Archive for the ‘investing’ Tag

How to become a value investor

First a quick note of news…I’m moving this blog to a self-hosted site in the very near future. In fact, the blog has actually already been transfered, but I’m sorting out some issues with getting traffic on this site to automatically forward to the new one.

For you, this basically means that you’ll need to update your bookmarks to the new site once it’s up (I’ll post the new domain once it’s active). For people who subscribe to the site through Feedburner, the transition should happen seemlessly. For those who subscribe some other way, I’ll also post the new feed address once it’s up.


A story of mine from the May issue on value stock investing just hit the website a couple days ago. While I’m happy with the final product, it’s a classic example of why I started this blog. For space issues, editors and I cut the story down to 650 words or so. But as you can imagine, value investing is just a tad more complicated than that.

Security Analysis by Benjamin Graham and David Dodd

Security Analysis by Benjamin Graham and David Dodd

Over the next four days I’m going to give a primer on value investing. I’m also hoping to have my regular news-based posts for readers who know this stuff already.

Here’s what’s coming up:

Today: Where value investing comes from. What is a value investor?

Tomorrow: What is a P/E ratio and how is it used properly?

Wednesday: Understanding a company’s business. How to make sure a company’s earnings don’t disappear after you buy it. Building in a “margin of safety”.

Thursday: What’s different about value investing today? Other measures of “value” in a company.

I hope you find it informative.


The invention of “value investing”

You might not be sure of the definition of value investing, but you probably do know its greatest living proponent, Warren Buffett. If you spoke to Buffett, he’d actually point to his mentor, Benjamin Graham, as the greatest value investor of all time.

Graham, and co-author David Dodd, literally wrote the book on value investing—- Security Analysis. In the preface of book’s latest edition, modern value investor Seth Klarman aptly summarized their philosophy this way:

Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—-the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety”—-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.

Whereas speculators hope that their purchases gain rapidly in value, Klarman says, value investors strive to avoid losing money.

You see, Graham and Dodd wrote the first edition of the book in 1934, after seeing the most dramatic stock bubble in history followed by the most dramatic bust. Their book was meant as a way of sorting through the thousands of low-priced securities to discover which were good investments.

It might surprise you to know that times like today, when stocks of nearly all companies are severely beaten down, are when Graham and Dodd would find the most bargains. It’s during manias like the tech bubble and real estate bubble that fairly valued companies are hard to come by.

The trick is figuring out what “fair value” is.

What is a value investor?

Imagine that your cousin Joe started a hero sandwich restaurant a year ago. Its earnings steadily increased for the first few months as customers got word about the place, but now they’ve leveled off, and Joe thinks it will earn about $30,000 this year after paying his rent and employee salaries. Joe’s grown tired of the fast food business and wants to sell it to you for $400,000. You have the money to buy it, but aren’t sure if it’s a fair price.

This is the dilemma facing any stock investor. An owner (the stock’s seller) doesn’t want to own it anymore. The stock’s buyer needs to decide what he’s willing to pay.

You could put your money in a money market account right now and earn about 2% on your investment without any risk. So if you bought Joe’s restaurant, where a competitor could come in and snatch your business in a heartbeat, you’d want a much greater return than that.

Before buying Joe’s company, you do a bit of research. You look in the classifieds of your local business newspaper, and find a lot of other companies similar to Joe’s. One is selling his burger restaurant for $500,000 and it makes $60,000 a year. Another is selling his pizza joint for $200,000, but it only makes $20,000 a year.

All told, you find that restaurants like Joe’s give their investors about a 10% return for their invested money.

But you take it a step further. You go to the local library and look at the microfiche of your local newspaper’s classifieds to find the prices that restaurant sellers were requesting for the last several years. During good economic times, when lots of people are eating out, you find that sellers requested prices that only have 6% or 7% returns. During bad economic times, they sold at prices that would give a 15% to 20% return, mostly because they were afraid that their earnings could keep falling or disappear.

On average, when evening out those good and bad times, companies like Joe’s gave their owners a 11% return.

Now back to Joe’s selling price. He wants $400,000 for a business that generates $30,000 a year. That’s a 7.5% return. On its face, and assuming there’s nothing about Joe’s company that make his earnings more certain than the next guy’s, Joe’s asking price is too high. You think the business is worth more in the range of $330,000 based on historical figures. But since you could buy companies very similar to Joe’s for a return as high as 12% (the burger place), you’re only willing to pay $250,000 ($30,000 divided by $250,000 gives you a 12% return). He declines, and you move on to other investment ideas.

Fast forward to next year. The economy has gotten much worse. Joe’s earnings are falling. His company will probably survive, but until the economy gets better, he only thinks he’ll make $25,000 this year. Right now, it looks like no one’s ever going to buy a hero sandwich again, and in a panic, Joe offers to sell you his company for $200,000.

That’s a 12.5% return. Your research on the economic cycles of restaurants shows that investors earned an 11% return on average. So you buy the company from Joe, knowing that once the economic mess passes, you’ll own a company that’ll still make you good money.

There, in Joe’s panicked sale of his hero restaurant, is your proverbial dollar for 50 cents.

Ok, so that example was a little quick and dirty, but in a nutshell, that’s what a value investor does every day. A growth investor buys shares of companies in the hopes that the company’s earnings will grow rapidly and make his investment worth it. A value investor finds companies with a proven track record of earnings, but waits until the company’s share price has been beaten down enough to make his purchase worth it.

Start thinking about every stock purchase you make as if you were buying Joe’s restaurant. That is, think of it as if you’re buying the entire business and as if your profits rely on how much the business makes in earnings, instead of on how much the stock price goes up the next day.

Even just that change in mindset will put you on the path of thinking like a value investor. Of course, figuring out how much similar businesses sell for, how safe a business’s earnings are, and what price is “fair” takes a bit more practice.

I’ll talk about how to learn to do that tomorrow and Wednesday.

– Joe Light


Finding bonds to invest in

If you’re arriving from Get Rich Slowly, welcome, and enjoy the site. You can see a quick summary of what this site’s about here. Or go ahead and subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

Now to building a bond portfolio:

Hopefully, you’ve read my summary of how bonds work at Get Rich Slowly and maybe even seen the basics of deciding whether or not to buy individual bonds here. If not, you might want to check those out, because this post assumes at least a rudimentary understanding of how bonds work and that you’ve decided you want to consider individual bonds (the linked stories will let you explore both those issues).

This story will tackle two issues:
1) How to find bonds to invest in, and

2) Understanding the risks in the bond

Tomorrow I’ll write about:
3) Constructing a bond portfolio/bond ladder, and

4) Finally, the process of actually buying a bond

How to find bonds to invest in

Unfortunately, it’s not nearly as easy as looking up a few ticker symbols on Yahoo! Finance and signing into your broker to buy them. Fortunately, it is a lot easier than it used to be, for what that’s worth.

The bond universe is tracked by the Securities Industry and Financial Markets Association at their website. While you can search for corporate bonds or municipal bonds by the name of the issuer at SIFMA’s site, it might actually be easier to start with a bond screener like the one on FINRA’s website, which is powered by MarketWatch.

This is what the initial bond screen page will look like.

This is what the initial bond screen page will look like.

We’re looking for corporate bonds right now. So under “Select Bond Type”, pick “Corporate”.

The rest of the selections will depend on your personal requirements for the bond. Here’s a quick rundown of each category, skipping ones that I’d leave blank:

Search by maturity: Select a range of dates by which you want to get your principal back. If you need the money for a tuition payment by April 1, 2014, for example, you might pick a range between today and that date. Don’t pick a maturity date past when you need the money. Selling a bond is difficult and costly for small investors. If interest rates go up after you purchase the bond, the bond’s value will also be much lower in a resale.

Coupon type: For the purposes of this exercise, select “Fixed.” This means the yearly payments that you receive will be set in stone. “Variable” rates will move depending on the terms of the bond. For example, they might be pegged to a popularly tracked interest rate like that of Treasury bonds. “Zero”-coupon bonds don’t make regular interest payments. Instead, you make money on the value of the actual bond going up and from the accumulated interest all at once, when it matures. You receive no payments in the interim.

Moody’s Rating (Or Fitch Rating or S&P Rating): Select “A3” or higher as the “Lowest” . This is the credit quality of the bond, as measured by the three big bond rating’s agencies. It’s basically their guess as to how likely it is that the company won’t be able to make all of its payments. The higher the letter grade, the more safe the bond (at least, according to the agency). Each of the agencies have a different ratings system, but the form on the website presents the letters in top-down order.

Industry Group: Leave it as “All” but understand that when you build your portfolio, you’ll want bonds from across industries, in the same way that you would diversify a stock portfolio.

Callable and Putable: Select “Exclude Callable” and “Exclude Putable”. Callable bonds can be “called back”, or paid off, by the company issuing the bond before the stated maturity date. A company might do this if interest rates go way down and the company wants to refinance its debt. Putable bonds, on the other hand, let you choose to sell the bonds back to the issuer. There are situations where you might still buy a callable or putable bond, but let’s keep things simple.

Convertible: Exclude for simplicity’s sake. Convertible bonds give you (or sometimes, the issuer) the option to convert the bond into the company’s stock at a predetermined price. It can add value if the conversion rate is better than the current stock price.

Run the screen, and you should get a list of several hundred bonds.

This is what the bond screen results page should look like.

This is what the bond screen results page should look like.

How do you choose among these? Well, for one, your inventory might be limited based on what your broker has available.

If you have a live-person broker, call him up and give your criteria. He’ll be able to quickly call up what bonds he has available that meet it. You can then compare the yields in his list to the ones you found in your own screen. If his inventory seems very limited, try another broker.

If you have an online broker, the online site’s inventory will most likely be a network of many different brokers (if it even has a bond component! Some don’t.). Keep in mind that with online brokers, you’re basically paying TWO commissions — the per bond commission (maybe $1) that the online broker charges and the commission to the broker in its network. Bond broker commissions are different than stock broker commissions. I’ll tackle those tomorrow or you can see the difference described in my Money article.

Understanding the bond’s risk

You screened out many risky bonds by selecting A3 or higher for the Moody’s rating (honestly, you might want to go even higher than that). But unfortunately, the credit agencies are often slow to update their ratings to reflect recent company announcements or new risks that have become apparent. Sometimes, it’s easy to see when they’ve been slow. In my screen (where I used the above criteria and April 1, 2014 as the latest maturity date), the highest yielding bond in the list pays 608%! Now which do you think is more likely, that the ratings agency is wrong or that the market just happened to leave such a sweet deal lying around?

A good rule of thumb is that the corporate bonds you buy should not yield more than a few percentage points above that of comparable Treasury bonds. You can see what treasury bonds are yielding here. If you did my screen, you’ll notice that that excludes the first 20 pages or so of bonds. The names of the issuers on those pages (almost all financial or auto companies) shouldn’t be surprising. And if you want to exclude them from the outset, you can do so on the original screen page.

I’d personally recommend picking a company that you recognize and whose business you can understand. Then, you can research that company in the same way you’d research its stock. You need to pick companies that are likely to survive until the maturity date. So when looking at a company’s balance sheet, you want low amounts of debt and high free cash flow. It’s hard to be more specific than that without getting into something complicated, but look here for a summary of how to read a balance sheet.

If you’re very uncomfortable with reading balance sheets and evaluating companies, you might want to leave it up to an investment professional or even just stick with a bond mutual fund or something guaranteed, like CDs or Treasury bonds. Otherwise, if you’re still interested, check out my post tomorrow on building the bond portfolio and actually buying bonds.

Thanks for reading,

Joe Light

The scariest thing a fund manager’s ever told me

I was just organizing some old notes from last year and ran across this gem of a quote from a mutual fund manager. My notes were hasty, and this is an old interview. So you should definitely take this as paraphrasing, but here goes:

Sometimes you have to know when to ride stocks on the way up even when you know they’re overvalued. I mean, if I didn’t do that, I’d miss out on some serious profits. You ride on the way up and then get out before the bottom falls out.

I’m not going to say who this was, because I don’t even remember the context of the interview. But good lord, does that kind of sentiment send shivers down my spine. Normally, when we think of mutual fund managers, we make a distinction between “growth” and “value”. Value fund managers invest in companies based on its low share price relative to its earnings. Growth fund managers are willing to pay a higher share price because they’re in the business of predicting what those earnings will be several years from now.

Dancing with a bull market

Dancing with a bull market

I feel like “momentum” fund managers deserve their own category — the quoted fund manager was definitely one of them (at least a component of his strategy was, anyway). Momentum investors are quintessential market timers or stock timers. They invest in a stock, not based on any valuation metric or growth estimate, but simply on how the stock price has moved in the past. I can’t say that their strategy is bunk. In fact “positive feedback” has become a pretty well established fact as the driving force behind bubbles like the real estate and tech stock booms. (For an early take on the subject, see a paper by the director of the National Economic Council and former Treasury Secretary Larry Summers.)

What bothers me is that those irrational swings in market sentiment that drive price are far from predictable. The fund of the manager I quoted trailed the market each year between 2005 and 2007 (he underperformed the market by more than 25% in 2007) before outperforming in 2008 and so far in 2009 (he outperformed the market by more than 25% last year.)

When you add those periods of under and overperformance up, you get a mutual fund that’s performed a little bit under the average for the market, a little bit over the average for its category, and I imagine has given quite a few investors heart attacks in the process. I wonder how many even stayed in the fund after those underperforming years.

There’s no question that the market has irrational tendencies. But personally, I prefer strategies that count on the market’s return to reason rather than count on its continued deviation from reason. Why? Well for one, ultimately, a company (or the companies a fund holds) is only as good as the profits it gives you. If a share of Company X had an earnings yield of 10%, that means your money is earning a 10% return no matter where the stock price goes. Alternately, and more accurately, you might look at the dividend yield.

Investing with the expectation that the share price will go up is kind of like buying into a Ponzi scheme. The stock will only give good returns as long as other suckers step in and drive it up even further. If you’re the last one holding the bag, and the company doesn’t make enough money to justify the share price, the price comes tumbling down.

As mentioned in a previous post, investors might already be starting to put a renewed interest in dividends. Some studies have shown that dividends, not rising stock prices, have been the source of market returns for some time.

I think of it this way: Pretend the market shut down, and you were stuck holding all the companies you own in your portfolio right now. Wouldn’t you want companies that are paying you money? Shouldn’t a fund manager want the same?

– Joe Light

Why your mutual fund company thinks it can rip you off

For the first time ever, a federal court has sided with investors who accuse their mutual fund company of charging excessive fees. Shareholders of Ameriprise funds sued the company for charging higher fees to the fund investors than what they charge for similar institutional accounts. gavel-by-jason-morrison

This quote, from an e-mail between Ameriprise officials, is priceless:

Even before the Board’s request, there is some indication that Ameriprise knew that a fee discrepancy between institutional accounts and mutual funds might concern the Board. In response to a Wall Street Journal article that discussed the industry-wide disparity in fees, an internal email noted that “this could come up in a Board meeting” and suggested that “we should have a reply, though it may or may not be convincing.”

No kidding.

You can read the entire court opinion here.

Some of the more damning evidence is how Ameriprise apparently set its mutual fund fees. According to testimony from Ameriprise’s own board, they charged fees not based on what their actual costs were, but on what they could get away with.

Ameriprise entered the negotiation with a pricing philosophy wherein it attempted to establish fees that were “in the middle of the pack of funds with a similar size, objective and distribution model.”

Don’t you just love it when a fund company strives for mediocrity?

The funds in question are Ameriprise’s RiverSource funds. Just take a quick look at Morningstar’s fund family page, and you’ll see why investors should have known these were a bad deal going in.

78% of RiverSource’s funds charge a 3% to 6% upfront load for the privilege of investing with them. In other words, to even get into an Ameriprise fund, someone who invested $500,000 over a number of years would have paid an initiation fee of $15,000 to $30,000. Even after that sacrifice, RiverSource funds still charge annual expense ratios of between 1% and 2%. In other words, after paying $30,000 up front, that investor then paid RiverSource about $5,000 a year to keep managing his money.

And, as mentioned in a previous post, that doesn’t even include the mutual fund’s brokerage fees.

But lets take one fund as an example and see just how much Ameriprise was potentially overcharging the little guys in comparison to its top customers. According to recent returns on the RiverSource Disciplined Value fund, institutional clients were charged somewhere between 0.38% and 0.74% in expenses per year. That’s very low.

The equivalent mutual fund? 1.28%, or more than four times as much, depending on the year.

Loyola University professor Charles Murdock testified on behalf of the investors that “the advisory service provided to the mutual funds was similar, if not identical, to the service Ameriprise provided to its institutional clients.”

So riddle me this: Why does a mutual fund company charge small investors twice as much as big investors for the same service?

I have a sinking suspicion that it’s because they thought they could get away with it.

Let’s hope this changes.

– Joe Light

How to frame the Fed’s economic outlook

Sorry for the late post. It’s that time of the month when magazine deadlines overpower more enjoyable pursuits.

The Fed came out with its “beige book” economic reading today. Writers are attributing its results to the market’s 100-point run up this afternoon.

Fed chairman Ben Bernanke

Fed chairman Ben Bernanke

Here’s the sentence that’s supposedly getting investors all excited about a rebound. After noting that the economy has continued to deteriorate, the Fed writes, “However, five of the twelve Districts noted a moderation in the pace of decline, and several saw signs that activity in some sectors was stabilizing at a low level.”

The districts that are seeing a more moderate pace of decline? New York, Chicago, Kansas City, Dallas, and San Francisco. (At least, that’s what I gather from reading the report. I don’t think the Fed spelled out which areas they were referring to specifically.)

It’s good news that some cities aren’t getting exponentially worse anymore, but how would investors react if I rewrote the sentence this way?

“Unfortunately, seven of the twelve Districts noted a steepening or continuation in the pace of decline, and several saw signs that activity in some sectors showed no signs of stabilizing.”

Both sentences are true. But guess what the headlines would have been had my line appeared as the second sentence in the Fed’s report instead of the original line?

As an experiment, I took a look at the June 11, 2003 beige book report. This would have been the tech bubble/September 11 equivalent of the report we’re seeing today. The report noted that four of the 12 districts showed signs of improving, but instead of the sentence of encouragement that we got today, investors got this:

“Although reports from the twelve Federal Reserve Districts indicated some signs of increased economic activity in April and May, conditions remained sluggish in most Districts.”

That day, the S&P 500 closed up a fraction of a percentage point.

Ok, granted, there were 1,000 variables that were different then. For one, investors thought that the weak economic conditions in June 2003 could mean another rate cut was on the way. Of course at the moment, that’s basically impossible.

But could a little bit of framing be going on here? I’m not an expert on the economy by any means, just an interested observer. I wonder how the Fed decides to take a “glass half full” point of view as it did this time versus the glass half empty view it did in 2003. Your thoughts? I’m interested.

– Joe Light

I’m a stock. You’re a bond. Target-date retirement funds are a pain.

When it comes to retirement planning, sometimes simple, no-brainer concepts take a hell of a long time to catch on. Take “human capital,” for instance. The basic idea is this: Your wealth is not only made up of the cash, stocks and bonds in your portfolio but by your future earnings potential. worker-in-suit-by-steve-woods

So, a 24-year old might be concerned that he only has $10,000 saved for retirement, but can rest easy that he has another $3 million in potential earnings over the course of his career. A 66-year old with only $10,000 in savings would be a little more worried.

“No duh,” you might say.

But let’s take a slightly different scenario. In the first case, take a 35-year old advertising salesman, making $70,000 a year (Note: this is improbably high, but possible). He has $50,000 saved for retirement. His pay is good but unpredictable. Depending on factors outside of his control, like the economy, he might have a particularly good year followed by a string of dismal years.

Next, take a 35-year old tenured professor, making $70,000 a year. He also has $50,000 saved for retirement. As long as his college merely survives, he’ll always have a job and depending on the school’s policies, will always get a moderate pay increase until he retires. He’ll get to work as long as he’d like and can pretty accurately project his income for years and years out.

The ad guy’s earnings are “stock-like” – erratic with possible good and bad years. The professor’s earnings are more like a bond – steady and easily forecast.

Now which of these guys do you think can take more risk in his portfolio? To me, it seems pretty obvious that the ad salesman should save more now and keep more of that money in bonds just in case his earnings take a dive.

But surprisingly, that concept hasn’t really caught on in retirement planning until recently, with the writing of York University professor Moshe Milevsky’s Are You a Stock or a Bond?. To see an interview Money magazine recently conducted with Milevsky, click here.

In my mind, it’s yet another blow to the idea behind target-date retirement funds. The 35-year-old ad salesman might be better advised to get into the target-date retirement 2015 fund (as if he were retiring in his 40s) than to pick the 2040 fund.

And to all you mutual fund companies, I pose this question: Why not just call them what they are? Why not call it a 90% stock/10% bond fund (or 90/10 Fund, 70/30 Fund, etc.) and let the consumer know that he’s going to have to figure out for himself what his proper allocation is or get help?

That certainly beats oversimplifying the most important investment decisions a wannabe retiree will make.

For another post on target-date retirement funds, click here.

– Joe Light

Why your fund’s expense ratio is only half the story

I just got out of an interview with Ric Edelman, a financial advisor and asset manager. The conversation was wide ranging, but he pointed out a weakness in reported mutual fund expense ratios that I hadn’t thought about until now.

When we tell people to find funds with low fees, most often, we’re talking about a fund’s expense ratio. It’s that seemingly small percentage of assets that a mutual fund company takes out of your fund to pay for things like fund manager salaries, rent for their offices, and so on. Of course, over time, just one percentage point of difference in your return can make a huge difference. (See chart, and sorry about the color issue. Needless to say, the fund with the lower expense ratio is the higher line.)

Growth of $10,000. Assuming an 8% annual return.

Growth of $10,000. Assuming an 8% annual return.

Unfortunately, that expense ratio, found so easily in the prospectus and categorized at Morningstar, only represents a fund’s ongoing costs. It doesn’t include the transaction costs that can bring down a fund’s actual return. In something like an index fund which has low turnover, that cost will be negligible. But in an actively managed fund, in which a manager is buying and selling stocks all the time, Edelman says that the fund’s total expenses can sometimes be significantly higher.

Let’s take the Dryden International Value Fund, by way of example. I’m not trying to pick on them. I just noticed that their portfolio turnover rate last year was 27%. In other words, it switched out about one in every four stocks that it owned last year. In the past, the fund’s turnover has been much higher, hitting a pinnacle of 121% in 2005.

According to the fund’s prospectus (page 53), the no-load shares’ expense ratio is 1.31%.

But let’s see how much that 27% turnover cost them last year. In the fund’s “Statement of Additional Information” on page 86. You’ll see that the fund spent $156,431 in brokerage fees last year. According to Morningstar, the fund’s Net Asset Value right now is about $136 million. That means that investors paid an additional 0.11% for those transaction costs without knowing it.

I’m not saying that 0.11% is a lot, but it seems like that kind of off-the-top fee is exactly what investors think they’re getting in an expense ratio. And according to a study by a few researchers from Boston College and Virginia Tech, the trading costs of a fund can sometimes exceed that of the expense ratio.

It took me about 30 minutes to find that Statement of Additional Information and calculate the added cost. If it’s unreasonable to do that yourself, a reasonable proxy is to just look at the turnover rate, which is pretty easy to find in the prospectus. The higher the turnover, the more you’re likely paying in hidden broker fees. But besides that, you probably want a mutual fund manager who picks stocks for the long run anyway and doesn’t have to switch around a quarter of his portfolio every year.

– Joe Light

Shocker: Treasury bonds beat stocks in the long run

Back in 1994, a Wharton professor by the name of Jeremy Siegel published a book (called Stocks for the Long Run) that helped form the basis of investing advice for the next decade. The book’s well-known conclusion: Stocks have returned on average about 7% (after inflation) for the last 200 years. Investors were almost guaranteed to get a positive return if they held on for at least 20 years.

Wharton professor Jeremy Siegel

Wharton professor Jeremy Siegel

There’s been a lot written about the “lost decade” for stocks, in which the market’s return has been zero or negative. But a new study by Rob Arnott shows that stock returns have been even worse when compared to the returns of U.S. Treasury bonds. (4/21 update: The study has come out.)

The study is running in the Journal of Indexes in their May/June issue. So I can’t yet link to it and have been asked not to quote it verbatim. But its basic conclusion is this: Starting at any time from 1980 to 2009, an investor in 20-year Treasury bonds, who rolled over their income every year, beat the S&P 500. From January 1969 through the end of this January, such a bond investor would also come out ahead (albeit by a small margin).

If you go back to 1801, stocks did beat those bonds by an average 2.5 percentage points per year (which is huge). But the Treasury bonds beat stocks during three long periods — between 1803 and 1871, between 1929 and 1949, and between 1968 and 2009.

The implications of this are pretty massive. For the most part, Treasury bond investors don’t have to worry about dramatic volatility. Stock investors do. As a result, stocks are supposed to provide a “risk premium” of a couple percentage points to pay for that chance their investment could drop. In effect, Arnott’s saying that the risk premium hasn’t been there for the last four decades. You could have chosen the absolute safest investment known to man and performed better than the guys rolling the dice on the stock market.

What does this mean to you, an investor looking to the next 40 years? It does not mean to stick all your money into Treasury bonds. Just as investors were wrong to think the stock market would roll on forever in the late 90s and early 00s, it’d be wrong to think Treasuries will beat stocks from now on.

Instead, the study reminds me of all those retirement scenarios that planners love to run. “If you invest 60% in stocks and 40% in bonds,” the scenarios say, “you’ll have a 95% chance of not running out of money in retirement.” But that means you do have a 5% chance that those assumptions don’t come true. And is a 5% chance of not making it small or big? You only get one shot at retirement.

You can’t control the market’s performance. Your job, then, is to make that outside chance of something terrible happening as small as possible. How can you do that? For me, it means saving more. I’m sticking 20% of my income into stocks and bonds every paycheck instead of 10%. I’ll have to live frugally, but that beats not making ends meet. It might seem like a big sacrifice to bring my chances from, say, 95% to 98%. All those new retirees might have thought the same thing 40 years ago.

– Joe Light

Why do mutual funds get prizes for losing money?

The 2009 Lipper Awards for the best mutual funds of last year were given out last week. Here’s the list of winners. While one of my colleagues at Money Magazine finds it pretty ironic that awards were given to funds that actually lost money in 2009, it doesn’t really bother me. money-prize-by-taroslav-b

The Intrepid Small Cap fund, for example, lost 7.1% last year. That’s pretty bad, but it’s more than 25 percentage points better than the small cap category as a whole. The bottom line is that small caps were a bad class of stocks to be in last year. The best decision you could have made (though no one could have seen this at the time) was to avoid small caps altogether. But unless you’re in an actively managed balanced fund, that seems like the kind of decision you should have made, not the fund manager. If the small cap category returns a positive 20% this year, you’d better believe that investors would be mad as hell if their small cap fund manager had moved a lot of the fund’s money to cash because he thought there were dangers in the sector. (Ironic disclosure: Intrepid has 7.5% of its money in cash, which is actually quite a lot. I wonder if that cushioned their losses last year.)

To easily see how your mutual funds are allocating their money, check out Morningstar. Most features on the site are free but might require registration.

Another useful tool whose founders I recently spoke to is Mutual Decision. Take a gander at the “Active Share” tool which will show you how active your “active” mutual fund manager really is by comparing his investments to those of his benchmark. After all, there’s no reason to pay a manager 2% a year if he’s mostly just following an index. The site (which costs money but has a free trial) was founded by a few college professors at Georgetown and Rutgers. They basically take academic studies on mutual funds and develop tools that allow investors to apply those studies to their investments. Interesting stuff, but I’d stick to the free trial until its proven that using the tools can actually save you money.

– Joe Light

“Investing is no longer child’s play”

Bill Gross, PIMCO’s chief investment officer, published his monthly investment outlook a few days ago. PIMCO is one of the largest bond fund managers in the world, and Gross’ newsletters are widely read and respected.

PIMCO's Bill Gross

PIMCO's Bill Gross

This month, Gross made a point that all investors should heed — especially those like me who have basically spent their entire lives traveling from one asset bubble or another:

Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks…In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return.

That emphasis was Gross’ by the way (He underlined it. I bolded it.).

It’s not hard to derive what this means for me and you, if you believe what he’s saying. Stocks’ historical 8% annual return? Meaningless. The “latte factor”? Dead. (Though, one could argue that David Bach’s gross oversimplification of the benefits of compound interest was misleading in the first place.) In other words, the core assumption that personal finance advice has relied on – whether it be from writers or financial planners – could just be plain wrong.

In retrospect, there’s no question that we’ve relied too much on a simple trendline to predict how stocks will perform over long periods of time. As one of my colleagues, Pat Regnier, put it a few months ago, you wouldn’t expect Microsoft to experience the same growth over the next 20 years as it did over the last 20, so why would you expect the U.S. stock market to keep performing as it has in the past?

So what could this new landscape look like? Gross believes investors will place a renewed value on earnings that reach their pockets, like dividends and bond payments. An investor would rather that his share of Microsoft send him a $2 dividend than hope that the share would increase $2 (or maybe even $3) in value. As such, there might be a renewed emphasis on companies with high dividend payments, and until stock dividend yields catch up with bond yields, bonds could be the preferred investment.

In short, investors’ wealth will only increase as fast as actual earnings increase. No more easy rides on speculative bull markets. “There should be no doubt that the bull markets as we’ve known them are over and that the revolution is on,” Gross writes. “Investing is no longer child’s play.”

– Joe Light