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"The story in Europe and Japan is getting very compelling," says Bill Wilby, director of equities at OppenheimerFunds. "It wouldn't surprise me to see a significant period where foreign markets outperform the U.S." Fund managers say the better overseas performance of late reflects cheaper stock prices abroad, an acceleration in corporate restructuring in Europe and Japan and the rises in commodity prices that have boosted many emerging-market economies. They also point to the dollar's decline since 2002, which enhances foreign stock returns for U.S. investors when translated back to greenbacks. During foreign stocks' last big run, investing abroad was limited primarily to an elite circle of institutional investors, while most individual investors watched from the sidelines. But that's changing. Money flows into international stock funds are expanding at a record pace and individual investors have more ways to invest abroad than ever before. Foriegn Funds Attracting U.S. Investors Today, there are more than 700 mutual funds dedicated to investing abroad, compared to just 55 in 1985, according to fund tracker Morningstar. There are also 44 international ETFs. ETFs offer exposure to broad international indexes, as well as to 24 countries, including investor favorites such as Japan, China, Germany and the United Kingdom. Moreover, 475 foreign companies trade on the NYSE or Nasdaq as American depositary receipts, compared with 331 companies in 1995. The outperformance by foreign stocks has been attracting the attention of the big institutional investors: U.S. net purchases of foreign stocks totaled $63 billion during the first seven months of 2005 -- up 33% from the same period last year and on track to exceed the record $89 billion in net foreign purchases in 2003, according to the U.S. Treasury Department. And this trend is being echoed among small investors. International stock funds have received net inflows of $52 billion through Sept. 21, on pace for a second straight record year, according to AMG Data Services. Some investors say that with U.S. interest rates poised to rise further while rates are holding steady -- or even falling -- in some major overseas markets, the gap between U.S. economic growth and growth in the rest of the developed world could begin narrowing. "The global growth engines of late have been the U.S. consumer and Chinese labor," says David Rosenberg, head of U.S. investments for Citigroup. "As the U.S. runs out of the ability to consume at the same rate, it is essential that Europe and Japan pick up the pace. And we are seeing signs that this is happening." Risks, Rewards & Allocations Investing abroad doesn't come without risks, notably currency swings, extra expenses and political uncertainty. Morningstar says the average international mutual fund has an expense ratio about 0.19 percentage points higher than the average domestic stock fund. That translates to an added $19 annually in fees on a $10,000 investment. Most international funds don't hedge their currency exposure, so their performance in some years can largely reflect currency movements. This year, for instance, the MSCI EAFE Index has returned 14.8% in local-currency terms. But the greenback's rebound in 2005 has lopped off nearly 10 percentage points of that return when converted to dollars. Investing in many overseas markets, especially in the developing parts of the world, is still considered riskier because the market zigzags are wilder, information on individual companies is harder to come by and foreign investors often are treated as second-class citizens by many companies. Even so, some financial consultants recommend that U.S. investors devote about 20% of their stock portfolios to overseas markets, up from a suggested allocation of around 10% just a few years ago. This reflects the belief that international stocks help diversify a portfolio, making it less volatile, and that many of the world's best companies are found abroad. The most attractive growth prospects these days are in emerging markets, and the MSCI Emerging Market Index has doubled in less than four years. But after that run, some global investors think more-consistent returns in the years ahead will be found in Japan and Europe. Tokyo's Nikkei Stock Average recently hit four-year highs -- a response to improving consumer demand, rising corporate spending and stronger earnings.
Wisconsin financial planner Ty Bernicke says retirees generally spend less as they age, so that it is reasonable for them to spend more when they are in retirement's early stages. Mr. Bernicke's conclusions, which relied on data from BLS's Consumer Expenditure Survey for 2002, were published in June in The Journal of Financial Planning (www.fpanet.org/journal/articles/2005_Issues/jfp0605-art7.cfm). Spending in practically every category declines with age. The only category in which spending rises with age is health care. "It's almost a tug of war between inflation pushing costs up and human nature pulling them back down," Mr. Bernicke said. People over 75 spent 26% less, on average, than those in the 65-to-74 age group. And the greater the age difference, the greater the difference in spending: Those over 75 spent 46% less than those aged 55 to 64, and 51% less than those aged 45 to 54. Most retirement planning today assumes that a person retains the same lifestyle throughout their life. But as age increases, spending decreases. The traditional advice that calls for an initial withdrawal of 4% is based on several assumptions. To compensate for inflation, the withdrawal rate would increase 3% every year. And the nest egg would generally be invested at least 50% in stocks - as a further hedge against inflation - with the remainder in fixed-income investments and cash. The approach is based on risk-assessment studies using all kinds of hypothetical examples of market returns. The withdrawal rates are intended to leave very little chance of running out of money. "Our whole premise is that if this $40,000 is to have the same purchasing power for the rest of your life, we have to inflate it," said Christine Fahlund, senior financial planner with T. Rowe Price, which advocates this method. "We're assuming that inflation is part of life." T. Rowe Price's method assumes a 40-year retirement. Mr. Bernicke assumes one of 30 years. To Mr. Bernicke, a couple who spend $40,000 in their first year of retirement may not need to spend as much when they are in their 80's. People who are 75 and older spend an average of $674 a year on apparel and services, while those who are 65 to 74 spend twice as much, based on the consumer survey he used. Those 75 and up spend an average of $896 a year for entertainment, compared with $1,371 for those 65 to 74. According to his calculations, a couple in the first year of retirement at age 55, with expenditures of $60,000, might be able to safely withdraw that much from a portfolio worth $1 million - a 6% initial withdrawal rate. They would not run out of money so long as they reduced their spending later on according to the pattern shown in the survey, he said. "Of course it depends on the mix of stocks and bonds in someone's portfolio," Mr. Bernicke said. "But a 6% withdrawal rate becomes very realistic." He said that this rate could vary because of many factors, including a retiree's spending level and the size of the nest egg. Others advocate loosening the purse strings in retirement, but for other reasons. In the October 2004 issue of The Journal of Financial Planning, Jonathan Guyton, a planner at Cornerstone Wealth Advisors, advocated an initial withdrawal rate as high as about 6%, drawing his conclusions from a study of market returns from 1973 to 2003. Mr. Guyton found that a person who retired in 1973, in the middle of a punishing bear market with very high inflation, could have supported a 6.2% initial withdrawal rate over 40 years with a portfolio that was 80% stocks. A portfolio with 65% in stocks could have borne a 5.8% rate, and one with 50% in stocks could have supported a 5.4% rate. "The difference between a 4% or a 5% withdrawal rate might be the difference between someone taking their grandkids on a vacation or not," Mr. Guyton said. "It's usually the last $10,000 that puts the quality in 'quality of life.' " In order to take out more than 4% that first year, Mr. Guyton said, investors need to follow a few rules. To generate income, they must always sell winning stocks before bonds or losing stocks. They cannot add more than 6% a year to their withdrawal even if inflation is higher than that. And no increases are permitted immediately after a year of investment losses. Mr. Guyton's research can be found at www.fpanet.org/journal/articles/2004_Issues/jfp1004-art6.cfm. To be sure, Mr. Bernicke's and Mr. Guyton's ideas have been met with skepticism by many planners who worry that medical costs may rise so fast that they will undo a well-constructed financial plan. The cost of prescription drugs has been rising more than three times as fast as inflation, according to data from AARP. Nursing home costs, meanwhile, have been rising 6% a year, according to surveys by MetLife. To hedge against these expenses, Mr. Bernicke advises retirees to buy insurance policies, but many planners say people need to save more and withdraw less. "I prefer a more conservative estimate of distribution," said Stephanie Hancock of Hancock Wealth Advisory. "I can't go back and say: 'Oops. You shouldn't have been taking out as much money the last few years,' if someone doesn't have enough." She is also skeptical about the assumption that people will cut back on expenses as they shift into retirement. "You have all this time on your hands," she said. "You could actually spend more." from Reality Retirement Planning: A New Paradigm for an Old Science by Ty Bernicke: Kenn Tacchino and Cynthia Saltzman [in "Do Accumulation Models Over-state What's Needed to Retire?" Journal of Financial Planning 1999] conclude that the current models used for retirement planning overstate the amount of financial resources needed for retirement. I agree with their contention that incorporating consumer expenditure survey data into the retirement planning process will create a more realistic retirement plan. The traditional [4% annual withdrawal] approach tends to indicate a much later retirement or decreased spending potential in early retirement years. This approach also gives the average American household an unrealistic view of their future by overstating what they need for savings to achieve their financial goals. Knowing the spending patterns of a consumer would allow the average individual to more accurately predict the size of his or her future estate. Larger estates typically require different planning strategies from smaller estates. The traditional approach too often projects that the consumers will deplete their nest egg by age 80, but when the assumptions of spending decreases in the reality retirement planning approach, retirees will have a growing nest egg at age 80. Investment management is another area of financial planning that is highly dependent on a consumer's anticipated future expenditures. Reality retirement planning has the tendency to require larger inflation-adjusted distributions early in retirement, with incremental decreases throughout a consumer's retirement years. This type of foresight would most likely determine a different asset allocation than what the traditional approach would suggest. [One could the extra security of having more of their portfolio in bonds as one ages.] from Decision Rules & Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe? by J Guyton: William P. Bengen in his three papers ["Determining Withdrawal Rates Using Historical Data." Journal of Financial Planning. October 1994, "Asset Allocation for a Lifetime." Journal of Financial Planning. August 1996, and "Conserving Client Portfolios During Retirement, Part III." Journal of Financial Planning. December 1997] concluded that [1] The safe initial withdrawal rate for pre-tax portfolios is 4.1% when all the equities [equities in the asset allocation was 5075%] are U.S. large-cap stocks. [2] When 30% of the equities are invested in U.S. small-cap stocks, the safe pre-tax withdrawal rate rises to 4.3%. Bengen raised the question of how a client unfortunate enough to have retired at the start of the 19731974 bear market would have fared over the next 30 years. He used average historical return data for the seven remaining years after 1995. An initial withdrawal rate of 4.3% could have been sustained for 30 years, but that the portfolio would have then been exhausted. Guytin's main finding: "when financial planners employ a balanced and diversified multi-asset class portfolio in conjunction with systematic decision rules pertaining to portfolio management, withdrawals, and inflation, the safe initial withdrawal rate increases significantly over previously published results." The safe initial withdrawal rate to provide 30 years of income increased from 4.3% to 4.7% for the 65% equity portfolio, and to 5% for the 80% equity portfolio that included international equities and real estate. Perhaps it is not surprising that the safe initial withdrawal rate rose by so great a degree with the inclusion of international equities and real estate. Of the 31 years of performance data since 1973, there were seven times when international equity was the top performing of the six equity asset classes, and another six times when real estate led the way. If the client was willing to forgo an inflationary adjustment following a particularly difficult year [a year in which stock values fell] with no make-up of that adjustment in the future -- the safe initial withdrawal rate rose from 4.4% to 5.4% when the desired outcome was to sustain the income stream for 40 years. In the 80% equity portfolio, the safe rate rose from 4.7% to 5.8%. When the desired outcome became the preservation of the portfolio's original purchasing power, the safe initial rate increased from 3.6% to 4.4% in the 65% equity portfolio; in the 80% equity portfolio, it improved from 3.9% to 5.0%. Somewhat offsetting these improvements was the reality that portfolio withdrawals were "frozen" ten times under this decision rule - about 30% of the time with each portfolio. If clients would be willing to forgo abnormally high inflation adjustments by agreeing to place a cap on their annual withdrawal increases to 6%: If the desired outcome is to sustain withdrawals for 40 years, the Inflation Decision Rule allowed the safe initial withdrawal rate to rise from 4.4% to 5.1% with the 65 percent equity portfolio, and from 4.7% to 5.4% with the 80 percent equity portfolio. If the desired outcome is to preserve the portfolio's original purchasing power through the end of 2003, the Inflation Decision Rule increased the safe initial withdrawal rate from 3.6% to 4.2% with the 65 percent equity portfolio, and from 3.9% to 4.7% with the 80 percent equity portfolio.
Consumers with higher credit scores -- the current U.S. average is roughly 723 -- have an easier time securing low-interest loans and other favorable terms on credit. The best way to raise a credit score is to pay bills regularly and on time, but there are other important considerations. Some of the most common missteps that lower scores include maxing out credit cards or home-equity lines, making only minimum monthly payments and shuffling debt between different accounts. Another important factor is the "balance-to-limit ratio," which measures what percentage of available credit is being used. Lenders like to see a credit utilization of under 60%, and consumer groups recommend keeping it below 50% of available credit. If a consumer has four credit cards with a $1,000 credit line each, for example, carrying a total balance of less than $500 per card will likely keep a credit score from declining. Scanning credit reports for possible errors or identity theft is a good idea, too. Consumers can obtain one free copy of their credit report from the three major credit bureaus each year (go to www.annualcreditreport.com), while scores can be purchased individually for as little as $5. If you need to place a fraud alert or credit freeze on your file, it shouldn't affect your score, though an alert will slow the credit-issuing process and a freeze will halt it completely. A survey by Providian and the Consumer Federation of America, also released yesterday, found that only 54% of Americans knew that maxing out a credit card would lower a credit score, while only 20% realized that making only minimum payments on credit cards would hurt their score. There was some good news, however. Compared with the 2004 survey, the percentage of people who obtained their credit score increased to 31% from 24%. Related Playing Numbers Game on FICO Credit Scores - M Umberger, Chicago Tribune , Credit Scores - D Darlin, NY Times , How to Rasie Your FICO - Kadet, WSJ / Kristof, LA Times, Credit Score Simulators - J Bayot, NY Times from the Consumer Federation of America press release: More than three-quarters of consumers (76%) mistakenly believe that they have the right to obtain their credit score for free once a year. "Clearly many consumers think that their right to a free credit report extends to credit scores as well," said Providian's Lewis. "Unless consumers apply for a mortgage loan or obtain our credit card, they must purchase their scores for a small fee," he added. Consumers also are confused about other characteristics of credit scores. Only 27% understand that scores measure credit risk, not credit knowledge, amount, or attitude. And less than half (47%) understand that individuals have more than one score -- one from each of three major credit bureaus and other scores as well. Only 54% understand that maxing out a credit card will lower one's credit scores. And only 20% know that just making minimum payments on credit cards will lower one's scores. Less than one-quarter (23%) know the identity of the three major credit bureaus. Many consumers do not understand how costly lower credit scores are. In the mortgage area, according to Fair Isaacs website, on a $150,000, 30-year, fixed-rate mortgage, consumers with credit scores over 760 will be charged a 5.42% rate with monthly payments of $844, while consumers with credit scores below 620 will be charged a 7.0% rate with monthly payments of $998 (if in fact they are able to qualify for the loan) an annual difference of $1,848. To help consumers better understand credit scores, CFA and Providian are making available a Web-based quiz, "Do You Know the Score on Credit Scores?," at http://www.consumerfed.org/score that tests the credit-score knowledge of consumers, providing key facts whenever incorrect answers are entered.
The Managed ETFs filing says its product would preserve the crucial benefits of ETFs, such as tax efficiency. But while many ETFs boast lower fees than traditional mutual funds, the fees associated with this actively managed ETF would be comparable to actively managed mutual funds. Much debate has taken place about how actively managed ETFs would function and whether they would negate some of the benefits of the structure. That remains to be seen, since no actively managed ETFs exist. One difference between the proposed ETF and traditional ETFs is in the transparency of the fund's holdings. Portfolio managers don't want everyone to see what transactions they are making, since that can lead to investors' copying their strategy or trading in advance of big transactions to take advantage of expected price movements. Traditional ETFs are highly transparent, which keeps the ETF price and the net asset value of the underlying securities in line. Here is why: Since professional investors who own ETFs can see what is inside the portfolio, they can tell whether the price of an ETF is trading above or below the NAV of the underlying holdings. If that is occurring, they can gather the ETFs, exchange them for the underlying securities and sell them for a profit, bringing the prices back in line. This degree of transparency can be a problem with active ETFs. Like traditional ETFs, this actively managed version each day will post the securities that make up the creation-and-redemption baskets -- the securities that are exchanged for ETF shares that trade on the market. With traditional ETFs, the holdings in the creation-and-redemption basket are almost identical to the securities in the ETF portfolio. But with actively managed ETFs, that won't always be the case. While the baskets may largely reflect the holdings of the ETF portfolio, they can also differ, since the manager can adjust the holdings at any time during the day. To avoid having to disclose those changes, the actively managed ETF would require that those changes not immediately be reflected in the creation-and-redemption baskets. That means if the portfolio managers want to have a 3% position in a specific stock that isn't yet in the portfolio, they can start ramping up their position in the stock. But until they reach their goal of 3%, it won't show up as a holding in the creation-and-redemption baskets. Traditional ETFs disclose their NAV every 15 seconds; the actively managed ETF will provide the NAV every hour. Every 15 seconds, it will provide a value that includes a random adjustment to the NAV. The actively managed ETF also will seek to maintain the tax efficiency of other ETFs, which is often lacking in traditional mutual funds. When a mutual-fund investor wants to sell a large number of shares, the manager must sell some securities in the fund to raise money. That can result in a capital-gains distribution, which is taxable to all shareholders in the fund. With ETFs, shares are bought and sold by investors on the secondary market, which doesn't trigger capital gains. And when shares are redeemed "in kind" by a market maker in the shares, no distributable capital gains occur. Another tax advantage: When investors in a traditional mutual fund want to sell shares, the fund doles out its highest-cost stocks to pay for it. With an ETF, though, when an authorized participant wants to exchange ETF shares, the fund delivers its lowest-cost shares. That helps protect the ETF from realizing future capital gains.
"There's enough awareness among investors that a lot think ETFs are neat, but they still don't entirely understand the market, including hedging," says Scott Martin, managing director of investments at Astor Asset Management LLC, which handles about $100 million in client money invested in eight ETFs. Hedging with ETF options, which allow investors to make bets that pay off if a particular fund tanks, can make sense for individual investors who own the shares but worry that they might fall in price. The most popular ETFs are based on stock indexes, but they can be based on any combination of stocks or other assets, such as oil futures or even ounces of gold. The American Stock Exchange, which pioneered the listing of ETFs, estimates that overall assets in ETF funds now stand at $264 billion, up from about $102 billion at the end of 2002. Now there also is a plethora of ETF options offerings. Earlier this month, the American Stock Exchange began trading options on 19 Vanguard VIPERs ETFs tracking a variety of indexes and three PowerShares ETFs. These options contracts convey the right to buy or sell 100 shares on a fixed expiration date at a set price. Trading volume in ETF options contracts has more than doubled between 2001 and 2004 to 162.3 million contracts, according to the Options Clearing Corp. So far this year, two out of the three most-active options are on ETFs, accounting for about 12% of all options volume, which will soon top one billion contracts and, in all likelihood, hit an annual record. Analysts say it's difficult to pinpoint how much of that volume represents trading by average Joes and Janes. But signs point toward hedge funds and institutions fueling the options boom. Wall Street pros have been accustomed to using options on individual stocks since the 1970s. That made it easy to adapt quickly to contracts on ETFs. Some financial advisers say individuals should consider using them to hedge their ETF holdings, too. And there are some new ways to do that. The online brokerage platform CyberTrader, a unit of Charles Schwab, recently added new features to its software to help individual investors devise more sophisticated strategies, including some that involve ETF options. After filling out a short questionnaire regarding goals and risk tolerance, an investor is presented with a few trading ideas that might include using ETF options as hedges. Randy Frederick, derivatives director for CyberTrader, estimates that options trading among his firm's retail customers has risen from 20% of their overall activity to 25% in the last 12 months. But stock trades still outnumber options three to one, including contracts on both ETFs and individual stocks. "The ETFs are a huge success, but you'll probably always have more traders in the actual equities than the options," says Mr. Frederick. Here's an example of how options can protect an ETF investment: Consider a hypothetical trade involving the Nasdaq-100 Index Tracking Stock, known by its ticker symbol QQQQ. Let's say shares in the fund are trading at $40 each, and an investor buys 200 shares for $8,000. For about $230, or $1.15 a share, the investor also can buy two bearish options known as puts conveying the right to sell all 200 of his or her QQQQ shares for $40 each anytime until late October. If the QQQQ shares decline two dollars over the next month, to $38, the options will go up in value and be attractive to exercise -- in the money, in trader jargon -- because the investor can still sell the shares at $40 each, losing only the $230 price of the options contracts rather than the $400 he would have lost on the decline in the share price. Of course, there's also risk on the options contracts, if the underlying QQQQ shares go up two dollars before expiration. The options will end up worthless and the investor will lose the $230 purchase price of the contracts, known among traders as the options' premium. But that investor will pocket $400 on the gain in the underlying shares, for a net gain of $170. Investors also can sell bullish options, known as calls, on shares they own. In effect, such a contract would act as a preplaced order to take profits, since a rally in the shares would cause an investor who purchases the option at a price $1 or $2 or above the price of the underlying shares to exercise it. The investor who sells the call also pockets some cash upfront for selling it. Conversely, if the shares fall, the investor who sells a call would cushion his loss with income from selling the call. Bernie Schaeffer, chairman and chief executive of Schaeffer's Investment Research, advocates the use of both ETFs and ETF options, among other instruments, in a widely followed newsletter he publishes. But he says many investors still haven't overcome their squeamishness about hedging because of the cost of premiums and other risks. "You have to get yourself in the insurance mentality as an investor," says Mr. Schaeffer. "When we send out our checks on our auto insurance and our homeowners insurance, we don't say, 'There goes more money down the tubes.' We know what the purpose is, and we wouldn't want to be without the protection."
We think the moat concept has broader applicability. In our view, investors who compete for returns in the financial markets can take concrete steps to widen their "investment moat" -- which in this context refers to an ability to consistently outperform a market benchmark. By focusing on market segments in which they boast a competitive edge, developing private valuation insights and reducing temperament-driven errors that impede rational thinking, investors can meaningfully improve their returns. Although we view these as the three key ingredients for widening an investment moat, we caution that we are offering a framework rather than a prescriptive recipe. Investment moats take many shapes, and the most successful investors will be those who adapt the framework to amplify their unique strengths. Only Enter Competitions You Can Win Who among us would bet their portfolio that they could beat Wayne Gretzky in a hockey shootout, or Tiger Woods over 18 holes at Augusta. Similarly, we're not sure why anyone in their right mind would knowingly sell a stock to Warren Buffett. While these are comical exaggerations, a moment's reflection can reveal the serious financial consequences of competing for the "wrong" returns. Let's illustrate with an example from the market for short-term returns. The competition for short-term returns is brutal. The proprietary trading desks at giant Wall Street firms and hedge funds such as Goldman Sachs or Bear Stearns risk billions of dollars trying to profit from near-term price movements. So it's not surprising that these firms have made huge investments in market information systems and well-connected traders to maintain their position at the head of the queue for the highly perishable information that drives short-term prices. Hedge fund SAC Capital is notorious for seeking the "first call" from analysts with news -- but when your fund single-handedly generates 2%-3% of the NYSE's daily volume, the sheer dollar value of your commission payments cements your perch at the head of the information-flow queue. It's crazy to compete with these firms. But why bother? If the majority of the market is focused on the near term, why not simply seek long-term returns that attract far less competition? Many investors must either report their returns each quarter or are simply too impatient to hold stocks that don't appreciate immediately. This trading frenzy often leaves attractive returns on the table. Take Anheuser Busch, for example. Unlike many companies that Berkshire Hathaway has disclosed as investees, Anheuser Busch's stock price is still lower than when Berkshire declared its hand. While the street ignores it in favor of stocks with more exciting near-term earnings prospects, a patient investor could readily accumulate a sizable stake in this 5-star stock. Less competition equals wider moat. Develop Private Valuation Insights "Buy what you know" is a useful concept popularized by Peter Lynch, Fidelity's master fund manger. Lynch's idea is that investors should focus on businesses they understand. For example, an investor who frequently shops at Gap and notices an increase in store traffic has arguably gained an informational advantage. We think this is useful advice, but in our view, investors must push further to convert such insights into an investment moat. Investing at a discount is the key. It's little use investing to exploit Gap's rising sales if the stock price already reflects it -- the competition has beaten you to it! Insights must be private to be valuable. The good news is that many investors already boast above-average expertise in select fields. Physicians are likely well acquainted with pharmaceutical and hospital management businesses. And it's possible to develop additional areas of expertise through a program of diligent reading and field research. When it comes to valuation, the going gets a little tougher. Hint: Limit your research and investing to stocks in one sector or stocks that meet certain strick criteria. Temperament: Steady Minds Earn More Than Steady Returns If you were given the keys to Suntrust Bank's STI vault in downtown Atlanta, you'd soon have access to one of the 20th century's most closely guarded commercial secrets -- the formula for Coca-Cola. While it's less important for Coke to guard its secret today -- much of its moat comes from its "share of mind" and global distribution network -- in the early days secrecy was vital. Intense secrecy is also common amongst institutional investors. This stealth is concentrated amongst managers pursuing quantitative strategies. As soon as any competitor gained access to (or reverse-engineered) a quant shop's investment algorithms, their moat from that strategy would rapidly drain. So what are we to make of the procession of successful investors who openly explain their methods? Warren Buffett, via his shareholder letters? How-to investment books by George Soros, Joel Greenblatt, Seth Klarman, John Neff, Marty Whitman, David Dremen, Bill Gross and Ben Graham? It's wise to conclude that these businessmen believe their investment moats originate elsewhere. We'll defer to one of the masters to reveal the secret; "The most important quality for an investor is temperament, not intellect." Temperament is necessarily some function of intellect. What matters is a conscious effort to harness temperament to make fewer investment errors. We've selected three manifestations of temperament -- overconfidence, independent conviction, and envy -- to suggest some error-reducing ideas. No doubt there are hundreds more. Overconfidence is a pervasive and often invaluable human trait. Without it, our ancestors may never have moved out of caves, explored new worlds, or challenged gravity. But overconfidence can have downsides for investors. Excessive trading is one. The more frequently you trade, the more likely you are to be pursuing low return strategies -- such selling a stock in the hope of buying it back cheaper, trying to outwit impossibly resourced Wall Street trading desks or hoping to precisely time short term price jumps. We struggle to list investors who have accumulated serious wealth via furious trading, but we could spend all day showcasing wealthy families who owe their success to holding shares of great businesses for generations. Turnover is expensive. Why volunteer for more? The next time you find your finger on the trading trigger, stop and ask whether you can prove that action will be more profitable than inaction. Independent conviction was popularized by Ben Graham. To paraphrase one of Graham's pithy quotes: You are neither right nor wrong because others agree with you. You will be right if your facts and reasoning are correct. The challenge is that investment decisions bear important financial consequences, and are often made alone. It can be all too easy to submit to a need for emotional reassurance by "herding" with other investors. But it can also be frightfully expensive, as investors who bought Cisco in January 2000 or Xerox in December 1972 now lament. As with many temperament-honing strategies, basic awareness is a critical step. In this case we'd go further and prescribe a program of "fact-based" investing. In our view, investors who substitute a reference to "the crowd" with a reliance on verifiable stock-specific facts will inoculate themselves from the market's emotional swings. Building a fact base for your investments will also help you avoid getting spooked by temporary price declines. It's pointless to buy stocks with a large margin of safety if a transitory 10% price decline makes you sell. Granted, this is much easier said than done, but moats wouldn't be worth much if everyone could have one, would they? Envy, not greed, makes the world go round. Envy may actually be the deadliest temperament - driven investment sin. We're frequently astounded that investors furiously scramble into the market's hottest sector, seemingly unable to miss out on the "easy" profits others are making. But rushing into a popular investment category strikes us as odd. Why buy when prices are highest and margins of safety lowest? Yet the lure of the 1990s dot-com bubble, today's real estate boom, or any of history's famous bubbles demonstrate envy's powerful siren song. But if someone else gets rich a little faster than you, so what? Some investor will always earn a higher return than you. The demons of envy can be thwarted with a combination of awareness and a disciplined strategy of limiting investments to those that can be purchased with a margin of safety. Sure, there will always be a "hot" market sector, but investing is a business in which the tortoise always wins in the end. Temperament is a subset of the broader academic research into behavioral finance, and we've barely scratched the surface here. We urge serious investors to explore this field in much more depth than our space constraints permit. We'd recommend the final "talk" in Poor Charlie's Almanack for those seeking an experienced practitioner's overview, and the works of academic heavyweights Danny Kahneman, the late Amos Tversky and Richard Thaler for those desirous of a more rigorous presentation. Profiting From Temperament: An Illustration Let's explore the concept of temperament with two investment examples: Investment A: You buy a stock for 50% of its estimated fair value. This stock never trades below your buy price, and the stock consistently appreciates until you sell it at fair value five years later. This is a rare experience, but most importantly -- it's EASY. Nothing soothes investors like repeated positive feedback from a consistently rising price. About the worst you could do here is to sell too soon, chasing near-term performance elsewhere. Now Investment B: Once again, you buy a stock for 50% of its estimated fair value. A year later, the stock has gone nowhere, while the fair value is unchanged. At this point, some investors will have sold. After another year, the price has declined 20%, while the fair value is unchanged. More investors will have sold by now. Then, after year three, the stock has declined another 20%, while the fair value is still unchanged. By now, many investors will be selling. But the investment thesis hasn't changed--buying and holding a stock that trades significantly below it's fair value. In year five the stock finally appreciates to fair value, and the remaining investors sell. The result is the same as Investment A, but only those with a temperamental advantage pocketed the profit. Unlike Investment A, this profit is extremely hard to earn. Those who can enjoy a fabulous advantage -- a temperament-enabled investment moat. Integration and Alignment: Completing the Jigsaw Puzzle No moat can protect a financial castle built upon contradictory foundations. No matter how you go about digging your own moat, make sure the pieces are complementary. It's little use attempting to develop the expertise to invest in highly technical fields like biotechnology if that means competing with research scientists with better and more rapid access to information. Investment moats are hard-won, but worth the effort. If you can circumnavigate tougher competitors, invest with insight and make fewer emotional errors, we think you'll enjoy the fruits of higher returns for the remainder of your investment lifetime.
From Losch Management Company 8-25-05: The moat of brand recognition caused Buffett to invest in Coke and Gillette. The moat of patents or copy write protection protects auto parts maker Gentex and Walt Disney. Superior financial strength can be a moat. Much of the time the company with the best balance sheet in an industry can dominate that industry. If managed correctly. A moat that stems from a dominating balance sheet can last a long time. One classic example of the danger of a narrow-moat firm is that of Palm handheld computers. This firm's personal digital assistants (PDAs) took the market by storm back in the late 1990s. But by 2001 several major competitors had entered into this market. The result: Palm's product quickly became a commodity, and the firm's growth soon evaporated.
The researchers found that the stocks of companies whose headquarters are in the same geographical area tend to rise and fall together. That means that the stocks of two companies based in Boston, for example, are more likely to move in tandem than those of two companies based thousands of miles apart. The professors could not find any rational explanation for this pattern. They found that this pattern could not be attributed to the tendency of companies in the same industry to be based in the same region - the way the high-tech industry, for example, is centered in Silicon Valley. When measuring the correlation of a given region's stocks, the professors controlled for the tendency of stocks in the same industry to move up and down together. The phenomenon they discovered exists above and beyond this industry effect. One of the more telling findings involved companies that moved their headquarters from one part of the country to another. Before such moves, their stocks were relatively highly correlated with those of companies near their old bases - and showed very little correlation with those in the areas where they would relocate. After the moves, however, the pattern reversed. The stocks lost most of their correlation with those of their old regions and became highly correlated with those in their new regions. A good illustration is Nextel, which moved its headquarters in 1996 to McLean, Va., near Washington, from the New York suburb of Rutherford, N.J. After the move, its stock became less correlated with those of New York-area companies and more so with those in and around Washington. To the professors, the probable explanation is that many investors are more inclined to buy the stocks of companies in their regions. After all, these are the companies with which they are most familiar - the ones most likely to pop up in conversations with other local investors. When investors in a region become more bullish, they tend to distribute their purchases across all companies based there - a rising tide that raises all boats. But this can also lead a region's stocks to decline more or less together - when a region's investors decide to reduce their equity exposure. Because they tend to be disproportionately invested in the region's stocks, their selling will necessarily be concentrated in those issues. That behavior seems irrational, because it involves buying and selling stocks with little regard for earnings, book value or other measures of fundamental value. Yet the professors found further evidence of the pattern when they focused on various measures of investor sophistication. They found, for example, that the pattern is strongest among stocks held primarily by individual investors. The likely explanation is that irrational factors like headquarters geography are more likely to influence individual investors than institutions like pension funds and endowments. The findings have important investment implications. One is that the definition of diversification should be expanded. Until now, a portfolio was considered adequately diversified if it had enough stocks in enough different industries. The professors argue that a diversified portfolio should also include companies whose headquarters are dispersed across many regions. The study also points to a new way to search for undervalued and overvalued stocks: First, consider the stocks of companies from a region whose stocks have been in favor. Because investors in that region may bid up all such companies' stocks without much regard for their underlying value, there may be some whose prices are unjustifiably high. The opposite is likely to be the case in a region whose stocks have performed particularly poorly. Because investors in that region may have indiscriminately sold the stocks of all local companies, there may be some whose prices are undeservedly low.
1. True or false: When a mutual fund changes portfolio managers, it can wait months before notifying shareholders. 2. True or false: Management needs your approval to change the style or investment policies of your fund. 3. Which of these fees is a no-load mutual fund allowed to charge investors: (a) termination fee (b) short-term redemption fee (c) low-balance fee (d) management fee (e) 12b-1 fee (f) all of the above. 4. Yes or no: In a taxable account, you transfer money from the XYZ Growth fund into XYZ Value. You never touch the money. Do you owe capital gains taxes on profits earned in XYZ Growth? 5. True or false: A mutual fund can continue to use a star manager's superior track record in advertising, even after the manager has left the fund. 6. A total expense ratio of 1.5 percent is considered below average in which of the following investment categories: (a) international (b) small-cap growth (c) large-cap growth (d) general bond funds. 7. When you call to make a change to your fund account, the management company says you will need a "signature guarantee." You get that guarantee from your: (a) notary public (b) banker (c) lawyer. 8. Over the most recent five-year period, which of these fund categories had the highest annualized return: (a) China region funds (b) balanced funds (c) general muni debt funds (d) large-cap value funds. Now check your answers in the space TWO articles below.
She's right, which is precisely why class is now in session. You're getting a pop quiz on basic things all fund shareholders should know. The questions are not designed to stump you, just to test your level of knowledge and awareness. Good luck. Here are your questions: 1. True or false: A fund that invests only in insured bonds or U.S. government bonds cannot lose money. 2. Which of these characteristics is least important when evaluating a bond fund? (a) yield (b) total return (c) expenses 3. You're in the 28 percent tax bracket. Which bond fund generates a greater after-tax return? (a) a national municipal bond fund yielding 4 percent (b) a corporate bond fund yielding 5.5 percent 4. True or false: You can lose money in a fund during a calendar year but still owe capital-gains taxes on the investment profits realized by the fund during the year. 5. True or false: Every time a fund pays shareholders a capital gain or dividend distribution, its share price falls by the amount of that payout. 6. Of these items, which ones are not included when a fund calculates its total expense ratio? (a) brokerage/trading costs (b) management fees (c) 12b-1 fees for sales and marketing of the fund (d) front- or back-end sales charges (e) shareholder mailings (f) interest expenses a fund incurs when borrowing money (g) account-maintenance fees 7. You own the XYZ Utilities fund. How much of that fund must be invested in utility stocks? (a) 100 percent (b) 80 percent (c) 65 percent (d) 25 percent 8. You invest in a general equity fund called ABC Aggressive Growth. What percentage of the fund can be concentrated in any one sector or specialty, such as technology stocks? (a) 25 percent (b) 65 percent (c) 80 percent (d) unlimited Now check your answers in the space TWO articles below.
2. False, although there are a few cases where management still needs your OK. Shareholder approval is required on "fundamental issues" -- which sounds like it should include investment policies -- but most firms have rewritten prospectuses so that style and policy issues are considered "nonfundamental," meaning they can be altered without a vote. 3. (f). "No-load" is about sales charges. Fees for closing accounts, quick redemptions, falling below minimum account size, or management of the fund have no bearing on the load. The 12b-1 fee, which is for sales and marketing, is trickier, but so long as it does not exceed 0.25 percent, regulators allow a fund to be described as having no sales loads. 4. Yes. Phone transfers are a sale and a purchase, and the sale is a taxable event, meaning you owe Uncle Sam for any gains realized by selling (or you get the tax benefit from any losses recognized in the trade). 5. True. The manager's record belongs to both the fund and the manager. That's why a manager can use his past record to pump up interest in a new fund, while the company running his old fund can continue to tout the superior results earned during the star manager's tenure. 6. (a) and (b). Lipper pegs the average total expense ratio for international funds at 1.70% and at 1.69 percent for small-cap growth funds. The expense ratio for the average large-cap fund is 1.47%; on general bond funds, it is 1.01%. 7. (b). A few Neanderthalish fund firms require written instructions plus a bank's guarantee that your signature is real before closing accounts, processing redemptions or changing an automatic investment plan. 8. (c). According to Lipper, general muni bond funds are up an average of 5.43% per year over the last five years, with China funds gaining an annualized average of 3.81%, large value funds up 3.09% and balanced funds up just 1.73%.
2. (a) Yield. This is just a flat percentage of principal, which is why total return is a better measure of what you can expect a bond fund to deliver. Expenses, critical to all investment decisions, are particularly important in bonds, because funds with higher costs are virtually guaranteed to produce lesser returns than lower-cost competitors. 3. (a). This is about "tax-equivalent yield" and requires some math. The corporate fund's after-tax yield is 3.96 percent (4.0 percent multiplied by 0.72, or the percentage you keep after taxes); in the muni fund, the after-tax yield is the entire 4.0 percent. 4. True. A fund is a pass-through vehicle, meaning that whatever capital gains it realizes get passed on to you; as a result, if the manager sells past winners and the fund suffers through a down period, investors can end up with a tax bill and a loss in the same year. 5. True. Accumulated capital gains and dividends are part of the share price until they are paid out. If a fund trades at $10 per share and pays a $1 distribution, its net asset value will fall to $9 when the payout is made. 6. (a), (d), (f) and (g). Trading costs, interest expenses and any fees that are neither predictable nor associated with day-to-day fund management are omitted from the expense ratio. 7. (b). If a fund is named for a specific investment or asset class, it must keep at least 80 percent of the portfolio in the assets for which it is named. 8. (d). Unless constrained by rules laid out in its prospectus -- which is rare -- a broad-based fund can go wherever management wants, provided that it pursues its stated investment goal. That means an aggressive-growth fund could invest in a single hot sector, because that move could be considered an aggressive pursuit of growth.
1 Bad Ideas & Erroneous Assumptions Wreck Retirement Plans As you decide how much to save each month and how to invest those dollars, you have to make assumptions about the future. For instance, lots of people presume that stocks are sure to beat bonds, that real estate always appreciates, that saving 10% a year is enough, that they will have steady employment until retirement and that stocks will deliver 10% a year over the long run. How solid are these assumptions? Some seem dubious, like the notion that stocks will deliver 10% a year. Others appear more reasonable, like the idea that stocks will beat bonds over the long run. But it is worth pondering what it would mean for your finances if even a dearly held belief like that proved incorrect. After all, who would have thought the Nasdaq would fall 78% over the 2.5 years through October 2002, or oil would go to $70 a barrel, or real estate would get so hot, the Sept. 11 terrorist attacks, or a hurricane would shut down New Orleans? The fact is, the unthinkable happens all the time. The lesson: Don't bank heavily on any assumption -- or your financial strategy could come unstuck. 2 Rising Monthly Obligations It's great to receive a regular paycheck. It isn't so great when your paycheck arrives and the entire sum is already spoken for. Unfortunately, this seems to be increasingly common, with families taking on a bewildering array of monthly commitments, including payments for the mortgage, car leases, credit cards, utilities, cable television, cellphones, DVD rental, satellite radio, Internet access and goodness knows what else. Colleen Walsh, an accountant and financial planner has dubbed this the "monthly mentality." Folks focus too much on what they can afford based on their monthly cash flow. Keeping up with the Joneses is more important than their own long-term financial well-being. As families take on more and more recurring monthly expenses, they leave themselves vulnerable to two key financial problems. First, with fixed costs consuming so much of their paycheck, it is hard to find money to save. Second, things could quickly turn ugly if these folks are laid off or get hit with hefty medical or home-repair costs. Sure, if necessary, they could ditch some of their monthly obligations. But once people get used to a certain standard of living, it is painful to cut back. 3 Too Many Illiquid Assets If you did get laid off, you could presumably keep yourself afloat for a while by dipping into savings. But that may be more costly than you imagine. If you are like me, the vast majority of your savings is in tax-sheltered retirement accounts. The problem: Tapping these accounts before age 59.5 typically means paying both income taxes and tax penalties. Granted, if you lost your job, you probably wouldn't be in a high tax bracket, so the tax hit may not be too severe. But let's say you got laid off in August or September and you have to raid your IRA to get through the months ahead. Because you have already hauled in a decent amount of income for the year, you could be in a moderately high tax bracket. Result: Federal and state taxes, combined with tax penalties, could snag 40% or more of your IRA's value. 4 Two Things Going Wrong at the Same Time Suppose you own a $250,000 house and you have $200,000 stashed in stocks and bonds. You also, however, have a $200,000 mortgage and $30,000 in auto loans and credit-card debt. Add it up, and you have $450,000 in total assets and $230,000 in total debts, giving you a net worth of $220,000. Doesn't seem particularly risky? Usually, it wouldn't be. But imagine you lost your job during a weak housing market. After some scrambling, you land a new job, but it is on the other side of the country. That means you have to sell your current home, relocate your family and buy another home, while continuing to cover living expenses and service debts. With any luck, thanks to your new job, you won't have any problem qualifying for another mortgage. But you still have to come up with a down payment for the new house. That may not be easy. Given the housing market's weakness and your need to sell quickly, you might end up unloading your current home for $225,000. After forking over a 6% real-estate commission and paying off your $200,000 mortgage, you would net just $11,500. Fortunately, as you cobble together a down payment for the new house, you can draw on your $200,000 in stocks and bonds. Unfortunately, much of this money is in retirement accounts, so tapping your portfolio could mean paying income taxes and tax penalties. One way or another, you would probably muddle through, somehow managing to relocate, keep your creditors at bay and buy a new home. Still, if all this seems a little precarious, there's a reason: It is. My goal here isn't to dissuade you from ever taking on debt or ever funding a retirement account. But bad things happen, so you need to give yourself some financial breathing room. That means limiting your debts, holding down monthly financial obligations and having some savings in a regular taxable account. But most of all, you need to think ahead. What if you don't have steady employment from now until retirement? What if real estate doesn't always appreciate? What if stocks don't return 10% a year? You need to build such possibilities into your financial plan -- before something goes wrong and it's way too late for planning.
To appreciate just how good bond-index funds are, check out the performance of Vanguard Group's stock-index and bond-index funds. Vanguard is the largest manager of index mutual funds aimed at ordinary investors, with 28 different funds offered, including four bond-index funds. Its best-known index fund is the $107 billion-in-assets Vanguard 500 Index Fund (VFINX), which according to Morningstar, Vanguard 500 has outperformed 79% of the funds in the "large blend" category over the past 10 years. Vanguard's second-largest index fund is the $59 billion Total Stock Market Index Fund (VTSMX), which tracks the entire U.S. stock market. That fund has outpaced 75% of competing funds over the past decade. Such results seem lackluster compared with the 10-year performance of Vanguard's Short-Term Bond Index Fund (VBISX), Intermediate-Term Bond Index Fund (VBIIX) and Long-Term Bond Index Fund (VBLTX). Those funds have -- respectively -- outpaced 87%, 94% and 88% of the funds in their category. The performance of Vanguard's other bond-index fund, the Total Bond Market Index Fund (VBMFX), beat a mere 75% of the funds in its category over the past 10 years. The reason: Vanguard Total Bond Market tracks the Lehman Brothers Aggregate Bond Index, which includes a hefty dose of mortgage-backed securities. These bonds haven't been great performers in recent years. While Vanguard is the biggest provider of bond-index funds for ordinary investors, it isn't the only choice. Other players include Dreyfus, T. Rowe Price Group and Charles Schwab. Why have bond-index funds fared so well? Partly, it's the expense advantage. While high-quality taxable-bond funds typically charge around 1% of assets each year, Vanguard's four bond-index funds have annual expenses of 0.2% or less, equal to 20 cents for every $100 invested. That advantage is there year after year after year. The typical manager trying to outperform a bond-index fund is starting each year at a 0.8 percentage-point performance disadvantage. "Bonds are where indexing really works," says William Bernstein, an investment adviser. "Just as location, location and location are the most important things with real estate, so expense, expense and expense are the most important things with a bond fund." Active managers are also hampered because the range of returns among high-quality bonds is so much narrower than that among stocks, notes Larry Swedroe, co-author of "The Only Guide to a Winning Bond Strategy You'll Ever Need," which will be published in January. That makes it tough for bond-fund managers to shine. "The bottom line is, there isn't the opportunity to add value the way there is with stocks," Mr. Swedroe says. As good as bond-index funds are, they probably shouldn't be your only bond investment, especially if you have a relatively large bond portfolio. A bond-index fund will give you exposure to a broad array of high-quality corporate and government bonds. But there's a lot more to the bond market than that. "We use Vanguard's intermediate-term bond index as a core fixed-income holding and then build around it," says Michael Smither, managing partner of IndexEdge Investment Consulting. "It might be half of your bond holdings. Then we might add on Vanguard High-Yield Corporate (VWEHX), iShares Lehman TIPS Bond Fund (TIP) and T. Rowe Price International Bond Fund (RPIBX)." The iShares TIPS fund is an exchange-traded fund that invests in Treasury inflation-protected securities, better known as inflation-indexed bonds. But if you have less than $20,000 to invest or you plan to add regularly to your holdings, buying an exchange-traded index fund probably isn't a good idea, because the brokerage commission and other trading costs will put a big dent in your return. Instead, you will likely fare better by sticking with a regular mutual fund. For instance, as a substitute for the iShares TIPS fund, you might buy the Vanguard Inflation-Protected Securities fund (VIPSX). Despite the stellar record of bond-index funds, you could still lose money if interest rates rise sharply, especially if you are invested in longer-term bonds. Mr. Bernstein, the investment adviser, notes that investors have typically received scant extra reward for buying longer-maturity bonds. As he points out, "that's especially true right now, with the yield curve so flat." Result: Mr. Bernstein advises skipping Vanguard's intermediate-term bond-index fund and instead opting for its short-term bond-index fund. Despite his fondness for indexing, Mr. Bernstein says folks with bigger portfolios may want to skip bond-index funds entirely. You can trade Treasury bonds cheaply through a discount broker or through the government's Treasury Direct program. Go to www.treasurydirect.gov for details. Combine the Treasurys with the Vanguard investment-grade fund, and you should have a high-quality bond portfolio for less than the cost of an index fund.
A quick look at the recent performance of actively managed mutual funds illustrates the point. If this were truly a stock picker's market, then concentrated or focused funds - those that hold a smaller number of stocks - should be producing outsized gains. Yet among actively managed funds, the average concentrated portfolio is trailing the average diversified fund, according to Morningstar. Extremely diversified domestic equity funds, meaning those that invest 20% or less of their total assets in their top 10 holdings, are beating concentrated ones - those that invest 40% or more of their money in their top 10. That is true not only for the year to date, but also over the last 12 months and three years. The same goes for domestic equity funds that are diversified, based on their total number of holdings. Those with 100 or more stocks are up 14.9% a year, on average, over the last three years through July. Compare that figure with the 10.1% annualized gains of concentrated funds with 30 or fewer stocks. This situation could stem from the fact that funds that invest in small-cap stocks have led the markets over the last five years. It's harder for small-cap funds to concentrate their bets, because that would mean buying sizable stakes in tiny companies - investments that would be hard for these funds to extricate themselves from. But even among small-cap growth and small-cap value funds, diversified portfolios that put less than 20% of their money into their top 10 stocks have been beating concentrated funds. Over all, diversified investing is beating the concentrated approach in seven of Morningstar's nine general domestic fund categories over the last 12 months and three years. Many people think that this trend will continue. A number of money managers and market strategists, are forecasting a period of modest annual domestic stock returns - around 7 to 8%, on average - over the next several years. Yet Mr. Caffrey contends that stocks that miss earnings expectations or report bad news may still lose 10 to 20% of their value in the short run. "In this environment, the downside risk of an individual stock could potentially swamp the upside potential." It may take just a mistake or two in a concentrated portfolio to wreck an investor's year. This isn't to say that concentrated investing never works. In the mid- to late 1990's, funds like Janus Twenty that made huge bets on a handful of stocks were the market's darlings. Concentrated investing tends to work best in momentum-driven markets, said James Peterson, vice president of the Schwab Center for Investment Research. The current market is very quality-focused - on earnings, cash flow and dividends," he said. Kunal Kapoor, director of fund analysis at Morningstar, says that concentrated investing makes sense for some investors, but only if they understand the risks involved. First and foremost, there's manager risk. Concentrated investing places big bets on a few stocks, but it places an even bigger wager on the skill of the person who buys and sells them. In a mutual fund, investors are betting on the ability of professional money managers to deliver big returns in exchange for greater volatility. If you are buying individual stocks, you are betting on your own skills to consistently produce big gains through big bets. Mark Dawson, a senior equity portfolio manager at Rainier Investment Management, doesn't want to make that wager. "There's almost a sort of machismo dimension to concentration," he said. "There's this notion that if you're a real stock picker, you'll be concentrated. We think that's a mistake. Our belief is that an investor benefits in their portfolio from acute attention to risk control, and the primary means of risk control comes from diversification." This is why the Rainier Funds limit their maximum exposure to any single stock to 5%. And to further ensure diversification, Mr. Dawson does not allow any of his sector bets to go five percentage points over or under that sector's weighting in the fund's benchmark. If a particular fund compares its performance against the S&P500 index, the fund's exposure to the technology sector has to stay fairly close to the index's exposure to technology. "The practical effect of this is that you are forcing yourself to spread your bets across the entire marketplace, including some unloved sectors," Mr. Dawson said. That might not be a bad approach for all investors to take, whether they're investing in stocks, bonds or more esoteric asset classes. Richard Bernstein, chief United States strategist at Merrill Lynch, says returns on investments are best when capital is scarce. "But right now, no asset class is starved," he said. He noted that over the last few years, huge amounts of money have flowed into small-cap mutual funds, emerging-market debt and equity funds and high-yield bond funds as well as commodities, currencies, venture capital funds, private-equity funds and hedge funds. "I just don't believe there is one asset class that's going to give you tremendously differentiated returns where it's worth the risk to make big bets," he said. "So my argument has been that people should stay very broadly diversified."
Answer: In the late 1970s this was called a "yield tilt" strategy. Today, it is most commonly seen in "equity income" funds that attempt to provide a dividend yield greater than the S&P 500 index. I admire this approach and think it is particularly useful for retirees. The greatest losses happen when we are forced to sell assets to meet income needs so the more you can do to have your investments provide all the cash income you need, the better. This, by the way, is the reason portfolio survival for any given income rate can be improved by buying a life annuity with a portion of your savings. The greatest danger in a high-yield-stock portfolio is that it will be concentrated in a few industries. Banks are among the top dividend payers today, along with real estate investment trusts, some electric utilities, the tobacco companies, and a few pharmaceutical companies. Less diversification means more risk. Another danger is that you can lose a great deal of money if you are forced to sell stocks to pay for an illness or other disaster. The only thing you can be certain of is that your personal disaster will happen during a period of falling stock prices, not rising stock prices. So you won't find me endorsing a 100% stock portfolio. As a source of protection and diversification, you should consider an 80/20 stock/fixed income portfolio with the bonds invested in a five-year ladder of Treasury notes. The ladder will provide you with a minimal-risk source of emergency funds and a relatively good yield. With yields on one- to five-year Treasuries now around 4%, it would meet your income requirement as well.
2. Don't believe in a company - Trading is not investment. Remember the numbers and forget the press releases. Leave the American Dream to Peter Lynch. 3. Don't trade over your head - If your last name isn't Buffett or Cramer, don't trade like them. Concentrate on playing the game well, and don't worry about making money. 4. Don't break your rules - You made them for tough situations, just like the one you're probably in right now. [Irene Dunne: "If we don't stand for something, we will fall for anything". ] 5. Don't try to get even - Every position must stand on its merits. Take losses with composure, and take your trades with discipline. 6. Don't seek the Holy Grail - There is no secret trading formula, other than solid risk management. So stop looking for it. 7. Don't forget your discipline - Learning the basics is easy. Most traders fail due to a lack of discipline, not a lack of knowledge. 8. Don't chase the crowd - Listen to the beat of your own drummer. By the time the crowd acts, you're probably too late. 9. Don't trade the obvious - The prettiest patterns set up the most painful losses. If it looks too good to be true, it probably is. 10. Don't ignore the warning signs - Big losses rarely come without warning. Don't wait for a lifeboat to abandon a sinking ship. 11. Don't count your chickens - Profits aren't booked until the trade closes. The market gives and takes away with great fury. 12. Don't forget the plan - Remember the reasons you took the trade in the first place, and don't get blinded by volatility. [Kipling: "If you can keep your head when all about you are losing theirs".] 13. Don't have a paycheck mentality - You don't deserve anything for all of your hard work. The market only pays off when you're right, and your timing is really, really good. [Mark Twain: "Don't go around saying the world owes you a living; the world owes you nothing; it was here first."] 14. Don't join a group - Trading is not a team sport. Avoid stock boards, chatrooms and financial TV. You want the truth, not blind support from others with your point of view. [Kipling: "If you can talk with crowds and keep your virtue".] 15. Don't ignore your intuition - Respect the little voice that tells you what to do, and what to avoid. That's the voice of the winner trying to get into your thick head. [Kipling: "If you can trust yourself when all men doubt you, but make allowance for their doubting too"..] 16. Don't hate losing - Expect to win and lose with great regularity. Expect the losing to teach you more about winning, than the winning itself. [Kipling: "If you can meet with triumph and disaster and treat those two imposters just the same."] 17. Don't fall into the complexity trap - A well-trained eye is more effective than a stack of indicators. Common sense is more valuable than a backtested system. 18. Don't confuse execution with opportunity - Overpriced software won't help you trade like a pro. Pretty colors and flashing lights make you a faster trader, not a better one. 19. Don't project your personal life - Trading gives you the perfect opportunity to discover just how screwed up your life really is. Get your own house in order before playing the markets. 20. Don't think its entertainment - Trading should be boring most of the time, just like the real job you have right now. "If you can make one heap of all your winnings and risk it on one turn of pitch-and-toss, And lose, and start again at your beginnings and never breath a word about your loss" . . then your one heck of a guy, but you shoulda 'diversified'.
[1] "All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical (technical) formations and patterns recur on a constant basis. I absolutely believe that price movement patterns are being repeated. They are recurring patterns. This is because markets are driven by humans -- and human nature never changes." [2] Don't take action with a trade until the market, itself, confirms your opinion. Being a little late in a trade is insurance that your opinion is correct. In other words, don't be an impatient trader. [3] "Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes. The big money is made by the sittin' and the waitin' -- not the thinking. Wait until all the factors are in your favor before making the trade." [Kipling: "If you can wait and not be tired by waiting" or Mae West: Anything worth doing is worth doing slowly.] [4] "When a margin call reaches you, close your account. Never meet a margin call. You are on the wrong side of a market. Why send good money after bad? Keep that good money for another day." [5] Livermore coined what he called "Pivotal Points" in a market or a stock. Basically, they were: (1) Price levels at which the stock or market reversed course previously -- in other words, previous major tops or bottoms; and (2) psychological price levels such as 50 or 100, 200, etc. He would buy a stock or commodity that saw a price breakout above the Pivotal Point, and sell a stock or commodity that saw a price breakout below a Pivotal Point. [6] "Successful traders always follow the line of least resistance. Follow the trend. The trend is your friend." A prudent speculator never argues with the tape. Markets are never wrong -- opinions often are. [7] Few people succeed in the market because they have no patience. They have a strong desire to get rich quickly. [Kipling: "If you can dream - and not make dreams your master".] [8] Livermore's money made in speculation came from "commitments in a stock showing a profit right from the start." Don't hang on to a losing position for very long. When you make a trade, "you should have a clear target where to sell if the market moves against you. And you must obey your rules! Never sustain a loss of more than 10% of your capital. Losses are twice as expensive to make up. I always established a stop before making a trade." An important point: Livermore's trading success came not because of any "inside" information or some huge store of knowledge he had about each and every stock. Livermore's trading success was derived from his understanding of human behavior. That formula for trading success has not changed since Livermore's hey day in the stock and commodities markets almost a century ago. Monthly Employment Stats
The department said Hurricane Katrina did not impact the August job tally, since it crossed Florida and hit the Gulf Coast after the government had surveyed employers. Economists expect the storm, which killed an untold number of people and left thousands more homeless, will prove only a temporary set-back to the nearly $12 trillion U.S. economy. But it is expected to lead to a drop in payroll employment this month. The decline in the unemployment rate came as a separate survey of households also found job creation robust. Analysts had expected it to hold steady at 5.0%. Last month's 4.9% reading was the lowest since before the Sept. 11, 2001, attacks and offered a reminder that labor market conditions had been improving before Katrina struck. The unemployment rate has fallen one-half percentage point since February. Job gains in August were broad-based, although factory employment slipped by 14,000 - the third consecutive monthly decline. Over the past year, the manufacturing sector has shed 110,000 workers. The report showed construction payrolls grew by 25,000 - a figure surely to swell in the months ahead as rebuilding after Katrina gets under way. The service-side of the economy created 156,000 jobs, spread across most sectors. Average hourly earnings increased two cents, or 0.1%, with the year-on-year reading edging down to a 2.7% gain from July's upwardly revised 2.8%. The length of the average work week held steady at 33.7 hours.
According to Manpower's quarterly survey, about 20% of employers on a net basis said they plan to add to their payrolls in October through December. The net employment outlook is the difference between the percentage of employers who expect to add to payrolls and those who expect to reduce them. This solid performance is similar to the results reported in the previous quarter and last year, capping a string of stable reports. The employment outlook has been unchanged for seven consecutive quarters. Manpower expects job creation in the fourth quarter to remain steady at between 150,000 and 200,000 jobs a month. Last week, the U.S. Labor Department said about 10,000 people left jobless by the storm filed for unemployment benefits in the prior week. The job forecast remains strongest in the West, where the net employment outlook is 22%, and weakest in the Midwest, where it is 17%. The construction market, which has been growing solidly, may become tight, Mr. Joerres said, as workers are needed to rebuild Katrina's damage. Employers in the wholesale and retail trade, though, are not as optimistic as they were last year at this time as they enter the holiday season. Last year's net outlook was 32%, but this year's figure is only 29% -- a drop Mr. Joerres attributed to shrinking discretionary income. Just the Facts Mutual Fund Fees Higher In Europe InstitutionalInvestor.com 9-26 Investors in Europe pay more in fees and charges for mutual funds than their U.S. counterparts, according to a study by Fitzrovia, the research arm of Lipper. The average total expense ratio, which factors in management fees and other costs, was 1.79% for a European equity fund, while only 0.92% for one in the U.S. and 1.68% for a U.K. fund. The difference in ratio among the three regions studied for bonds funds was similar to that of equity funds. Fitzrovia explained that costs are lower in the U.S. because there is a single market as opposed to different markets in Europe, and disclosure of total expense ratios in the U.S. discourages mutual funds from upping their fees. In the U.S., lawmakers and the media have put fund promoters on the defensive over mutual fund fees and expenses. Also affecting the fees is the size of mutual funds; Europe is home to 52% of the funds with a total of $5.5 trillion, while the U.S. has 15% of the funds worth $8.1 trillion. "The difference in absolute industry size and average fund size plays its part in the differing levels of" total expense ratios, according to Fitzrovia. History and the Katrina Effect I David Brooks, NY Times 9-04 Katrina was the anti-9/11. On Sept. 11, Rudy Giuliani took control. The government response was quick and decisive. The rich and poor suffered alike. Americans had been hit, but felt united and strong. Public confidence in institutions surged. Last week in New Orleans, by contrast, nobody took control. Authority was diffuse and action was ineffective. The rich escaped while the poor were abandoned. Leaders spun while looters rampaged. Partisans squabbled while the nation was ashamed. The first rule of the social fabric - that in times of crisis you protect the vulnerable - was trampled. Leaving the poor in New Orleans was the moral equivalent of leaving the injured on the battlefield. No wonder confidence in civic institutions is plummeting. Last week's national humiliation comes at the end of a string of confidence-shaking institutional failures that have cumulatively changed the nation's psyche. Over the past few years, we have seen intelligence failures in the inability to prevent Sept. 11 and find W.M.D.'s in Iraq. We have seen incompetent postwar planning, scandals on Wall Street, the horror of Abu Ghraib, a steady rain of suicide bombings, the world's inability to do anything about rising oil prices. Each institutional failure and sign of helplessness is another blow to national morale. The sour mood builds on itself, the outraged and defensive reaction to one event serving as the emotional groundwork for the next. History and the Katrina Effect II Mark Hulbert, MarketWatch 9-01 Ned Davis Research has found that, six months after the 28 biggest geopolitical crises between 1940 and 1998, the stock market on average was 2.3% higher than where it stood immediately before those crises began. We probably should not be surprised by this finding. The markets are a discounting mechanism, reflecting companies' earnings, cash flow and dividends over many years into the future. Only if Katrina's impact were to be a nearly permanent decrease in the profitability of American corporations would a permanently lower stock market level be justified. This appears to be what Timothy Lutts, editor of the Cabot Market Letter, had in mind in the September 1 issue of his newsletter when he wrote: "Our sympathies go out to all affected. But the region will recover; it's the American way." Insiders vs. Analysts Mark Hulbert, MarketWatch 9-25 A new academic study concludes that when insiders and analysts directly disagree, the insiders are usually right. The study was written by three finance professors: James Hsieh of George Mason University and Lilian Ng and Qinghai Wang, both of the University of Wisconsin at Milwaukee. The professors focused on the 10 years through 2003. For each calendar quarter over that time, and for each stock, they first determined whether the consensus rating from Wall Street analysts had gone up or down. They also measured whether there had been net purchases or sales among that stock's insiders - the company's officers, directors and largest shareholders. Consider first those calendar quarters when there were more insider purchases than sales of a company's stock, and when the Wall Street consensus about that stock had become more bearish. Such stocks, on average, outperformed the market over the next four quarters, according to the professors. In fact, these stocks performed almost as well, on average, as stocks for which both insiders and analysts were bullish. According to the professors, this means that when insiders are bullish, the consensus of Wall Street's analysts is largely irrelevant to how a stock performs over the next year. In such cases, investors can safely ignore that consensus and rely on the insiders' behavior alone. Quick Facts, Stats & Opinions Treasury bond market investors almost seem to be inviting the federal government to increase its borrowing. The 2004 budget deficit was $412 billion, a record in dollar terms. But it amounted to 3.6% of the U.S. economy overall as measured by gross domestic product. By contrast, the 1983 deficit was 6% of GDP; the 1992 deficit was 4.7% of GDP. It's not surprising bond investors would have been more nervous about red ink in the 1980s and early '90s; it was consuming more of the economic pie. (Tom Petruno, LA Times 9-25) It's surprising how much running [a car's] air conditioner can adversely affect fuel economy. There are many factors at work, from your type of driving to the mechanical condition of the car's climate-control system. But air conditioning can decrease one's mileage 5% to 25%, based on Department of Energy statistics, our own tests and what we hear from other drivers. (Jonathan Welsh, WSH 9-20) In the first eight months-plus of this year, the number of rising stars has exceeded that of fallen angels, maintaining the trend set in 2004, according to Diane Vazza, head of Standard & Poor's Global Fixed Income Group, in a new report. Vazza noted that so far this year, 45 rising stars companies whose debt has been upgraded from junk status to investment grade have been recorded worldwide so far this year; the upgrades affect rated debt worth $95.2 billion. For the same period in 2004, S&P reported only 31 rising stars. Through September, Standard & Poor's also counted 28 fallen angels companies whose debt has been downgraded from investment grade to junk. The ratings agency pointed out that the volume of debt affected by the downgrades $501.7 billion has "vastly outpaced" the equivalent affected by upgrades, though much of this volume is attributable to the downgrades of General Motors and Ford. Worldwide, S&P singled out 30 companies as candidates to become rising stars, three fewer than the number cited in August. The 30 companies account for $62.1 billion in rated debt, added the ratings agency. Sectors displaying the highest numbers of potential rising stars included high technology, telecommunications, capital goods, media and entertainment, and retail/restaurants, according to S&P. (Stephen Taub, CFO.com 9-15) While having a retirement income that keeps pace with inflation may seem like the ultimate goal, it could leave you feeling increasingly shortchanged, especially if you retire early. "If you're keeping up with inflation, you're falling behind the Joneses by two percentage points a year," explains William Bernstein, author of "Four Pillars of Investing." The reason: Wages -- and hence the general standard of living -- tend to rise at roughly two percentage points a year faster than inflation. (Jonathan Clements, WSJ 9-14) The 29 energy stocks in the Standard & Poor's 500-stock index make up almost 10% of the cap-weighted index, up from 5.8% at the end of 2003. Energy stocks have historically accounted for about 8.28% of the index, according to S&P. Year-to-date, the sector has surged almost 36%. That follows a rise of 28.77% last year and 22.4% in 2003. (Meg Richards, Associated Press 9-11) Data from the Promotion Marketing Association (PMA) Coupon Council, a coupon advocacy group, shows that 76% of the general population uses coupons. In 2004, 84% of women and 68% of men used coupons that they received from Sunday newspaper inserts and retailers' fliers, in addition as those found in magazines, in and on packages, and online. (Progressive Grocer 9-02) In a new survey of chief financial officers released Wednesday, 29% said they were optimistic about the economy's prospects, down from 72% at this time last year, the lowest reading ever for this survey conducted by CFO Magazine and Duke University. The CFO's concerns include high fuel costs, the housing bubble, higher interest rates, reduced pricing power and soaring health care costs. As a result, CFOs predict that employment and capital spending growth will suffer. And that was before Hurricane Katrina slammed into the economy. (Danielle DiMartino, Dallas Morning News 9-01) These steps speak to an extraordinary vulnerability. Katrina was a blow to the nation's energy solar plexus. One storm knocked out a quarter of the nation's oil and gas production, 15% of refining capacity, three crucial pipelines that are arteries of the economy, and the electrical power needed to keep them in business. "No investor would concentrate their investments that heavily in one area," said Larry Goldstein, president of the Petroleum Industry Research Foundation in New York. "But because of environmentally sensitive citizens who don't want these facilities in their neighborhoods, we have forced our critical energy infrastructure into a very narrow area that's a natural disaster corridor." (Jim Landers, Dallas Morning News 9-01) Home Page Previous Factoid Top Sites
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