems Inc., (accessed April 8, 2011).

St. Jude Medical, (accessed April 8, 2011).