August 2009

The Easiest Way to Beat the S&P500

You say it's impossible to beat the market? This is aimed towards the efficient market and Boglehead crowd. I pose to you a large cap passive index fund that has beaten the S&P500 after fees over the last year, 5 years, and by a huge 8.78% YTD. It goes by ticker symbol RSP, the equal-weight S&P 500 index.

Increasingly popular, it trades over 1.3 million shares per day on average, and it beats the market the same way that monkeys beat the average human stockpicker. In the famous stockpicking test, monkeys threw darts at a dartboard where stock ticker symbols were laid out at random. The "stock picks" of the monkeys outperformed the human investors. The S&P 500 is market-cap weighted, meaning that the largest companies have the biggest positions in the index. Truer diversification would mean blindly picking the companies and giving them all the same weight, as there is no more confidence in one firm than in another. The only cost to you is a 40bps expense ratio, which is 32bps per year above the SPY.

If no one can beat the market, why give the largest companies more weight? The only way that RSP diverges from the index is by giving the smaller companies a higher weighting, which over time would capture more returns due to small-cap bias, which is well documented by even the grandfathers of the efficient market hypotheses, Fama and French.

So if you have pledged yourself and your retirement plan to the undying belief that markets cannot be beaten over the long run, check out RSP. My only short-term caveat to this is that this market rally has been lead by the more beaten-down stocks, and while the equal-weighting thesis will hold up for the longer term, the rest of the year may see this prior outperformance flip to underperformance.

Do you think that equal-weighting won't beat the S&P 500? Shoot me a line in the comments section; I'd love a discussion.

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Emergency Funds: Where Should They be Kept?

In a thought provoking article, My Money Blog discusses whether 401k plans are a suitable place to keep emergency funds. The question arises whether the possibility of extra interest earnings makes it worthwhile to keep emergency funds in a different source than cash accounts. Cash accounts have been the standard because they are the safest and the easiest to access. 401k loans take time to set up and must be paid back with interest (though the interest does go to your account).

Here is the chart from MMB detailing the proposed change:

The idea is that stocks are more tax-advantaged than cash. They certainly are, but getting the cash out quickly when you need it will be more difficult, with selling the stocks and getting the broker to wire you the funds. Money market cash can be withdrawn immediately at the nearest bank.

After thinking about this for a while, I believe that the higher the interest rates, the more attractive the 401k emergency fund would be. With higher interest rates come more interest earnings that the 401k structure would shelter from taxes. Right now we have below average dividend yields and all time lows for interest rates. In my opinion, the interest income from cash would not be enough to justify the extra work involved in this strategy. See the charts below for some historical comparisons of dividend yields (the first chart courtesy of multpl.com) and interest rates (courtesy of moneycafe.com).

If you want to run the numbers for yourself, just consider the interest income expected from cash holdings, and calculate the your expected taxes on that amount. Then calculate the expected dividend earnings based on the current dividend yield, and figure out the taxes on 15% of those earnings. If the differential is high enough for you to justify the work involved, go for it.

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Not Investing will Lose You Money

Well, in purchasing power, not in terms of the number of dollars you have. But the value of your dollars will surely decline. Click on the chart to the left.

In fact, from 1920 to the beginning of 2009, the dollar has lost 94% of its value. If you had cash stuffed under your mattress, your safe "investment" would be down to a pittance of its original value.

Think of the countries that have seen their currencies destroyed. Germany and Japan are shown on the chart, but there are other countries that did not understand how to handle inflation. Hungary and Brazil come to mind, while countries like Zimbabwe and Venezuela are current examples of struggling monetary policy. After such extreme devaluation, a person's entire savings is worth nothing but paper.

If you have any excess funds that are not being used, they should be put to work, at least in money market savings accounts or high grade bonds if nothing else. Gold holds its value well over time, but in the long run, it has a 0% return after inflation. Commodities are a direct inflation hedge, while stocks are also good for that purpose.

Contrary to the believe of some people, a rebalanced portfolio of commodities will have a positive return after inflation. Commodity prices are governed by supply and demand, and if the world population is increasing and a growing number of products are made, then the portfolio will have returns after inflation. However, these are like stocks in that they are subject to large swings in value, and would not be appropriate for anything but long term savings.

If you are going to invest your money to preserve or increase the purchasing power, but need to control against downward movements in the markets because of possible liquidity needs, you would need a portfolio that had a standard deviation of around 6% or below, or a maximum acceptable drawdown of around 8-10% at the most.

While short term bonds will meet that criteria of volatility, a better course would be to separate your portfolio into risky and risk-averse portions. This way, you could have better returns than short term bonds with the same amount of risk. So if you have a stock and bond portfolio with an expected 9% return and 10% std. dev., you could separate that from the risk averse portion of money market funds. If the maximum historical drawdown of your risky portion is 25%, then you would allocate 40% of your total portfolio to this, and the rest to a money market fund. You would have higher returns, and you would not lose your purchasing power over time. Or you could use a simple investment model shown in our newsletter section that has provided provide higher returns and lower volatility.

One final word: It is extremely unlikely that the US will ever go through an extreme inflation scenario such as the one shown below. But in hyperinflation scenarios like Hungary, by the end all currency in circulation in the country was worth less than 1 US dollar. The Hungarian paper currency in this picture was being swept out of the gutter.

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Where Do Investment Returns Come From?

What drives a portfolio’s return? In a passive portfolio, the risk and return is driven mainly by equities. The risk reducer is the bond portion. Bonds steady out the returns in down markets, while providing a drag on the portfolio in bull markets. The fact is, a typical portfolio of stocks and bonds is dominated by the risk of stocks, and does not provide proper diversification. If you can handle an occasional loss of more than 30-40%, then the normal “diversified” portfolio can work for you.

There are several other types of assets that can be used to good effect in your portfolio, and are offered as mutual funds or ETFs. A sample list is as follows:

High Yield bonds

Foreign and Emerging Market bonds

Merger funds

Commodities

Real Estate

Inflation-indexed bonds

Precious Metals (usually included in commodity indexes)

Bear Market funds

Convertible bonds

Preferred stock

Private Equity etf

If you were to use several or all of these asset classes in a balanced portfolio, the risk/reward dynamics can be improved. For instance, a 60% stock, 40% bond portfolio might have 9% annual returns with a 11% standard deviation, which significantly reduces volatility from an all stock portfolio, but doesn't lose much in returns. Including some of the above mentioned asset classes can lower the standard deviation to between 9 and 10%, without significantly changing the return.

The trick is determine how large a portion of the portfolio should be allocated to these other funds. We will look at this in future posts, including active management of all of the above mentioned funds.

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Rule of 72 - Investment Truism Series

H ave you ever heard of the Rule of 72? It's a good rule of thumb to tell you how long it will take for your money to double. This means that if you earn 10% per year on your portfolio, after roughly 7 years your money will double. If you earn 4% on your money, it will take 18 years for your money to double. Click this Bloomberg retirement calculator to figure out your different savings scenarios:

The funny thing about the Rule of 72 and compounding in your portfolio that the investment public doesn't realize is how large the difference in your portfolio size can be over long periods of time with small changes in return. Check out this example:

As you can see, the difference between 10 and 12% returns after 30 years is equivalent to almost 11 times your original investment. With a 10% return, you will have 15.9 times your original investment, while with 12%, you will have 26.7 times your original investment. An investor should focus on terminal wealth more than the volatility of the portfolio. Taking on some more risk in exchange for the higher returns can be worth it if you can stomach the volatility and know how to diversify.

What kind of returns will you need to have a secure retirement? Keep in mind that inflation will always be taking a bite out of your returns, at an average 4% clip per year. If your current portfolio can only provide 4% returns after inflation, look at how long you will have to work before you retire. If you aren't willing to take the risk, are you willing to save more or postpone retirement?

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The Simplest Financial Plan on Earth

This is an old article, but a good one. Scott Adams, the creator of the Dilbert comics, wrote a 9-point manifesto for a savings and retirement plan. It was published in his book "Dilbert and the Way of the Weasels," but I am taking this from the Marketwatch column by Paul Farrell.

Make a will
Pay off your credit cards
Get term life insurance if you have a family to support
Fund your 401k to the maximum
Fund your IRA to the maximum
Buy a house if you want to live in a house and can afford it
Put six months worth of expenses in a money-market account
Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement
If any of this confuses you, or you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner, not one who charges a percentage of your portfolio

This is as simple as it gets, but it's really all you need to know to get set financially. The investment point isn't optimal, but it is better than 95% of the recommendations out there. And before you should ever worry about investing, you need to take care of your debt burdens and make sure that you have liquid funds available if you find yourself unemployed or in tight financial straits for some other reason.

If you need help on the investment part, consider a subscription to our newsletter, which is currently in the works.

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More Pundit Bashing

This post from Bespoke Invest is quite interesting (if expected), via MarketSci. It shows that strategists, pundits and advisors don't lead the market in their recommendations, but as a group, they are followers.

It sure doesn't do much good when your advisor recommends that you reduce your stock allocation in December 2008, just as it's ridiculous to increase the recommended allocation to stocks today.

Look at 2000-2001 and the end of 2008. Strategists have not done an adequate job of helping investors make the right allocation adjustments in changing markets. Either one should have a static allocation process, or a system that automatically moves their allocations in response to market movements or changing fundamentals. Fighting yesterday's battles will not win tomorrow's.

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The Fallacy of Listening to Market Predictions

Nick Gogerty shows in his latest post why pundits can offer horrendously bad advice and live to fight another day (or years). For example, when a Cramer or similar personality says to expect the market to fall, the market can rise 20% and the analyst can still claim victory about calling the ensuing correction.

Gogerty offers the solution to predictors who would establish a credible track record:

A prediction or opinion to be useful and actionable needs 3 components.
Entry (A time, price, fair value or point of entry)
Exit (A time, price, fair value or point of exit)
Risk : Reward (Sharpe ratio, Loss limits, Stop losses, Probability of success, risk of ruin etc.)

So we should demand more from those we listen to for prognostications, for to borrow from the beacon of gentility and refinement Sir Charles Barkley, "Anything less would be uncivilized."

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Saving Your Portfolio in a Crisis

An interesting article from ETFtrends talks about having a plan to implement on your retirement portfolio before any crisis happens. Will you sell off the risky parts of your portfolio during adverse circumstances? Will you buy and hold through all time periods, relying on the diversification of your assets to give you outperformance in the long run?

If you plan to sell during or in anticipation of drawdowns? If you do, what will be your signal? You could choose a moving average, an ATR stop (explained below) or a percentage stop at a fixed number.

An ATR (or average true range) stop is more advanced and tougher to implement than the other strategies. The typical average true range is calculated for the previous 14 days, but it would work well over many different ranges of days. For the 14 day example, take the average range from high to low over the last 14 days. The high or low includes the previous day's close, so if the market gapped up or down, it would calculate the maximum range to include the gap. So a 2 ATR stop would be to sell off an asset if it declines more than 2 times its average true range.

ETFtrends recommends a 200-day moving average stop. The problem with this is whipsaws, which can occur when the assets in your portfolio fluctuate around the average. To mitigate this, one can use a buffer, such as requiring the asset to rise 5% above the moving average in order to buy again. An easier way would be to use the 10-month moving average, which is the same thing as the 200-day moving average, but the buys and sells would only take place on a monthly basis. This 10 month moving average strategy was popularized at World Beta.

I will talk more about this last strategy in upcoming posts, as well as the ATR strategy.

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The Best Long Term ETFs and Mutual Funds

Do you want the best returns for the long run? Go to where the growth is.

The financial community loves to talk about US stocks having a 7% real return, after it was popularized in Jeremy Seigel's Stocks for the Long Run. This translates to 10-11% return before we take inflation into account. The problem with this is that it examines one very unusual subset of time where a country goes from a small fledgling nation to the largest economic empire on earth.

The dataset used by Seigel essentially uses the last 200 years of stock information, beginning in 1802. At that time, the US had admitted 16 states to the Union, and Thomas Jefferson had not even signed the Louisiana Purchase. During the next century and a half, we expanded across a continent and had only one major war on our home soil. America was the very definition of an emerging market.

We cannot expect the US to grow and innovate on the scale seen in the past. For portfolio growth, emerging markets are the best bet. Look for nations where factories are being built and most of the populace is poor. Industrializing countries where much of the citizenry are rural and looking for opportunity in the cities are where we need to invest. Resource rich nations are also a good bet.

MSCI Barra identifies 22 countries as emerging markets. Some of the countries identified have been growth engines for some time, such as China. Better growth opportunities may exist in countries like India, Colombia, Peru and Indonesia. With the exception of India, these countries have been overlooked, and all are growing much faster than the US. So make sure that you have some exposure to these emerging markets, or you will miss out on some of the world's economic growth. The comparison below between the Vanguard Emerging Markets Fund and the S&P500 shows what a difference high growth countries can make in your portfolio.

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Don't Expect Average Market Returns Each Year

As shown in the Big Picture today, the typical mean-variance explanation of how market returns work is quite the poor one. Annual market returns are not explained by a normal distribution curve, and fat tails happen so much more frequently than people would expect. See this chart:

Look at how often negative shocks happen in the market, shown on the left hand side of the curve. And the average return is extremely underrepresented. The positive side of the curve is around where the normal distribution says it should be.

This flies in the face of the academic world, and their images of efficient, random markets that show a normal mean-variance world view. I would love to see Burton Malkiel screaming in the SPX futures pit with his life savings on the line, as I highly doubt he would act rationally or randomly.

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What this Site is All About

This blog is important to me because I feel that most people wrongly believe that the market is a fickle animal beyond their comprehension or grasp. I strongly believe that one can both understand the market and profit from their knowledge. As in sports, there is no holy grail, but you can become stronger and smarter through patience and diligence.

I work in the investment industry, splitting time between managing fixed income, pension allocations and bank relationships. I found out about the outperformance possibilities of an active portfolio in college, when I was referred to the book How to Make Money in Stocks by William O'Neill. I had never before considered that analysis and emotional discipline could lead to higher returns. Since then, I have read everything I could find, from white papers to Fama and French, from Buffett's shareholder letters to archaic Wall Street books from the 1800's.

There are mountains of valuable information out there, but the hardest part for an investor is to filter out the noise and find quality information, while having the discipline to stick to your chosen course of action. On this site I will filter out the noise, while understanding that everyone will need to find their own way with their risk tolerances, temperament and time horizons.

If you believe that markets cannot be timed, and that passive investments are the way to go, you will find valuable information here. If you believe that there must be something better than purely passive allocations, you will find valuable tools here as well.

Disclaimer

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Retirement Savior recommends that you consult a stockbroker or licensed financial advisor before buying or selling securities, or making any investment decisions. You assume the entire cost and risk of any investing and/or trading you choose to undertake. Any securities discussed at Retirement Savior may result in the loss of some or all of any investment made.

All contents on this site and provided in the newsletter are provided for information and educational purposes only, not as investment advice, as an endorsement of any security, or as an offer to buy or sell any security. Members and visitors should assume at all times that any and every ETF, mutual fund or other investments that appear on this website in any form is currently owned or will be owned by the contributors to Retirement Savior.

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Contact Me

We enjoy hearing from all readers and subscribers. Would you like to see a certain topic discussed in a post? Do you have any suggestions for the site? Any ideas would be appreciated.

Alternatively, you can always send a message on Twitter @Retsav

Why you will Love the Investment Newsletter

In time, Retirement Savior will issue a proprietary newsletter to increase returns and lower your risk. The investment model is currently trading, but the newsletter portion of the site will take time to build. Until then, there will be monthly performance updates, along with commentary. Thanks for your patience, and visit us again soon!

We have analyzed data for many different asset classes since the 1970's to find the factors with the most influence on returns and risk. This has resulted in an easy to implement investment model that tells you the few ETFs that you should be in each month to maximize your returns and lower your overall risk. See the chart and graph comparisons for the difference between our Active Trend Models vs. market portfolios**.

The last graph shows that our Flagship model has almost twice the return, and over three times the risk-adjusted returns of a typical 60% stock, 40% bond retirement portfolio. There are three main tools used to achieve the highest return with the lowest risk:

1. Bull Market Monitor - This is the most important part of the toolbox. The monitor signals the all clear for the lowest risk periods to enter the market, and then signals when the market says to move part or all of your funds into safer assets that will perform well in down markets.

There are several academic papers and books that show the risk reduction of this type of process. Some of these methods include Dow Theory, Moving Averages, and only buying stocks/assets at 52-week highs. The most notable test was in the book Stocks for the Long Run by Jeremy Siegel. Retirement Savior uses a different process, as Seigel's method can whipsaw one in and out of volatile markets repeatedly, but we do use signals that follow the larger trends.

2. Weed out the Weakest Asset Classes - Academic papers have identified trend following and momentum investing as a consistent way to outperform. If you identify and only invest the strongest funds and asset classes, you will beat the market in the long run, sometimes by quite large amounts. The buy and hold investor's argument against this method is that it loses all outperformance after taxes and transaction costs. They are missing the point. 401k and IRA legislation means that tax considerations need not stand in your way. Low cost brokers like Zecco and TradeKing give the average investor the ability to invest in ETFs with commission prices out of reach even a few years ago. Even in your non-401k and IRA investments, the outperformance of the Retirement Savior model merits consideration on an after-tax basis.

3. Active Risk Adjustment - The riskiness of stocks, bonds, real estate, and other assets change over time. As the risk profile changes, your exposure to each asset should go up or down in kind. As opposed to a fixed allocation to each asset class, adjusting the portfolio mix to reduce risk will decrease drawdowns and overall portfolio volatility. Though it can cost a little in total returns, it heightens the risk-adjusted returns of the portfolio. In our purely long portfolio (not the one that can move all-in to cash and bonds), this adjustment process reduces risk from the equivalent of a moderately aggressive 80% stock/ 20% bond to a moderate 60% stock/ 40% bond portfolio. See the following chart for the much lower risk profiles for the Active Trend Models:

** The charted portfolios are all shown gross of ETF fees and trading costs, as they are unique to your individual portfolio. The average fee of the ETF examples used in the model is 35bps, even including the array of international and commodity ETFs. If you use Zecco as a broker and have a $25,000 account balance, you have 10 free trades per month which will take monthly transaction costs out of the equation. This more than covers our models that generally make 1-2 asset class changes per month.

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