In a recent post , I described a market timing experiment where a market timer decides each month whether to own the S&P 500 or to hold all cash. The result was that the market timer had to guess right 60% of the time from December 1990 to March 2008 to keep pace with an investor who simply bought and held through the whole time period. That experiment assumed that the investor was using a tax-sheltered account, as the Canadian Capitalist observed in his comment on that post. What happens if you have to pay taxes on the interest, dividends, and capital gains? I ran the experiment again, this time taking into account taxes. To give the market timer as much help as possible, I assumed that the buy-and-hold investor sells everything at the end of the complete time period and pays capital gains taxes. Tax rates vary from one jurisdiction to the next. For this experiment, I assumed a tax rate of 40% on interest income and 20% on dividends and capital gains. I assume that the marke...

Government intervention into the U.S. housing crisis has become an issue in the ongoing presidential race. McCain, Clinton, and Obama have each made statements about how the crisis should be handled. I find that my opinion on this matter shifts depending on who I focus on. Let me go through some hypothetical players so that I can show you what I mean. Case 1: Irresponsible Homeowner Carl saw his friends making money from rising house prices and decided to buy a condo to get in on the action. He chose a condo selling for $280,000, but he couldn’t really afford it on his modest income. In an obviously shady arrangement at the height of mortgage excesses, he managed to get a mortgage for $300,000 with only half-size payments for the first year. Carl knew he couldn’t afford the higher payments after the first year. His plan was to profit from the increased value of his condo in a year by either selling it or renegotiating his mortgage based on the new condo value. Things have...

All available evidence and logic tell us that the vast majority of investors can’t beat the market by market timing. This applies to professional money managers as well. I tried a little experiment to see how accurate a market timer’s predictions would have to be to succeed at beating the market. Market timing refers to the practice of jumping in and out of the stock market in an attempt to avoid market declines. The Experiment Suppose that a market timer decides at the beginning of each month whether to have all of his money in the S&P 500 stocks or all of it in cash. His goal is to avoid being in stocks during the months where stocks perform worse than cash. Each month the market timer has a certain probability of guessing right. If he just tosses a coin, this probability is 50%. The question is how high this probability has to be for the market timer to beat the strategy of just buying and holding through thick and thin. I gathered data on the S&P 500 from December...

People have a lot of tendencies that serve them well in many aspects of their lives, but can be harmful when it comes to investing in stocks. One of these tendencies is to prefer the familiar over the unfamiliar. I saw this during the high-tech bubble when ordinary people with minimal investing experience suddenly had stock options worth more than their houses. For some reason, these people found it difficult to cash out even though the stock options represented 80% or more of their net worth. I used to try a little mental exercise with these people. I would say “imagine that your options have been cashed out and the money is sitting in your bank account. Would you use it all to buy stock in a high-tech company at soaring prices?” The usual answer was something like “No way! That would be a ridiculously risky thing to do.” But, to my knowledge, only one person who tried this mental exercise with me was persuaded to cash out most of his options. Most people continued to hold their...

Bloomberg reports that mutual funds are selling stocks and hoarding cash. Of course, this would have been a better strategy when stocks were at a peak, rather than after they have dropped. This is definitely not a case of better late than never. When it comes to selling stocks in anticipation of dropping prices, I take the approach of better never than late. I just stay invested in stocks through the ups and downs because I don’t believe that I can predict the future direction of the market. It always seems easy to look back and think that what happened was inevitable, but it’s never so easy when you look forward. Mutual funds have a history of selling stocks at market lows and buying in at market highs. We can see this by tracking their cash levels. At market lows mutual funds tend to have high cash levels, and at market highs they tend to have low cash levels according to Larry Swedroe in his book “Rational Investing in Irrational Times.” So, it seems that the professional mone...

When we save for retirement, we tend to focus on that magical day when we will stop working. However, you won’t need to withdraw your entire retirement savings all at once on that day. For the most part, you’ll just need a certain amount per month plus the odd larger amount for things like a car, boat, or skydiving gear. Your retirement could easily last for more than 20 years. So, you’ll have to continue making decisions about how to invest your savings after you’ve retired. Most people (including me) believe that it makes sense to invest more conservatively as you get older. This usually means increasing the amount of money you invest in bonds and cash rather than stocks. In his book “Rational Investing in Irrational Times”, Larry Swedroe offers the following guidelines for percentage of money in stocks vs. how long it will be until you need the money: 0-3 years: 0% 4 years: 10% 5 years: 20% 6 years: 30% 7 years: 40% 8 years: 50% 9 years: 60% 10 years: 70% 11-14 years: ...

Insider trading is buying or selling a company’s stock when you have important inside information about the company that has not been made public. We tend to think of insider trading as being illegal, but that is an oversimplification. The top executives of a company almost always have inside information. If insider trading were illegal, then these executives could never trade their own stock. In the U.S., insiders are allowed to create prearranged trading plans, called 10b5-1 plans, for trading stock. The idea is that the executives can set out a plan to commit to trading stock at particular prices or at particular times. This way, the stock trades will happen automatically when the time comes, and the executive is protected from accusations of insider trading. Insiders beat the average But the insiders still seem to outperform other traders significantly. Business Week reported that “Alan D. Jagolinzer, an assistant professor at Stanford University Graduate School of Business...

Bloggers have been challenged to post their top 3 investing mistakes. Here is my contribution. 1. Putting my first savings into fixed income investments I was young and nervous because I owed $85,000 on my first mortgage. My mortgage permitted doubling monthly payments, and my wife and I were taking advantage of this feature every month; I wanted the mortgage GONE. This didn’t leave much for retirement savings, but we did manage to save some money each year. Unfortunately, I knew very little about the stock market at that time, and we put all of our savings into fixed income investments at our bank. We continued this way for several years giving up the gains available in the stock market. This was a big mistake. 2. Buying actively-managed high-cost mutual funds My first tentative steps into the stock market were through mutual funds . I worked with a few different financial advisors who turned out to be little more than mutual fund salespeople. It took me quite a while to fig...

Among the games that mutual fund managers play to artificially boost reported returns, such as closing underperforming funds and fund incubation , you can add a practice called front running. Larry Swedroe describes front running in his excellent book “Rational Investing in Irrational Times.” A fund family starts up a new fund hoping to report good returns and attract a flood of investors. They begin by choosing some stock that has low trading volumes so that a modest size purchase will drive its price up sharply. The fund family then purchases a block of shares for the new fund. Then they purchase a larger block of shares for one or more of their large established funds. This will drive the price of the shares up and artificially inflate to apparent returns of the new fund. Done correctly, the number of shares purchased for the established funds isn’t enough to make much of a difference to their returns. But, the new fund’s returns will look great and with a little adverti...

Well, this is it. It’s obvious now that the stock market will never come back, and that we’re dropping into a permanent recession. Unfortunately, not everyone believes this yet. You see, things can’t start improving until everyone believes that they will never improve. It’s time to head out and buy supplies for your bunker, unless you still have some left over from when the world was going to end in the year 2000. Whatever you do, don’t say anything optimistic about the future of the economy. Remember, it’s not what happens in a year or more that matters, it’s the anticipated carnage tomorrow that we need to focus on. How can we handle these enormous problems? I proceed by recognizing that I don’t know how to predict when the stock market will go up or down. So, I don’t try to buy or sell in anticipation of market moves. To deal with today’s low stock prices, I have kept money I’ll need in the short term out of stocks. Now, I’ll hunker down and hope that things get better in a few year...

On a personal level, Eliot Spitzer’s choice to make use of a prostitute is a serious matter for him and his family. He deserves some pain for his actions. However, a much more serious matter for anyone who invests in the U.S. is his effort to clean up the investment industry. The investment industry has legal responsibilities to act in the best interests of investors when handling their money. However, it is fair to say that much of the industry focuses on working around these laws to acquire as much investor money for themselves as possible. Spitzer was heavily criticized for his attempts to clean up the investment industry, but these criticisms came mainly from those making money by taking it from investors. Chuck Jaffe has an interesting article discussing some of Spitzer’s efforts. Spitzer’s personal failings are a serious matter for his family, but are trivial compared to the billions of dollars lost by investors each year. Individual investors need more politicians willing...

Most commentators advise investors to shift money from equities to fixed income as they age, and this makes sense. We may disagree on the exact asset allocation percentages and exactly how soon before (or after) retirement to start lightening up on equities, but it seems clear enough that the average 40-year old should have more in equities than the average 80-year old. However, there is a body of academic work that argues that investors should maintain a constant asset allocation regardless of their age. This work is based on what is known as constant relative- risk aversion (CRRA). I’ll show the problems with CRRA in an example below. One consequence of the CRRA assumption is that the optimal asset allocation percentages remain constant regardless of the length of the investor’s investment horizon. Paul A. Samuelson advocates this view in his keynote address to “The Future of Life-Cycle Saving and Investing” conference. I first heard of this conference and the correspondin...

Many investors seem unaware of the fees they pay to own their mutual funds. Disclosure rules are intended to prevent this sort of problem, but they don’t seem to be effective enough. In an earlier post , I discussed the possibility of including fee summaries on financial statements. An even better time to properly disclose fees is when you first start working with a financial advisor. Suppose that you meet with a financial advisor and agree to invest with her. She seems like a great person, and her investment advice seems sensible as far as you can tell. Then she hands you the following disclosure statement: Initial portfolio size: $150,000 Initial investments: 30% bond fund, 50% stock fund, 20% international stock fund Estimated Fees: Immediately: $6300 Year 1: $3135 Year 2: $3324 Year 3: $3526 Year 4: $2718 Year 5: $2781 Year 6: $2838 Year 7: $4815 Year 8: $5164 Year 9: $5540 Year 10: $5944 10-year total: $46,086 Gulp. Surely these can’t be right. Will you really ...

All mutual funds have a management expense ratio ( MER ) that covers the costs of running the fund. In addition to the MER, some mutual funds charge “loads”. Loads are fees paid either when you buy into a fund (front-end load) or sell out of a fund (back-end load). Back-end loads are also called deferred sales charges. The purpose of a front-end load is simple enough. The financial advisor who sells you a mutual fund is paid out of front-end loads. But what about funds that have deferred sales charges? Does the financial advisor have to wait until you sell to get his money? Things look even worse for the financial advisor when the deferred sales charges are “contingent”. This means that the sales charge declines over time. In a typical arrangement, if you sell in the first year, you get charged 5% of your initial investment, but only 4% if you sell in the second year, and so on until it drops to zero in the sixth year. Does this mean that if you hold on for more than 5 years your...

Before reading her latest book “Women & Money,” I didn’t know much about Suze Orman other than the fact that she is a TV personality who talks about money. I wasn’t expecting much from her book but was pleasantly surprised. The book is billed as “for women only,” but this mostly applies to the first 55 pages devoted to motivating women to read (and act on) the rest of the book. If you have thoughts on how useful these 55 pages are, I’d be interested in hearing them; they didn’t really apply to me. The actual financial advice starts in Chapter 6, and most of it applies to men as well. The section on retirement investing (page 115) is particularly good. Much of the detailed advice is intended for Americans, but the broad advice is useful for Canadians as well. Orman recommends that until you are a few years away from retirement, 100% of your retirement money should be invested in stock index funds. She prefers low-cost index exchange-traded funds (ETFs), but considers low-cost ...

In an earlier post I was looking at what fraction of your portfolio should be in stocks. I also listed Larry Swedroe’s table of time horizon vs. stock percentage from his book “Rational Investing in Irrational Times”. His table basically says to put everything in stocks if you won’t need the money for 20 or more years. The stock percentage then drops steadily to zero when you are three years from needing the money. I’ve been looking for some justification for this advice. The answer comes from considering the utility of money . The basic idea of utility is that the wealthier you are, the less an additional dollar is worth to you. An Example Suppose that if you invested your entire portfolio in risk-free investments, you would have $1 million when you retire. A game show host then makes you the following offer. You can just take the $1 million or you can toss a coin to get either $800,000 or $2 million. Would you take the sure $1 million or would you take the chance? What I r...

A strategy is said to be dominated if it is guaranteed to give the same or worse results than some other strategy. This term is usually used in game theory, but it can apply equally well to investing. Most of the time when we have a choice between two alternatives, we don’t know for certain which choice will lead to a better outcome. Should you buy stocks or bonds? In a given year, stocks might give better returns or bonds might give better returns. In some cases, the choice turns out to be clearer. Suppose that I offer you a bet: we’ll toss a coin, and the winner gets $100 from the loser. I see you hesitate, and I make a second offer: I’ll give you $10, and then we’ll toss the coin for $100. No matter which way the coin comes up, you’ll be ahead $10 taking the second offer rather than the first. This means that the first choice is dominated by the second. This doesn’t necessarily mean that you should go for the second offer. Depending on your circumstances (and whether you thi...

Most commentators advise people to reduce the percentage of stocks in their portfolios as they age. Some popular rules of thumb are to make the stock percentage 100 minus your age or 120 minus your age. Larry Swedroe in his excellent book “Rational Investing in Irrational Times” offers his own advice. Swedroe expresses his advice in terms of how long until you need the money (time horizon) rather than age. Here is Swedroe’s table of time horizon vs. percentage in stocks: 0-3 years: 0% 4 years: 10% 5 years: 20% 6 years: 30% 7 years: 40% 8 years: 50% 9 years: 60% 10 years: 70% 11-14 years: 80% 15-19 years: 90% 20 years or longer: 100% How do we test this advice? Unlike almost everything else in his book, Swedroe offers this table with no analysis of where the numbers came from. I decided to try to come up with my own answer to this question. It is surprisingly difficult to come up criteria for optimizing a portfolio for some end time. The best I have come up with so...

There was an interesting discussion earlier this week over at Canadian Financial DIY about how much people should invest in stocks. This post pointed to an article by Zvi Bodie and Paul Hogan that discussed the cost of insuring a portfolio against loss among other things. You may remember Bodie as a co-author of the book “Worry-Free Investing” (see my review of this book starting here ). He is a big proponent of investing in inflation-protected bonds rather than stocks. His reasoning is basically that stocks are too risky, even though they are expected to give higher returns. In their article, Bodie and Hogan make the following claim about insuring a portfolio: “proof positive of how stocks are risky even in the long run is that if you try to insure a portfolio against a shortfall, you will find that the premium rises as the time horizon lengthens.” An Example Let’s look at an example to explain what they mean. Suppose that you are about to invest $10,000 in a stock index, but...

Researchers at the University of Cambridge have found simple ways to compromise bank card readers. The next time you’re at a store punching your PIN into a debit card reader, if there is a paperclip or needle sticking out the back of the reader, you should be suspicious. The researchers Drimer, Murdoch, and Anderson have documented their findings in this technical report . They chose two different models of card reader and bought two each of them online for a total of $80 for the four readers. They then took one of each type apart to see how it worked and were then able to compromise the other readers simply. The card readers they examined were actually a type that is intended to work with higher security bank cards called smart cards. Instead of just a magnetic stripe, these cards contain a microchip that gives higher security. These cards are being deployed throughout Europe and are currently being tested in Canada. The researchers were able to probe the inside of the reader to get P...

How you ever wondered what all the fuss is about with pension disputes? We often hear about battles between a company and its workers over pensions. The workers accuse the company of stealing from the pension fund, and the company denies it. The stories rarely make it clear what is going on. In his usual clear and compelling way, Warren Buffett discusses pensions in his latest letter to shareholders on page 17 in a section called “Fanciful Figures – How Public Companies Juice Earnings.” Why Should Pension Funds Exist at All? Let’s consider the case of a 45-year old worker William who works for the fictitious company SomeCorp. A traditional pension is a promise made by SomeCorp to pay William certain amounts of money each month after he retires. Given this situation, it’s not immediately clear why a pension fund should exist at all. As long as SomeCorp makes the promised payments, the company should be able to run its affairs as it sees fit, right? Not so fast. What happens if SomeCorp...