Here is some lighter fare for a Friday. The first quote is this article referencing itself. Unfortunately, it probably applies to some of my other articles (and some articles by other financial bloggers as well). “When ideas fail, words come in very handy.” – Johann Wolfgang von Goethe This next quote from Warren Buffett explains more clearly than I ever have why most professional money managers don’t really try to beat the index. “Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)” The last bit makes me think of someone watching a video of hundreds of lemmings going over a cliff, pausing the video...

Some commentators say that while professional money managers used to provide value because stock markets were inefficient, modern markets are too efficient for money managers to make up for the fees they charge. I agree with the latter part of this claim, but I haven’t thought much about the former part. The idea is that in the “old days” there was little information available to the little guy, and professionals supposedly had a huge advantage. But, with the instantaneous spread of information on the internet, professionals no longer have an edge. For the claim about the past to be true, money managers had to be buying when stock prices were low, and selling when they were high. After all, the only way to outperform in the stock market is to sell stock for more than you pay for it. I came across a 30-year old quote from Warren Buffet showing that money managers in the past weren’t doing their job very well for at least one time period: “An irresistible footnote: in 1971, pension fu...

The idea behind asset allocation is that by carefully choosing how much of each asset class (like cash, bonds, and stocks) to own, you can get higher returns without taking on more risk. Any sub-optimal portfolio can replaced with an optimized portfolio with higher expected return or lower risk. This mantra has been preached by many commentators to the point where thoughtful investors devote so much attention to their asset allocations that they lose sight of other important considerations. But, optimizing your asset allocation gives less benefit than you might realize. An Example Suppose that Jen has a retirement portfolio made up of 40% bonds and 60% stocks. We’ll assume that the stock and bond money is invested in low-cost index exchange-traded funds (ETFs) to minimize fees. Using the figures from the paper Portfolio Optimization by John Norstad (2002-09-11), Jen can expect a compound return of 5.23% per year above inflation. What happens if we allow Jen to include cash...

Back in 1986, a study by researchers Brinson, Hood, and Beebower concluded that over 90% of the variance in pension fund returns was determined by their asset allocation decisions rather than the individual equities they chose. Investment advisors like to abuse this statistic for their own gain. What the researchers did was to replace the pension funds’ individual equities with appropriate indexes and see how much the returns changed. It turned out that they didn’t change much. When a pension fund allocated a fraction of its money to mid-cap stocks, it tended to choose a broad mix of mid-cap stocks that performed very close to the average of all mid-cap stocks. The same thing happened for other asset classes. This isn’t very surprising. Christopher L. Jones observed in his book, The Intelligent Portfolio , that investment advisors abuse this 90% statistic to steer investors toward investments that are profitable for the advisor. I didn’t recognize it at the time, but I had an...

A friend observed a contradiction between two of my articles. In one I point out that it’s important to pay attention to small amounts because they can add up . In another I argued that pennies are a waste of time . In fact, I routinely refuse pennies in change from cash transactions. So, which is it? Do small amounts matter or don’t they? It depends on how small the amount is. If you spend $10 on fancy coffee and donuts, that is wasting the equivalent of a thousand pennies. The difference between a penny and a ten-dollar bill is the same as the difference between running to first base and running a marathon. The average cash transaction will produce about two pennies in change. I average 2 or 3 cash transaction per week. So, I’m refusing about $3 per year in pennies. It would take me more than 3 years for this to add up to spending $10 on coffee and donuts once. Thirty years worth of pennies invested at 8% interest with 3% inflation would have a present value of about ...

I enjoy playing low stakes poker for fun. I’ve even tried it in casinos in Las Vegas. Part of the ritual in casino poker games is that the dealer takes a cut of a few dollars out of each pot, and the winner of each hand often gives the dealer a tip of a dollar or two. This gives a good illustration of how small things can really add up. In low stakes games the players are often very impatient. I found that I could make about $20 per hour by simply being patient and disciplined. Playing this way is boring, but slightly profitable. To win this $20 each hour, I actually lose about $180 and win $200. Of course, the winning and losing occur randomly, and it took many hours of play before I considered these average figures to be fairly reliable. The problem is that the casino’s cut and the dealer’s tip come out of the $200 rather than just the $20. My “gross earnings” are actually more like $40 per hour. Even though the cut and tip are just a small fraction of each pot, they eat up a...

According to CNN, a Ponzi scheme run by Andres Pimstein fell apart recently in Miami, Florida . A Ponzi scheme is a fraudulent investing scheme where investors are paid returns out of other investors’ principal instead of being paid from the returns of a legitimate business. Ponzi schemes fall apart when there aren’t enough new investors to pay the existing investors. The fraud grows exponentially until the pool of suckers runs out. What I find interesting about this story is the way that people are tricked into these schemes. Potential investors are offered guaranteed big returns in a short time. If this were a legitimate business, why wouldn’t the pitch man just borrow some money from a bank and keep the huge profits himself? The usual explanation for why people get caught in these frauds is that greed overcomes reason. I think that is just a partial explanation. My guess is that the people, like Pimstein, who run Ponzi schemes are charismatic. Potential investors probably lik...

In a previous article we discussed how increasing a portfolio’s risk level can increase expected returns . This risk premium is most dramatic for long-term returns. You might ask can we keep increasing the risk level indefinitely to get ever higher expected returns? The short answer is no. Starting from a low-risk portfolio of fixed-income investments, we can increase risk and return by adding a diversified mix of equities. However, once we get to the all-stock portfolio, the party is pretty much over. Unless you have very unusual stock-picking skills, choosing individual stocks increases risk without increasing the expected return. There are many ways to increase risk, but most of them give lower returns, such as casino gambling and lottery tickets. To get higher expected returns along with the higher risk requires leverage. This means borrowing money to invest. Unfortunately, the interest on borrowed money cuts into the expected returns. Many analyses of leverage assum...

There is a tendency for higher investing returns to come with higher risks . The difference in expected return between safe and risky investments is called the risk premium. It’s obvious that once you choose a risk level, you should go for the highest returns possible. The challenge is to choose an appropriate risk level. One barrier to understanding risk is the way it is usually expressed. Saying that the S&P 500 has a 20% standard deviation means little to most people. In his book, The Intelligent Portfolio , Christopher L. Jones offers a good solution to this problem. Jones first assigns a risk level of 1.0 to the market portfolio , which is an average portfolio consisting of all asset classes in the proportions that exist in the marketplace. All other portfolios then have their risk level expressed relative to the market portfolio’s risk. So, an all cash portfolio has a risk level of about 0.2, and a single large-cap stock has a risk level of about 3.0. This seems l...

In his book, The Intelligent Portfolio , Christopher L. Jones discusses the average portfolio at great length. This average portfolio is also called the “market portfolio,” and it consists of every class of asset in the proportion that it exists in the marketplace. Jones attributes many qualities to this portfolio, but it has its limitations. Jones gives a table of how much money is in each type of asset (e.g., cash, various types of bonds, different classes of stock, etc.). If you believe in the market portfolio, then you should buy into each asset class in these proportions. Jones justifies this saying “when it comes to predicting the future, the market is usually smarter than any one person.” However, he exposes the problem with his reasoning when he says that the market portfolio “represents an efficient allocation of asset classes for an investor with an average tolerance for risk.” What if your tolerance for risk isn’t average? The perfect airplane seat is only perfect for t...

I was on the Air Canada web site considering booking a flight when some “special offers” caught my eye. Apparently there is a flight to Las Vegas available for only $94. I wasn’t planning to go to Las Vegas, but I decided to click a few buttons while I daydreamed about a fun weekend. After selecting some dates, I was dumped into a screen with the final price of $423.79. Apparently, the $94 was a one-way price. And a flurry of surcharges added another $235.79. I particularly liked the fuel surcharge. Is fuel optional? The sad thing is that I was expecting worse. I doubt that very many readers are surprised at these numbers. How did we get to a place where we expect advertised prices to have nothing to do with the actual amount we have to pay? I think it is a side effect of visible sales taxes. We’ve been conditioned from a young age that everything costs more than the advertised price. At first it was just a little bit more, but creative businesses have been pushing the envelo...

Many commentators tell us that we each have a certain level of tolerance for investing risk and that we should make choices that work for us. As long as we are all true to our feelings about risk, we can all be right, even if we make different choices. This is bunk. Betting next week’s grocery money on a horse is dumb whether you have a risk-taking personality or not. Buying stocks with the house down payment that you’ll need in 6 months doesn’t make sense even if you’re comfortable with it. The appropriate way to invest money depends mainly on when you’ll need it and for what purpose. How much of a risk-taker you are may determine what choice you make, but it shouldn’t. The larger the sum of money, the more important it is to be driven by rationality rather than feelings. The examples involving crazy risks are easy to agree with, but the mistakes of being too conservative can be harder to accept. Investing retirement money you won’t need for many years in bonds just doesn’t make...

A while ago I described my experience with Bell’s internet service . Since I switched providers, Bell has made numerous pointless efforts to get me back as a customer. The latest offer has a picture of a beaver inviting me to “get a lot of internet for a very little price.” The offer says that I will pay $9.95 per month. Wait a minute, there’s some fine print. That’s just for 6 months. Then the price then goes up to $22.95 per month. And I have to sign up for two years. Hold on, there’s more. I’ll be charged an extra $2 per month for modem rental and there are extra charges for using more than 2 Gigabytes per month. Something else is wrong. This offer is for a much lower speed of service than I had before I made the switch. So there you have it. If I switch back to the same service I used to have with Bell, I’ll pay some amount that has nothing to do with all the numbers in this offer. Clear as mud. Maybe it will all be worth it to get “the most powerful internet,” wh...

Investing contests are often won by someone who puts all of his hypothetical money into a few risky stocks whose share prices double or better over a short time. Is this skill or luck? The truth is that we can’t tell. If the same person wins several contests in a row, then we may be forced to believe that the good results come from skill. Any time you have thousands of people picking stocks, it’s inevitable that a few will have outstanding results. How can we tell if the winners were skillful or lucky? In his book, The Intelligent Portfolio , Christopher L. Jones discusses methods of distinguishing skill from luck. Jones chose the example of the Legg Mason Value Trust fund as an example. This fund beat the S&P 500 each and every year from 1991-2005 by an average of 7%! To get a handle on whether this is an unusual result, Jones uses simulations. He simulated 10,000 funds with similar investing styles, but making random stock selections, and checked how they performed compare...

I’m a big fan of safety margins. When I drive over a bridge, I’m glad it has been designed for several times the weight of the cars on it. Investing strategies should be designed so that you’ll be okay financially even if your returns are lower than you hope. But, we can sometimes make the mistake of layering too many safety margins and lose track of likely outcomes. In his book, The Intelligent Portfolio , Christopher L. Jones does some computer simulations to show that even though the S&P 500 returned an average compound rate of 6% above inflation for the past 40 years, there was a 1 out of 20 chance that the return could have been as low as 1.2% above inflation. This analysis is based on assumptions about the distributions of stock market returns. What happens if we take a look at actual returns over the past century? According to a chart produced by Crestmont Research, in the 58 rolling 40-year periods since 1910, the S&P 500 compound average return has ranged from infl...

Life only follows one path, but we can’t predict which path we will follow into the future. The fact that investments have risk means that we don’t know for sure what returns we will get. What we can do with some analysis is to list possible outcomes and estimate the chances of each outcome. The company Financial Engines uses a technique called Monte Carlo simulation to generate possible outcomes as part of personalized investment advice to its clients. (Disclosure: I have no connection to Financial Engines or its products.) Monte Carlo methods are well-known in the sciences, and it’s not surprising that they are useful in economics as well. Christopher L. Jones, who works for Financial Engines, includes examples of their simulations in his book The Intelligent Portfolio . I found the long-term simulations of stocks and bonds particularly interesting. The way the simulations work is that you start with some portfolio of investments, and the software generates thousands of possible...

We would all like to have investments with high return and low risk. Despite the sales pitches for get-rich-quick schemes, such investments don’t exist. In his book, The Intelligent Portfolio , Christopher L. Jones explains the forces that cause higher-return investments to have higher risk. Given a choice between two investments with the same expected return, investors would select the one with lower risk. Investors “expect higher returns as compensation for taking on the additional risk.” Suppose for a moment that a high-return, low-risk investment existed. Investors would immediately start buying this investment and drive its price up to the point where the returns are lower and more consistent with the risk level. Market forces will always act to maintain the relationship between risk and return. One thing I would add that Jones did not mention is that this relationship is based on our collective guess of the risks and returns of each type of investment. Such market wis...

I have already discussed the forces that led to individuals managing their own retirement money . In his book, The Intelligent Portfolio , Christopher L. Jones explains how this led to product-based compensation for financial advice. For wealthy people, investment advisors traditionally charged a percentage of the total portfolio each year. For this money, advisors were expected to have high levels of expertise over a broad range of financial topics. Investors got personalized attention requiring substantial amounts of the advisor’s time. Now that there are so many small investors managing their own retirement money, this model doesn’t work well. Advisors simply don’t make enough money on $50,000 portfolios to justify the time and effort. Something had to change. Enter commissions. When an advisor sells a mutual fund or insurance product, he gets a commission that is often invisible to the client. The result is, in Jones’ words: “This approach suffers from a big conflict...

In my parents’ generation, most people didn’t need to know how to invest money. They saved modest sums at the bank, but few routinely owned stocks. This question of why we’re all becoming investors is answered on the first page of The Intelligent Portfolio , written by Christopher L. Jones. I found that this book is well written and contains many interesting subjects. However, I don’t always agree with the author. I will be discussing several topics from this book individually over the next while. It turns out that people are living longer, making retirements much longer. The cost to defined benefit pension plans is skyrocketing. Companies don’t want to pay for these dramatically increasing pension costs. So, pension plans are being replaced with individual retirement accounts. In Canada these accounts are primarily RRSPs, and in the U.S. they are mostly 401(k) plans. Instead of funding pension plans, many companies now match contributions to individual retirement accounts...

I confess that I’ve never actually created a budget for my family. I’ve started budgets a few times, but never made it even half way through. Patrick over at A Loonie Saved describes an approach to family budgeting that seems less painful than what I tried to do. He begins with what he calls descriptive budgeting and evolves into prescriptive budgeting. What I have done for my family a few times over the years is some financial forecasting. I looked at our spending patterns, income, and one-time expenditures at a very coarse level to predict how much savings we would have a year or two later. This is similar to Patrick’s descriptive budgeting, but I suspect that my analysis was much less detailed. If you’re looking at your budget for the purpose of estimating future savings without trying to change your spending habits, you don’t need much detail. If I always take $400 out of a bank machine each month, it doesn’t matter what I spend it on unless I’m trying to reduce this sp...

Whenever economic conditions change, there are obvious primary effects and less obvious secondary effects. Rising oil prices have the primary effect of causing people to spend more on gas. Secondary effects include reduced oil use, reduced demand for gas-guzzlers, higher food prices, and increased research into alternative energies. Asako Ohinata at the University of Warwick did a study of the effect of a working families tax credit on fertility in the UK . The question was whether people would actually have more children if given a modest economic incentive. The results were mixed. The tax credit did not affect when couples had their first child. But, among couples who had one child, they had a second child sooner as a result of the tax credit. This speaks to the amazing power of economic incentives. If you want to reduce dependence on foreign oil, then increase gasoline taxes. If you want to reduce garbage output, then tax items at the time of purchase based on the amount of g...