Tuesday, January 31, 2012

Is China the Best Place to Invest

By Larry Swedroe


One of my major focuses is demonstrating that so much of the "conventional wisdom" of investing is wrong. One of the more persistent beliefs held by investors is that if you want high returns, you should invest in countries experiencing rapid economic growth.

It seems that even professor Burton Malkiel, author of A Random Walk Down Wall Street, believes the conventional wisdom, as he has been touting China as the place to invest. For example, in 2011, he stated: "Institutional investors are missing out on investing in the world's fastest growing economy; since the early 1980s China has expanded at more than 9 percent a year, after inflation." To see if the conventional wisdom is correct, let's take a look back.

Antti Ilmanen, in his book Expected Returns, reports that from 1993 through 2009, China's GDP growth rate averaged more than 10 percent. If ever there was a test that would demonstrate that high rates of economic growth translate into high investment returns, this should have been it. Yet, Ilmanen found that U.S. dollar-based investor would have earned negative returns over the period. The negative return has now been extended to 19 years as the iShares Trust FTSE China 25 Index Fund (FXI) returned just 2.1 percent in 2010, and then lost 17.7 percent in 2011.

If the Chinese example doesn't convince you that the conventional wisdom is wrong, perhaps the cumulative weight of the evidence from the following studies will: One study found that for the period 1900-2000, the real return from stocks and a country's growth rate was negatively correlated (-0.27); another study ranked 83 countries and found that the lowest growth countries outperformed the fastest growing countries by almost 7 percent a year.

The explanation is pretty simple: Markets price for risk, not growth. Countries with high projected growth rates are perceived as less risky than those with low projected growth rates. Thus, you shouldn't expect high returns from countries with high growth rates.

Monday, January 16, 2012

Invest Smarter Than an MLB Star

By Larry Swedroe


COMMENTARY The lawsuit by former baseball All-Star Denny Neagle against his financial advisor should serve as a warning to all investors: Working with an advisor you can trust is important but shouldn't replace your own education on financial matters.

Denny Neagle, who pitched for six teams during his 13-year career and was a two-time All-Star, and his ex-wife filed suit against their former advisor, alleging that they were supposed to be in liquid investments such as stocks and bonds, but ended up in illiquid, expensive investments such as hedge funds and private equity funds. The lawsuit also claims they now can't access large portions of their portfolio and experienced large losses on alternative investments.

What put them in this position? They claimed they were "utterly unsophisticated" when it came to finances and were looking for help.

Certainly, Neagle, who signed a $51 million contract in 2000, isn't the first athlete to run into financial troubles. For example, NFL quarterback Mark Brunell, who earned an estimated $50 million during his pro career, filed for bankruptcy in 2010; news reports blamed failed business ventures. Three-time WNBA MVP Sheryl Swoopes, who also earned an estimated $50 million throughout her playing career and endorsements, filed for bankruptcy in 2004. She told the New York Times, "Growing up not having a lot of money, I was suddenly in a position to change my lifestyle and help those around me. But I didn't surround myself with the right people. I got in a position where it was like, 'Oh, wow, what happened?' "

It's easy to write off situations like these as athletes being irresponsible. It's also easy to place the blame at their feet, saying they should know better and stop being so trusting. But you don't have to be an athlete making millions to fall into the same traps. According to the National Foundation for Credit Counseling's 2011 Financial Literacy Survey, more than 40 percent of respondents gave themselves a C grade or lower for their knowledge of personal finance. And about three out of every four agreed that they could benefits from advice and answers from a professional.

Such issues can affect all walks of life. Think of the people taken in by Bernie Madoff and Allen Stanford. Or think of Olga Kuschnieryk, an 85-year-old who worked in a forced-labor camp during World War II before coming to America. She worked at a meatpacking plant and had sent more than $330,000 to a financial advisor before discovering he was running a Ponzi scheme.

Working with an advisor or financial professional can be hugely beneficial, but that doesn't absolve you of your responsibility to know your own financial picture. What investments do you hold? How big is your portfolio? What fees are you paying? How much risk are you taking? There's a large difference between not letting someone else handle the day-to-day management of your portfolio and being completely unaware of what you have.

Thursday, January 12, 2012

Embracing Imperfection

By Jim Parker

New Year's resolutions often involve making promises to ourselves we can never keep. But instead of tilting at windmills, we can often generate better results by merely resolving to be less dumb in certain areas. And money is a good place to start.

One human tendency is to judge the effectiveness of our retirement savings strategies by looking at performances on one-, two-, or three-year horizons. We do this because we are wired to be more sensitive to short-term losses than to long-term gains.

This is why much of the financial services industry and media encourage a short-term focus for an audience with a long-term horizon. This is akin to looking through the wrong end of a telescope. The thing you should be focusing on looks even farther away.

The result of this short-term mindset is that investors end up following the herd and seeking safety when opportunities are plentiful and seeking risk when opportunities are few. The less dumb thing is to maintain a level of discipline amid the noise.

Another human tendency—and one allied to our built-in loss aversion—is to be suckers for the supposedly "free" or discounted offer. Like Homer Simpson, a zero price tag makes us fall for pitches selling us stuff that is neither necessary nor good for us.

In the world of investment, it's this tendency that makes people gravitate to strategies that headline high returns without mentioning the risk, or that conveniently bury fees, commissions, and other costs. Regret lies on the other side of those decisions.

A less dumb thing is to focus on return and risk. They're related. Focusing exclusively on return can lead to rude awakenings when risk shows up. Focusing exclusively on risk can lead to disappointment when returns are delivered.

A third tendency among humans is to succumb to what behavioural scientists call "hindsight bias." Essentially, this is our habit of viewing events as more predictable than they really were. Call it the "I saw it coming" syndrome.

There is a fair bit of this around at the moment, with plenty of "experts" saying the sovereign risk crisis was completely predictable. This is strange because the overwhelming consensus among institutional investors a year ago was that fixed income would underperform in 2011. The crisis may have been predictable, but the market reaction wasn't.

The consequence of hindsight bias for investors is they tend to be forever rewriting history and forever seeking to interpret performance based on what they know now rather than what they knew a year or more before.

A less dumb thing is to accept there will always be a level of uncertainty. The future is unknowable. And all we can do as investors is to ensure the risks we take are related to an expected return, that we diversify around those risks as much as possible, and that we exercise a level of discipline amid the noise.

It's a way of embracing your imperfection, and it's a New Year's resolution you have a chance of sticking to.

Monday, January 9, 2012

Year End Review

By Weston Wellington

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald's. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald's (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the "January Indicator," the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. "Overheating is the biggest worry," one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a "sell" signal on August 3, and on August 5, Standard & Poor's downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. "I feel like a deer in the headlights," said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: "There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part."

Good advice then, good advice now.

Mark Gongloff, "Investors' Forecast: Sunny With a Chance of Overheating," Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, "Stock Surge Rings in Year," Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, "Tech Sends Stocks Soaring," Wall Street Journal, July 20, 2011.

Steven Russsolillo, "'Dow Theory' Confirms It's an Official Swoon," Wall Street Journal, August 4, 2011.

Damian Paletta, "U.S. Loses Triple-A Credit Rating," Wall Street Journal, August 6, 2011.

Tom Petruno, "Investors Stampede to Safety," Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, "Tired of Ups and Downs, Investors Say 'Let Me Out'," Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor's Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

Thursday, January 5, 2012

Things Change

By Jim Parker

It's that time again when harried finance editors ask reporters to call investment professionals and cobble together top predictions for the coming year. These are fun to write. But for readers, they're more entertaining a year later.

Take the late 2010 Barclays Capital Global Macro Survey of more than two thousand institutional investors. The pick for the best performing asset class in 2011 was equities (with 40% support), followed by commodities (34%) and bonds (less than 10%).1 The consensus prediction was a 15% gain in the S&P 500 for the year to around 1,420.

As we now know, the truth turned out to be rather different. To the beginning of December and using broad indices, diversified fixed income was the best performing asset class of the year, followed by government bonds. Returns from commodities and equities were negative. The year-to-date return for the S&P 500 was close to zero. (And remember, these are the forecasts of big institutional investors.)

Barron's, meanwhile, was telling readers this time last year that smart stock pickers were "looking eastward" in 2011. The year was to be dominated by fast growth and rising inflation, and the smart thing was to reweight toward China and other tigers.2

That didn't really turn out to be such a good idea, as China had another bad year. The Hong Kong Hang Seng index was down nearly 17% to early December. The Shanghai Composite was down by a similar amount.

Conversely, the gloom around fixed income in late 2010 was all pervasive. Barron's surveyed 10 strategists and investment managers and found nearly all expected stocks to outperform bonds in 2011. "You've got to believe in outright deflation to put new money into bonds right now," said one investment banker.3

The logic might have been impeccable, but the strategy wasn't so. As of early December, US debt securities, as measured by a Bank of America Merrill Lynch index, had risen by 8.7% in 2011, their best performance since 2008.4

In other words, bond yields might have been seen as unusually low a year ago. But they have fallen even further since, and those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price.

So if the experts can't get the broad asset class movements right, what chance on earth have they of correctly and consistently predicting individual stock or commodity performances? But year after year, that doesn't stop them from trying.

One prominent investment bank team was quoted by The Australian Financial Review last January as saying that platinum was the metal to back in 2011. As of early December, the spot platinum price was down nearly 14% for the year. On the Australian stock exchange, platinum stocks Platinum Australia and Aquarius Platinum—both recommended by the bank—had delivered total returns to the end of November of –83% and –53%, respectively.5 Ouch!

Stock picks often go wrong because forecasters base their calls on what turn out to be incorrect assumptions on macro-economic variables like base lending rates and inflation. Take the AFR Smart Investor magazine "expert panel," which in late 2010 suggested to readers moving out of international fixed income and into cash given expectations of rising cash rates in Australia.6 As it turned out, Aussie rates did not move until November, and when they did the direction was down, not up.

Currencies are another variable that defy even the most assiduous forecasters. In its 2011 outlook, published in the London Daily Telegraph in December 2010, a major British bank forecast sterling would be the best performing currency of the year.7 The banks also predicted stock markets would outperform bonds, with the FTSE 100 rising about 18%. A year later, sterling ranked only a distant fourth behind the Japanese yen, Norwegian krone, and Swiss franc, and the FTSE was nearly 6% lower.

It's a tough business, isn't it? And remember these are major financial institutions with armies of expert analysts, mountains of data, and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future! You can do all the analysis you want, but events have a way of messing with your assumptions.

The second lesson is you don't really need forecasts to succeed as an investor. Yes, equity markets were rocky again this past year. But a properly diversified fixed income portfolio provided excellent returns. Staying diversified both across and within asset classes helps lessen the effects in down times and ensures you are still positioned to reap returns when riskier assets come back into demand.

The third lesson is that the past has gone. The news may be gloomy, but that information is in the price. When risk appetites are low, the price of safety is higher than at other times. But the expected reward for risk is higher. Conversely, when risk appetites are high, the expected rewards are lower.

It's human to feel anxious about bad news because we fear loss more than we like gains. But in this case, the loss isn't real unless you realize it, so it makes sense to stay with the asset allocation your advisor has tailored for you.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that things change. What's more, they often change in ways we least expect.

1. "For 2011, It'll Be All About Equities," Pensions & Investments, December 27, 2010.

2. "Asian Trader: Stockpickers, Look Eastward," Barron's, December 20, 2010.

3. "Outlook 2011," Barron's, December 20, 2010.

4. "Treasuries Rise on Concern Europe Struggling to Resolve Crisis," Bloomberg, December 7, 2011.

5. "Platinum to Become the Price of Metals in 2011," Australian Financial Review, January 7, 2011.

6. "How to Rebalance Your Portfolio in 2011," AFR Smart Investor, December 17, 2010.

7. "Sterling Best Major Currency Next Year, says Barclays," The Daily Telegraph, December 10, 2010.

The 10 New Year's Investing Resolutions

By Larry Swedroe

The New Year is a time to reflect on the changes we want or need to make. The following are my recommendations for New Year's resolutions that will not only make you a better investor, but will also improve the quality of your life -- assuming you have the discipline to stick to them.

1. I'll adhere to my investment plan. If I don't have one, I'll immediately develop one.

2. I won't take more risk than I have the ability, willingness or need to take.

3. I will avoid all complex investments and won't invest in something if I don't fully understand its risks.

4. I'll ignore all market and economic forecasts, because they have no value.

5. I'll remember that just because something seems obvious now, it doesn't mean it was obvious before it happened.

6. I won't confuse strategy with outcome. If my plan doesn't return what I expected, that doesn't mean my strategy was wrong. Sometimes you win; sometimes you lose.

7. I won't react to current market trends. Instead, I'll remember rule No. 1.

8. I won't treat the unlikely as impossible, nor the likely as certain.

9. I'll take my risk in the stock market and use bonds to dampen my overall risk, if necessary. My bonds will be of the highest quality.

10. I won't confuse yield and return. If an investment has a high yield, there's a high degree of risk, even if I can't see it.

And here's a bonus resolution, which will not only help you, but probably provide some good laughs, too. I will keep a diary of my market and economic forecasts and review them at the end of the year. That will help me avoid the mistake of being overconfident of my skills.