The Investment Scientist

Archive for the ‘Security Selection & Market Timing’ Category

I asked my assistant to do an updated stock market seasonality study.

The data we used was the S&P 500 index from 1927 which we found in Nobel Prize winner Robert Shiller’s database.

We assumed that at the beginning of each year we invested $1 in the index, and we observed how the investment fluctuated over the year. Then we took the average over three different periods of time: the last 20 years, the last 50 years, and the last 86 years.

Here is the chart we got: Read the rest of this entry »

ImageAccording to Nobel Laureate Eugene Fama, there are three major risk premiums.

1. Equity premium is the additional “wage” one can earn from taking stock market risk over not taking stock market risk.

2. Small cap premium is the additional “wage” one can earn from taking small company risk over taking large company risk.

3. Value premium is the additional “wage” one can earn from taking non-growing company risk over taking growing company risk.

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ImageSince its inception on March 9, 2003, RSP has returned 193%. At the same time, SPY has only returned 97%. This is extremely puzzling as both RSP and SPY hold the same S&P 500 stocks.The only difference is that SPY is a cap-weighted fund and RSP is an equally-weighted one. This begs the question, is RSP’s outperformance normal; and more importantly, is it likely to continue?

To answer the question I asked my intern Nahae Kim to run a regression based on the Nobel Prize winning Fama-French Three Factor Model.

R(x) – rf = alpha + beta1*(Rmkt – rf) + beta2*SML + beta3*HML

Where R(x) is the return of the selected fund, x being either RSP or SPY, alpha is the “skill” of the fund, beta1 is the market risk loading, beta2 is the small cap risk loading and beta3 is the value risk loading.

Here is what I got from the two regressions.

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ImageThat was a message I got from a new client of mine. I must admit, it really bites. Yes, I sold his Apple stock. And yes, since then the price has gone up 15%. So of course, I can understand he’s upset and beginning to question whether I know what I am doing.

Having studied improvisational comedy, I’m aware that regardless of how I feel, it is wise to always validate others’ feelings. So I replied, “Yes, I should have asked you before I sold it.”

Afterward, I sent him some data to mull over.

Nasdaq just crawled its way back to 4000 a few days ago, and this time Apple is the biggest and hottest stock in the Nasdaq 100.

Last time when Nasdaq passed 4000, the top ten tech stocks (try saying that ten times fast) were, Microsoft, Cisco, Intel, Qualcom, Oracle, JDSU, Nextel, Sun Micro, Veritas and MCI Worldcom.

Since the last time Nasdaq passed 4000, Microsoft has gone down 34%, Cisco 59%, Intel 53%, Qualcomm, the only up stock in the group, has gone up 25%, Oracal has gone down 67%, JDSU 98% and the remaining four are no longer in business; they were either merged out of existence or end ignominiously.

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images-42It is exceedingly difficult for mutual funds to beat market indexes. For the past decade, Standard and Poor’s has methodologically documented returns by mutual funds and what they found is something those fund managers do not want you to know: the majority of mutual funds under-performed their respective indexes literally every single time.

Here is an infographic published by MoneySense, a Canadian financial magazine, that shows 90% of Canadian money managers under-performed the market index in 2012; I can assure you that US money managers are doing no better.

                                      FundManagers

ImageRecently a business owner asked me to review his investment portfolio. He is currently with an Ameriprise financial advisor and his gut feeling tells him something is amiss.

He is paying the advisor 1.6% in fees. First of all, this fee is quite exorbitant. For the size of his portfolio, he shouldn’t be paying more than 1% in advisor fees.

Adding insult to injury, for the fee that he is charging, this advisor puts his money into a collection of very expensive mutual funds like ODMAX.

It is very easy to check the expenses of a mutual fund. I just googled ODMAX and I found out it has a load of 5.75% and an expense ratio of 1.36%. (For those who don’t know, load is a one time charge to pay commision to the Ameriprise advisor who doubles as a broker. Expense ratio is an ongoing annual charge.)

ODMAX is a mutual fund that invests in emerging market stocks. If you use the low cost alternative, aka a Vanguard fund, you will pay no load and the expense ratio is only 0.33%, a saving of 1.06%.

Don’t ever underestimate these tiny savings. Because in ten years, the savings will be more than 10%, in twenty years, more than 20%. This businessman is in his 50s; he can easily live another 30 years. I asked him: “How would you like to be more than 30% poorer in retirement?” That is exactly what this financial advisor will make him.

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One very very sharp reader of my blog sent an email to me, and here is what it said:

Aren’t these 2 philosophies opposites of each other? If the market prices correctly based on all available information, how can the stock price be different from the expected dividend? Aren’t these 2 prize winning economists speaking in opposites?

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ImageAs far as investment philosophy is concerned, I am solidly in the camp of Nobel Prize winner Eugene Fama and Vanguard founder Jack Bogle. They both believe that the market is by and large efficient, and there is no point in picking stocks.

Most of my money is in broad-based passively managed asset class funds, but I do set aside 5% just to have some fun with and right now I only have three stocks in my fun account.

Safeway

I bought SWY last November after going to the Chicago Booth Entrepreneur Advisory Meeting. From the meeting, I learned that big retailers routinely write off their inventory at a huge loss. The reason being that they can not control demands as they have little information about the needs of the individual consumer, though they can usually make a rough guess on aggregate needs.

I noticed my wife had been shopping at Safeway more and more. After a little digging, I found out Safeway had set up a technology system to track each individual’s needs and price sensitivities. Then it can make targeted offers to shoppers like my wife that unfailingly brought her back over and over. I recalled my earlier meeting and realized they would save tons of money just from better inventory management.

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ImageIt really caught me by surprise when Eugene Fama, the newly minted Nobel laureate in Economics said: “It doesn’t matter that much.” when speaking about investing outside of the US.

OK sure, I can understand his point. Why invest outside of the US when the US markets already account of 40% of world capitalization? “The U.S. market is so well-diversified already that combining it with global markets doesn’t really matter,” so said Fama.

However, I think it actually does matter ….

Proportionally, the US market is getting smaller. Right after the second world war, the US market accounted for 70% of world capitalization, now it only accounts for 40%. For a country that boasts only 5% of of the world’s population, this is still exceptionally high.

For the foreseeable future, there are better than even odds that the combined markets outside of the US will grow faster than the US market will do alone. Why forego those opportunities?

The diversification benefit you’d get is certainly not negligible either. During the so-called ‘lost decade’ of 2000 to 2009, the US market, as measured by the S&P 500, had a net loss of 9.1%, while international developed markets went up by an anemic 12.4%, but emerging markets went up by a whopping 154.3%.

It would have made a bog difference if you have a piece of emerging markets in your portfolio.

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I jumped out of my chair in delight when I learned that Eugene Fama and Robert Shiller had won this year’s Nobel Prize in Economics. These are two economists that greatly influenced my investment philosophy and their works have been an integral part of how I help my clients build and preserve wealth.

Let me explain their contributions:

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ImageWhen I was in California, I had a very intelligent debate with a doctor. He mentioned that in 2012, the US took in $2.5T in revenue and spent $3.6T in government expenditures.

He accurately pointed out, “If I spent like that, I would be bankrupt in a few years.” He believes so strongly that the US is going the way of national bankruptcy that he has moved substantial amounts of his money overseas and has invested a great deal in gold.

I happen to believe that gold is the most unproductive of assets, since it does not generate dividends or interest and it actually costs money for upkeep in a safe in a Singapore bank.

On top of that, by throwing so much money into gold, one could over prepare for a disaster that is very unlikely to happen and thereby miss out on all the opportunities to grow wealth in this country.

But I still need to explain why the US won’t go bankrupt anytime soon. Here are two explanations:

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ImageI am not a fan of permanent life insurance. Over the years, I have helped many people extricate themselves from costly life insurance policies. Invariably, they were sweet talked into buying these products without any real need.

But recently, I’ve actually had to help a client shop for a permanent life insurance policy. They have a child with a potentially permanent medical condition. Of course we hope and pray that he will outgrow his medical problem, as many kids do, but as parents, they must prepare for the worst.

This is one of the few legitimate reasons for using permanent insurance. Other legitimate reasons include to pay for estate taxes, or to facilitate business succession.

Here is the decision process I employed to help my client, bearing in mind that insurance products are not under the purview of the SEC and are usually chock full of hidden costs.

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teenreader1. ThinkAdvisor highlighted a Maryland study which showed that states which pay the highest fees to Wall Street (for managing pensions) have the lowest returns. That says it all about Wall Street. No wonder Rick Ferri wants you to steer clear of actively managed funds.

2. Reuters Money reported how Health Savings Accounts (HSAs) can be used as retirement savings accounts. This information is especially useful for small business owners and self-employed individuals who tend to neglect their retirement savings and face high deductibility in their health insurance. Here is the garden variety of ways they can save for retirement.

3. DIY Investor Robert Wasilewski encountered a bear while hiking. He survived to write about it, but he mused that the same reactions that kept him in the gene pool will surely “eliminate you from the investment pool.”

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investment-portfolio

When I write a blog post, I like to drive home one and only one point at a time.

In my last blog post, the point I wanted to make was that cost matters. In case you didn’t notice, not only did I reduced my new client’s cost by 85 basis points, I also reduced the number of funds in her portfolio from 39 to 4.

With such a small numbers of funds, is the portfolio diverse enough?

Emphatically yes. In fact, it is much more diversified than the previous portfolio of 39 actively managed funds.

What I use are asset class funds; DFQTX holds all 5000+ stocks traded in the US equity market; DFTWX holds all foreign stocks; DFGEX holds all domestic and foreign REITs and of course VBTIX holds all bonds. With these four portfolios, you are holding all of the world’s productive assets. How much more diversified can you get?

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Rebalancing your portfolio

Rebalancing your portfolio

Recently, I visited a prospective client in New Jersey. He is currently a client with Fisher Investments, and his advisor told him never to rebalance since that involves market timing.

I have to hand it to this financial advisor for recognizing that market timing is an unproductive endeavor, but he is so wrong about rebalancing that I am compelled to write this article.

Rebalancing is not a market timing activity, it is calendar-driven or condition-driven. For instance, you may decide that you will rebalance your portfolio on January 1st of each year or whenever an asset class allocation is off by 20%.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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