This is the second part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . Once we factor out the heavy emphasis on low-risk (and low return) investing, this book contains a vast amount of useful unbiased information. For example, Chapter 3 shows how to plan for retirement including figuring out how much money you will need to retire, minimizing taxes, and minimizing investment fees. Chapter 4 covers saving for college. The cost of education beyond high school has been rising faster than inflation for some time. Whether this will continue is anyone’s guess. The authors discuss the many different college savings plans available in the U.S. In Chapter 5, the authors discuss investing in a home and the various ways a home can be turned into a retirement asset including a reverse mortgage. There are many things to consider when it comes to reverse mortgages, and the authors do a good job of explaining them. Chapters 8 throug...

This is a review of the book Worry-Free Investing (Prentice Hall, ISBN 0-13-049927-7), by Zvi Bodie and Michael J. Clowes. This book is aimed at Americans, but many of the ideas are relevant to Canadians as well. The authors are clearly very knowledgeable about a wide range of practical investment matters as well as academic work on investing. The book contains a lot of useful information and practical advice explained clearly. In this regard, it is much better than most investing and personal finance books. The main drawback of this book is the overemphasis on safety. The authors recommend extremely safe investments that, unfortunately, offer low returns. To meet typical goals such as an adequate retirement income and paying for children to go to college, the safe investments recommended by the authors require people to save large amounts of money every year because they will get low returns. The particular investments the authors recommend are Inflation-protected Bonds (I Bond...

In the previous post , I discussed the idea that a stock has an intrinsic value that is different from the current price of the stock. The stock market can become irrational and sometimes value a stock well above or well below its intrinsic value creating profitable opportunities for knowledgeable investors. So what? Most of us can’t figure out the intrinsic value of a stock any better than we can pick lottery numbers. If you’re like most people who fall into this camp, your best bet is probably to avoid individual stocks and invest in low-cost broad index funds. (See this post for more about index funds.) There are index funds that allow you to own a small slice of an entire economy. You can own your share of stocks in the US, Canada, and other countries. The better index funds have very low Management Expense Ratios ( MERs ). The stock market as a whole has an intrinsic value just like an individual stock. U.S. markets dropped about 10% in the first 3 weeks of January. Is it r...

What is a stock really worth? One answer is “whatever the stock is trading for in the stock market.” Unfortunately, this is not a useful answer. The stock market just tells you the price at which people are willing to buy and sell a stock. The true value of a stock (also called the intrinsic value) is determined by the value of the business represented by the stock. If a business is worth $10 million, and there are a million shares, then each share is worth $10. But, how do we determine the value of a business? Suppose that we know what is going to happen to ABC Company. ABC will pay a $1 dividend per share each year for the next 50 years and then close down. Now each person can decide how much to pay for a share that will pay $50 over 50 years. Some might be willing to pay $10 and others $15. This amount that you are willing to pay is your assessment of the intrinsic value of the business. Suppose that you decide that the intrinsic value is $15. If you find that the majority of people...

I don’t usually write about consumer items, but I just had an interesting experience. I bought a scanner from a well-known chain store. When I opened the box, it contained a note from the last sucker who bought this scanner with an explanation of what is wrong with it. The note came with actual pictures of scans gone wrong. I’m grateful to this anonymous person who took the time to help out the next sucker to buy this scanner (me in this case). The two pages of explanation were not exactly hidden. They were the first thing that I took out of the box. Obviously the store employees never even looked inside. They just put it back on the shelf to sell it to someone else. Nice. I don’t see much point in naming the product or the store. But, I do like the consumer strategy of including a note any time you are forced to take a defective product back to a store. For your altruistic side, you are helping out other people. For fun, you could even include an email address with your note ...

We are starting to see the fallout from the actions of a rogue trader , Jérôme Kerviel, in France who lost $7 billion of bank Société Générale’s money. Bank officials insist that this rogue trader acted on his own. The bank’s investors aren’t so sure. I don’t see what difference it makes. Huge bets were made that put all of the bank’s assets at risk. What difference does it make whether Kerviel acted alone or not? Either the bank officials are guilty of authorizing these huge bets or they are guilty of running a bank with such lax safeguards that a junior trader could put all the bank’s assets at risk. The end result is the same for the bank’s investors: they could have lost much more money, and the bank officials are to blame. Even if these bets had made money, instead of losing $7 billion, bank officials would deserve to be held accountable for taking unwarranted wild risks. If it turns out that Kerviel made fraudulent trades, he would deserve to be punished. But this p...

A rogue trader working for a bank has managed to lose a record $7 billion making unauthorized trades. The trader, Jérôme Kerviel, worked at the bank Société Générale in France. He lost the money trading in the European stock index futures market. Stock index futures are essentially side bets between two parties on whether the stock market will go up or down. This rogue trader made about $40 billion in bets that the stock market would go up, and as we have seen over the last week, those bets didn’t work out very well. When the bank discovered the huge bets, they sold them off quickly and ultimately lost $7 billion in the process. There have been many stories about rogue traders over the years. One thing all the stories have in common is huge losses. Don’t these rogue traders ever get lucky and make money? My guess is that many of them do make money, at least for a while. What would bank management do if they discovered a rogue trader who risked billions, but had made a bill...

In my previous post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility. The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get. This explains the inconsistency among various reports of average stock market returns . One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear. Let’s go back to the example in the previous post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everything over 3 years, even though the average outcome is ...

In a previous post , I showed how the average real return in the US stock market from 1926 to 2000 is 9.3%, but that this translated into a compounded real return of only 7.4%. The reason for this difference is the volatility of the returns. Let’s go for a better understanding of the cost of volatility without any advanced math. A Simple Example Suppose that you have $10,000 invested for two years. In the first year you lose 10%, and the next year you make 10%. It might seem at first that you have your $10,000 back, but that isn’t exactly right. After the first year you were down to $9000, and then in the second year you earned 10% on that $9000 to get a total of $9900. In the end you lost 1% of your money. However, the annual returns were -10% and +10% for an average return of 0%. The lost 1% over the two years is not due to a negative expected return; it is due to the volatility of the returns. The average return is 0%, but the compounded return is about -0.5% per year. Anoth...

I know I promised a discussion of risk and volatility, but that will have to wait. The stock market is crashing! Shouldn’t we be doing something? Yesterday morning the newspapers and online news sources were nearly unanimous: stocks are headed down and it’s going to be ugly. It can be tempting to sell everything at times like this, and many investors will sell. But if you do sell, when will you jump back in? Maybe you’ll buy once the market rises consistently for a week or two to show that the carnage is over. But this amounts to selling low and buying high. This is the opposite of what you want to do to make money. Any attempt to time the trading of stocks to make more money is called market timing. It can be tempting to try market timing, but be aware that there are others out there who are trying to beat you at this game. Collectively, market timers can’t make more money than those who simply buy and hold their stocks. In fact, on average they have worse results because they...

I intend to review the book Worry-Free Investing by Zvi Bodie and Michael Clowes, but for now I want to discuss one part of the book that reports historical U.S. stock market returns that are higher than I was expecting. In Chapter 6, the authors discuss U.S. stock returns from 1926 to 2000. They actually give real returns, which means the returns after inflation is subtracted out. Based on the historical data, they calculate the average yearly real return on stocks to be 9.3%. But, others say that the long-term real return on US stocks is 7%. This may not look like a big difference, but if you play around with one of the many free retirement calculators available online, you’ll find that an extra percent or two of return on your investments each year makes a big difference over the long term. So, which one is the correct historical average return? It turns out that they are both right because they are talking about different things. The 9.3% figure comes from taking the returns...

Graham McWaters and Gary Ford work for financial institutions and are writers and public speakers on financial matters. This is a review of their book, “The Canadian Guide to Protecting Yourself from Identity Theft and Other Fraud,” published by Insomniac Press. Although there is some focus on Canada, much of the material is relevant in the US as well. This book is a useful guide to the different types of fraud that people need to understand and avoid. The authors do a good job of personalizing the material with victim stories. Some types of fraud covered are debit and credit-card fraud, gathering personal information from computers on the internet, real-estate fraud, investment scams, and telephone-based scams. A frequent problem with personal finance and investment books (and self-help books in general) is repetitiveness. It’s not unusual for a book to have only 20 pages of real content repeated in multiple ways to produce a 200-page book. This book is better than most, but is ...

One of the arguments for using financial advisors is that they provide a steady hand that helps keep you from making rash investment decisions that will hurt your returns. The study by Bullard, Friesen, and Sapp released in December 2007 casts doubt on this argument. As discussed in this post , the study showed that mutual fund investors actually get lower returns than the funds’ reported returns because of poor market timing. You would think that working with a financial advisor would keep investors from making such mistakes, but apparently not. Another aspect of the study was to examine how investors working with a financial advisor fared compared to other investors. The study’s authors summarize: “We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds.” Instead of a steady hand, we find that investors working with financial ...

You’d think that the reported return on a mutual fund would give an accurate picture of how much money the fund’s investors made. A study by Bullard, Friesen, and Sapp released in December 2007 shows that this isn’t necessarily the case. It turns out that a fund’s reported returns only apply to buy-and-hold investors who held the fund from the beginning to the end of the reporting period. But not all investors do this. Due to the timing of investor money flowing into and out of the fund, the actual returns seen by investors are often lower. The study found that for one class of funds, investors underperformed the reported returns by 2.28% per year! These funds are like guys on online dating sites who say they like long walks on the beach and talking about their feelings, but turn out to be beer-swilling football watchers like all the rest. Across all actively-managed funds, investor money underperformed the reported returns by an average of 1.7%. Over 25 years, this would build u...

One of the choices investors have to make is whether to handle their investments themselves or work with (and pay) a financial advisor. People have a lot to say on both sides of this issue, but I’ve heard one clever argument several times now. It goes something like this: “You wouldn’t do your own surgery, right? So, why would you try to handle your own investments? Leave this stuff to the experts.” On the surface, this reasoning seems compelling. The image of some guy trying to operate on his own belly is pretty amusing. Anyone who comes up with a catchy line that makes people laugh must be right. But, this analogy breaks down very fast. Exactly who is the brilliant surgeon in the financial world? The financial planning industry would say that the average investor is not as smart as a surgeon, and I agree. Maybe professional money managers who run mutual funds are the surgeons. But these professionals as a whole don’t do any better than the stock market averages. When...

This is the last part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here . The audio program contains an extended pitch for long-term care insurance. See this essay for a discussion of some of the things to look out for with this type of insurance. According to a Consumer Law Page article (the web page with this article has disappeared since the time of writing), “sales agents are driven by high commissions” in the long-term care insurance business. I don’t know whether it is a good idea to buy long-term care insurance or not, but it would seem that those who sell it make good money. Some good advice Let’s not focus entirely on the negative side. On the positive side, the CDs were nice and round. I’m just kidding. Here are some of the good points made in this audio book. · Make a realistic financial plan consistent with your goals. · It’s okay to start investing with small amounts. Just keep saving. · Avoid frequent inves...

This is the fourth part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here . Mutual funds charge various fees that reduce investor returns. Some of these fees are paid to investment advisors for bringing business to the mutual fund. Edelman claims that fees are the least important thing to worry about when choosing mutual funds, and that “all of the academic data show that there is no correlation between performance and fees.” I had to pause the audio program there and think about that one. The main components of mutual fund fees are the MER that is paid each year and any loads that are paid when entering or exiting a fund. It is true that academic studies show little or no correlation between loads and fund performance. But this actually means no-load funds are better. Why pay loads if they don’t lead to higher returns? As for the yearly MER, academic studies definitely show a correlation between high MERs and lower fund retur...

In this third part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth,” we look at his views on market indices and index funds. This review began here . A market index is a measure of how the stock market performed as a whole. In a sense, it tells you how well the average investor has fared (not counting taxes, commissions, and other fees). You can choose to get the market average performance by investing in a low cost index fund (look here for more information about index funds). Edelman says that you shouldn’t measure your returns against market indices. This seems like a bad idea to me. If you do better or worse than an index in a given year, it doesn’t mean much, but if you do worse than the index over a long period of time, you need to examine your investing approach and consider switching to index funds. The discussion of index funds begins with Edelman saying that he doesn’t care if you buy an index fund or an actively-managed fund. This was p...

This is the second part of a review of Ric Edelman’s audio book “No-Nonsense System for Building Wealth.” This review began here . Edelman recommends keeping your mortgage, making the minimum payments, and investing any extra money you have even if you’re able to pay off your mortgage. The main support he gives for this advice is that many of his wealthy clients keep their mortgages. Any time you borrow to invest, you are said to be using leverage, and this increases your investment risk. It stings any time your investments drop in value, but the sting is worse if their value drops below the amount you owe. This idea of leverage is similar to the leverage you may have used as a kid on the teeter-totter. I remember pulling my side out to make it longer than the other side so that I could control the movement even if the other kid was heavier. I could make him go way up more easily. With a well-timed hard push I could also make him crash into the ground more easily. It works the sa...

Ric Edelman is a financial advisor whose personal financial planning firm manages nearly $2 billion for its more than 5000 clients. His audio book “No-Nonsense System for Building Wealth” (Nightingale-Conant Corp, Simon & Schuster Audio) makes big promises about the financial success you can have by following his advice. He is a compelling speaker who has appeared on the Oprah Winfrey Show, but not all of his points hold up under inspection. Edelman makes many good points such as the fact that most financial advisors don’t know much about investing, and most of the financial press is full of noise that you shouldn’t listen to. Concerning the financial press, Edelman says the following. "Many in the financial world have their own agendas. They aren't necessarily trying to give you financial information. What they are trying to do is generate profitability for themselves." Sadly, the same appears true of Edelman. Most of his advice is good, some of it not so good,...

In part 1 , I explained why the average professional money manager doesn’t get better returns than the stock market averages. Once we take into account the high costs charged by professional money managers, we find that index funds beat most actively-managed mutual funds. However, it is possible to find analyses within the mutual fund industry that seem to contradict these conclusions. This is because mutual fund lists contain only those funds that are still active. Poorly-performing funds get closed or merged with other funds . Wouldn’t it be nice if we could all throw out our worst performances? “Judge, I’d like to point out that that in 3 out of 5 football games I attended this year, I didn’t go streaking onto the field.” If we calculate average mutual fund returns after throwing out bad funds, we get an artificially inflated average return that is higher than the returns investors actually received. This is called survivorship bias. In the book “A Random Walk Down Wall Street...

Actively-managed mutual funds have professional money managers who can do a better job of investing than the rest of us, right? That’s not what the evidence says. Studies show that the average professional money manager does not get better results than the market averages. There are a number of reasons for this including the difficulty of investing very large sums of money and the pressure to show decent results every quarter or face having investors leave the mutual fund. The simplest reason, though, is that professional money managers control so much of the total money invested in stocks and bonds that they dominate the averages. The US Federal Reserve’s December 2007 statistics contain a breakdown of stock holdings in Table L.213. It is not immediately obvious which line items correspond to professional money managers, but if we include just state and local governments and their pension plans, insurance companies, private pension funds, mutual funds, closed-end funds, and exchan...

Lee Valley Tools Ltd. has initiated a class action suit against Canada Post over shipping charges. Before 7 years ago, Canada Post charged for shipping packages by weight. Then they introduced a new system where they charged for either weight or volume depending on which gave the higher charge. The idea was to charge more for big bulky packages that take up a lot of space, but aren’t very heavy. This all sounds reasonable enough, except that Lee Valley alleges that the machine Canada Post uses to measure volume can overstate the volume by as much as 20%. Another allegation against Canada Post in all this is that they keep any overpayments. Commercial customers have to weigh their packages and calculate the charges themselves. If Canada Post finds that the customer paid too little, they demand more money, but if the customer pays too much, Canada Post keeps the difference. Nice. If Canada Post loses this suit, it could be very costly for them. Of course, if Canada Post loses and ...

You may have heard of risk-adjusted returns in connection with mutual funds. The basic idea is that a risky investment may not be better than a predictable investment even if the risky investment has a higher expected return. There is some validity to this, although it is too often used to justify the poor returns of mutual funds compared to the overall stock market. Normally, any discussion of risk-adjusted returns includes some intimidating math. I’ll explain the problems with risk-adjusted returns without needing the math, and I’ll give pointers to where the math can be found for those who are interested. According to the theory, before comparing investments, you should do a risk-adjusted return calculation that will reduce the returns according to how risky they are. The riskier they are, the more the returns are lowered before any comparison. By “risk” here, we mean volatility, which is a measure of how much the returns vary over time. An investment that grows steadily has low...

Wouldn’t it be great if you knew when the stock market was going to go down? You could sell your stocks, wait for a while, and buy them back when the stock market was going to rise again. You’d get rich very quickly. Sadly, there doesn’t seem to be any magic way to know when the stock market will go down. You just can’t predict short-term swings in stock prices. But the sting of watching the value of your holdings drop 10% can make it tempting to look for signs of a market decline. Many people actually do a reverse kind of market timing. They get nervous and sell after stock prices drop, and they buy back in after prices start to rise again. Many commentators offer the sound advice that you should keep saving money and ignore short term stock market swings. Suppose that you have taken this advice to heart. Maybe you pour savings into low-MER index funds every month without thinking about whether stocks are up or down. Even so, you will still be forced into a situation whe...

Most commentators agree that people should be investors rather than traders. However, it’s impossible to be an investor without trading sometimes (or at least once). This is like telling people not to become smokers, but expecting them to take a puff once in a while. Let me start by explaining what I mean by “trader” and “investor.” A trader is someone who buys and sells stock. We usually use the term “trader” to mean those who trade stocks frequently and base their decisions on recent stock price movements rather than the health and future prospects of the businesses behind the stocks. An investor is someone who examines businesses to try to predict their long term success in terms of revenues and profits. Some commentators stop there, and I know what they mean, but none of this analysis makes any difference unless you actually buy the stock. Investors have to be traders at least part of the time. Let’s say that you are an investor who has found a business you would like to...

Happy new year! I have a few fearless predictions for the upcoming year. 1. Half of all financial prognosticators will correctly guess whether the stock market will go up by more than usual this year. Of course, the other half will get it wrong. Maybe we would be better off if we ignored people who pretend to know what is going to happen to stock prices in the short term. 2. Interest rates will either go up, or down, or stay the same. This is a safe one. Some people will pick just one of these three possibilities, but I don’t believe they know what will happen to interest rates any better than the rest of us. I doubt that even the people who set interest rates know for certain what they will do more than a few weeks in advance. 3. Newspapers will continue to print explanations for what happened in the stock market each day. We see articles with titles like ‘markets jittery amid inflation concerns’ or ‘market rally blunted by corporate earnings pessimism.’ I rarely find these expla...