Reprinted with the permission of the American Association of Individual Investors (AAII)

If you’ve ever been to the track, you know that big winnings come from betting against the crowd.

Bet on the favorites and you may cash in a couple of small winning tickets; but scope out an underdog the crowd doesn’t believe can win and you collect a big payoff. There simply isn’t much reward in betting with the consensus.

The same holds true in the investing universe. To be consistently successful, you must adopt a contrarian’s mentality and bet against the crowd. There are a host of good businesses out there-even a lot of great businesses-you might invest in, but if you want substantial returns, you have to place less emphasis on the prospects for the business, and more on the prospects for the investment.

Investors commonly confuse a good business with a good investment. Many good businesses have expectations embedded in their stock prices that are just too high. The reason is that investors tend to extrapolate events forward in a linear fashion-that is, they believe a company doing well will continue to do well and if performing poorly, will continue to perform poorly.

Cisco Systems (CSCO) and Microsoft (MSFT) are highly successful companies, but their stock-implied growth expectations in the late 1990s would have translated into sales in excess of the U.S. gross domestic product. As an investor, you face the task of recognizing whether current expectations are overly optimistic or overly pessimistic. Changes in expectations-not earnings growth-move stock prices.

The advantage lies in being able to determine whether the deficiencies in current expectations are too optimistic or too pessimistic.

Good Companies

What makes a business a “good” business?

There are certain characteristics inherent in all good businesses. In particular, good businesses are not only profitable, but they also generate free cash flow net of capital reinvestment (capital expenditure).

Good businesses also generate a return on their invested capital over and above their cost of capital. They continue to grow their business-reinvesting in new assets-for as long as their return on their invested capital exceeds their cost of capital.

Good businesses are able to sustain or increase their rate of return on their invested capital. A fading return on invested capital indicates the business is becoming average and no longer special; a choppy return on their invested capital indicates a cyclical business model.

Investors should prefer businesses with revenue growth, operating margins and asset turnovers that are above average relative to others in their industry, since these drivers are the financial impetus behind return on invested capital. Accelerating dividend payments are also preferable, since they are a sign that the company’s management is interested in paying shareholders income while maintaining sufficient cash flow to run operations.

What Makes a Good Business vs. a Good Investment

Good Business Cash flow is positive Profitability Return on invested capital is greater than the cost of capital Return on invested capital is stable or trending upward Has the ability to reinvest cash flows back into the business, which allows for asset growth Sales growth continuing Operating margins improving and better than peers Asset turnover improving and better than peers Good Investment Stock-implied expectations about future cash flows are overly pessimistic Market price differs substantially from warranted price

Good Investments

While there are many factors that constitute a good business, there is one primary consideration when it comes to a good investment: expectations.

A business is worth the present value of its existing assets plus the net present value of its future investments. So the current price of a stock is based on what investors collectively (”the market”) expect the business’ future to be.

Of course, no one can predict the future, so when analyzing a stock’s price you are left with two choices.

One is to take a crack at forecasting a company’s future performance, translate that into annual cash flows and calculate the firm’s “warranted price.”

As an alternative, one can analyze stock-implied expectations (the cash flow expectations embedded in a stock’s current price), back out the cash flows, and determine whether the market’s assessment of the future seems reasonable (see below ). This helps determine whether the consensus view is sensible, and whether the company will meet, beat or miss expectations.

Since changes in expectations drive stock prices, it only makes sense to start out by investigating what those expectations are.

Divergent Opinion Rules

Just because a company happens to run a good business, doesn’t mean investing in it will be profitable. Remember, as an investor, you aren’t rewarded for betting with the consensus. You need a divergent opinion, cultivated by an informational or analytical advantage. More often then not, it is information combined with common sense that contributes to outwitting the consensus. Here are two examples:

• Dell Inc. (DELL) has consistently operated a great business, generating returns on invested capital in excess of 20% per year since 1996. Given the track record, investors focusing on the economics of the business instead of the embedded expectations would have thought this a prime candidate for investment. But if they had put their money into Dell in 2005, they would have lost over 30% of their capital-despite the fact that return on invested capital increased to a near all-time-high level-because stock-implied expectations were calling for returns to be much higher.
• Century Aluminum Co. (CENX), another great business, has enjoyed an upward return trend since 1999-indicating an improving business-and generated returns nearly twice their cost of capital for the past three years. Investors have earned over 50% year-to-date 2006 because previous stock-implied expectations calling for the business to generate cost of capital returns have since been readjusted upward.

A Different Kind of Risk

Market forecasters must accurately predict future cash flows and discount rates and then determine a fair market price.

Expectations analysts take the current market price and back out market implied cash flows, asset growth rates (reinvestment rates), and return on invested capital.

While somewhat complicated, this can be done repeatedly with surprising accuracy. The reliability of the conclusions drawn from expectations analysis is also based on the ability to assess the market’s expectations as reasonable or unreasonable, which determines the direction of market error- either too optimistic or too pessimistic. The approach forgoes the exceedingly high level of accuracy required in market forecasting in favor of a more philosophical look at the investment’s prospective future (i.e., will margins expand or contract, will revenues grow faster or slower, etc.).

The level of risk can be further reduced by limiting the companies to those that trade at or below cash and book value.

For example, if you choose to buy a stock with market expectations for negative future cash flow because you think the business will generate positive cash flow, and the stock trades slightly above cash, your downside risk is limited because if you are wrong, the stock will fall only to cash value (unless management spends that cash).

Calculating Implied Expectations

Expectations analysis involves taking the current market price and backing out market implied expectations. How is this accomplished?

The foundation for the pricing equation is that the value of a firm today is the value of its stream of expected cash flows over its life, discounted back at a specific rate of return. So you need to do the same kind of analysis as you would for any cash flow valuation method. The key components are the firm’s current asset base, the return on investments the firm generates on its assets, the firm’s future asset growth rates (reinvestment rates) and the degree to which these returns change as the company’s life cycle matures.

But by reverse engineering the calculation, you can determine the stock-implied expectations based upon current stock price, as well as put in your own assumptions to better understand what the stock should be trading at in the future. You can also compare these assumptions to those embedded in a company’s peers, as well as against a company’s own historical performance, to better understand where the most uncertain assumptions lie.

Of course, there are many factors that can affect a firm’s cash flows, and institutional investors like our firm use sophisticated (and expensive) software that can crunch a wide variety of factors into consideration to determine the implied expectations.

For individual investors performing expectations analysis on a stock, the analysis can be performed using spreadsheet software and the equation:

where is the sum of all future cash flows. [The on-line encyclopedia Wikipedia has a longer mathematical explanation of this under "discounted cash flow" at http://www.wikipedia.org/]. So if you know the price and the discount rate, you can back out the firm’s expected future cash flows. Once done, you have only to determine whether or not you believe those cash flows will be realized, missed or exceeded.SummaryIt is important to understand and correctly interpret the expectations embedded in current stock prices when making investment decisions. Changes in expectations alone will cause changes in stock prices.Being a good business-or even a great business-isn’t enough because the market doesn’t reward you for investing with the consensus.Successful investing on a consistent basis is the result of developing a correct contrarian thesis and acting on it.

To Find a Good Investment, Ask the Right Questions

One very important aspect of evaluating stocks lies in asking the right questions. Perhaps that sounds rather obvious, but investors tend to ask the wrong questions, or ask questions not to get objective information but rather to secure support for opinions they have already formed.Today, with so many sources of investment data, opinions and analyses, investors can easily find support for any hypothesis. Whether they think a particular stock will rise or fall, there is ample data to back up their judgment.For example, satellite radio companies XM (XMSR) and Sirius (SIRI) get a lot of play. Investors who like them as a buy will cite their triple-digit revenue growth as validation. In contrast, investors who think the companies have peaked and are ready for a fall can point to their negative margins and inability to generate more than 10 cents on the asset dollar in sales for reassurance. There is ample support for both viewpoints.Investors who can suspend judgment for as long as possible tend to be better investors, allowing the big picture to materialize before one or two data points steer them in the wrong direction.Active investing also means challenging market opinion, and asking what performance is expected of the company in order for it to merely achieve the level of valuation suggested by its current stock price. Inherent is the discipline to resist trying to prove you are right about a stock, but rather to question where the market’s collective intelligence about a stock’s price suggests the market is wrong. The subtlety of this insight can make a big difference.The quality of any investment process depends on the rigor and tenacity of the framework used. Here are some key questions that can help reveal where reality may be contrary to the market’s view.What Is the Context of the “Good” Information?The context of information can be just as important as the information itself.Over the last few years, valuation levels of JetBlue (JBLU) have essentially “priced in” cash returns at their cost of capital. That’s about the same level the company achieved in 2002 and 2003. (The spread between returns and the firm’s cost of capital were essentially zero during those years.)The problem here is that there’s no value to growing a business that only achieves its cost of capital. If the firm is paying 6% for its capital and only generates a 6% return, it hasn’t created any value.It’s only when it can achieve returns in excess of its cost of capital that value is created for shareholders.How Good Does the Story Have to Be?It’s easy to get caught up in a great story. New products or newly launched businesses are frequently accompanied by breathless press releases suggesting a rosy future for the stock.It’s easy to see if the company’s sales are strong, but understanding the expectations in the stock price helps frame the correct question: “Just how good does the story have to be?”Everyone knows the exciting Google (GOOG) story, but what has the collective market priced-in at its recent $425 per share? Assuming Google’s economic profitability remains stable, what level of revenue growth is necessary to support that price?Within five years, Google needs to achieve revenues 2.5 times current levels. And that’s just to support its current price. For it to be considered as a worthy long-term position, one would have to believe that the market has underestimated Google’s potential by at least 20% or more.This is not to question or denigrate the incredible performance of GOOG in the past, but rather to arrive at the correct investment question, which is, “How much better can GOOG get?” What Will Be the Catalyst to Market Efficiency? In the case of undervalued stocks, what will be the catalyst that sends the market a signal that a correction is needed? Without that event, these stocks may never realize their potential. For example, in 2003, Motorola (MOT) returns had fallen to 20-year lows (nearly zero) and the stock price dropped in six of the previous seven years to an incredibly low $8 per share. At that level, the stock price implied virtually zero growth and little chance for improved returns. The depressed price and performance expectation might have continued were it not for one salient event: CEO Chris Galvin stepped down. That catalyst was enough to attract a crowd of investors who otherwise would likely have ignored MOT’s prospects. Combined with an expected change in business strategy, MOT’s stock climbed over 30% in a matter of weeks and doubled over subsequent months. In addition to management change, earnings surprises and other corporate actions can drive performance. For some stocks, the key question to act on might simply be, “Is management change imminent?” Amazing investment opportunities may follow.

Steven Holt Abernathy is principal and chairman and Brian Luster is a senior analyst and portfolio co-manager at The Abernathy Group in New York, NY. The firm specializes in asset protection and wealth management. You can contact the authors at 800-342-0956, info@abernathyfinancial.com or at http://www.abernathyfinancial.com/.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.AAII.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Jennifer Openshaw, CEO of Family Financial Network and author of The Millionaire Zone

The stock market has risen relentlessly, and real estate and commodity markets have peaked. It’s a good chance to park some cash, as a lucky few did in the late 1990’s. Are bonds the answer? That’s for you to decide. But just as the Internet and e-broker platforms revolutionized stock investing ten years ago, now it’s becoming easier for individual investors to invest in individual bonds. Here’s why.

Historically, bond investing has been the domain of institutions and a handful of elite brokers. Try to buy an individual bond and you’ll be amazed at what you will - or won’t find. Wholly designed for institutional players, bond investing tools resemble a visit to the dungeon in Hogwart’s Castle: weird terminology and acronyms flying around like energized bats and a strong sense that many bond features, research or record of previous trading are forever hidden behind closed trap doors.

And if you happen to find a bond you like you won’t necessarily be able to buy it - unless some dealer just happens to have a few lying around.

As a result, bond mutual funds have been the “push” of most investment advisors. But it’s a steep 20 percent admission charge to attend the party - 80 to 150 basis points (0.8%-1.5%) in management fees on an investment designed to earn about 5 percent in the first place.

This is hardly a consumer friendly choice. I’ve always thought it odd that one of the market’s safest havens is so difficult for the individual investor - at least until now.

An Open Bond Market

For years, individuals could buy U.S. Treasury savings bonds online easily through Treasury Direct (see www.savingsbonds.gov) . But that was about it. Discount and so-called “premium discount” brokers have made what’s best described as a slow push into electronic individual bond investing. Of those I checked out, Fidelity and its Open Bond Market platform introduced in late 2004 seem to have come the farthest.

The Open Bond Market brings many of the features sought by stock traders to an individual’s fingertips: research capability, selection tools, price transparency and trading history. Further, the Fidelity platform provides liquidity by adding the inventory of some 80 plus dealers and some 10,000 issues, cutting out the painful search for a dealer with inventory at an acceptable price.

What’s Under the Hood

The Internet stock trading platforms of the late 1990’s were made possible by repackaging tools previously used by professional traders. And so it is with Fidelity and most of the others. A rapidly growing Wall Street firm known as MarketAxess (NASDAQ: MKTX) has built a electronic bond trading platform incorporating information, analytics, and price and trade history for investment grade and high-yield corporate bonds for institutional investing clients. Known as Corporate BondTickerTM, platform elements are now being adapted to retail by Fidelity and others.

The appearance of real time information has had a tremendous impact on price transparency and trading efficiency in the market. According to MarketAxess spokesman Stephen Davidson, quoting a recent study, some $1 billion in trading cost savings has been realized by institutional clients annually. He adds: “The secret is providing transparency, price discovery and superior liquidity investors seek.” MarketAxess currently handles some 90% of electronic investment-grade corporate bond trading today, of which only 8-10% currently is brought in through the retail channel. While MarketAxess itself currently has no plans to enter the retail trade, you’re likely to see a growing presence of efficient and retail-friendly e-platforms built upon new the functionality that supports Corporate BondTickerTM.

Using The Tools

I’ll be the first to point out that, even with better tools, buying individual bonds isn’t for everyone. Credit risk makes bond diversification very important. That combined with the use of laddering to spread maturities and reduce interest rate risk means that individual bond investing probably isn’t for smaller portfolios.

But if you have a larger portfolio, say $100,000 or more, it’s worth checking out these tools. Even if you’re not at that “number,” it’s not a bad idea to learn about these tools and bonds in general.

Fidelity has done a nice job of bundling the tools and making them easy to use. The Bond Selector, found at http://fixedincome.fidelity.com/fi/FISearchIndividualBonds lets you select among a wide assortment of issuers and bond types. Important features include:

• Screener. Narrows the search to certain types of bonds, yield ranges, and risk ratings. Also allows selection of Fidelity “Tier 1″ - a group of issues pre-screened by Fidelity for quality.

• Industry selector. For corporate bonds, you can choose one or more industries

• Risk-reward tools. The handy “scatter graph” lets you visually pick you spot on the yield curve. Mouseovers reveal the individual bond and agency rating for each point on the scatter graph.

• Laddering tool. Visually construct a bond portfolio to meet income needs and risk parameters over a longer term.

• Reduced commissions. Online trades cost $0.50 each for U.S. Treasuries (free for initial auction Treasuries) to $2 for corporates with a minimum of $19.95 per trade.

Anyone intending to buy individual bonds should take the time to learn bond investing techniques and strategies. E-broker educational tools are a good place to start. I also recommend the instructive American Association of Individual Investors frequently-asked-questions page, found at http://www.aaii.com/faqs/bonds.cfm.

Reinventing the Bond Market

Creating a friendlier and more level playing field for do-it-yourself individual investors is the whole idea, and there are signs it’s working. According to Fidelity Senior Vice President for Retail Fixed Income Securities Andy Wrobel, some 80 percent of Fidelity’s retail client bond trades are now done online rather than through brokers. This compares to 30 percent when the Open Bond Market started out. Customer response has been “overwhelming.”

Wrobel adds: “Our goal was to reinvent the bond market for the retail customer. The bond market was like buying a car 10 years ago; with no real time Blue Book or any other tool you never knew if you were getting a good deal. That’s changed now.”

It’s still in the early stages, and I don’t expect people to ever trade bonds like stocks. But so far as expanding possibilities for individual investors, I believe he’s right.

The stock market has risen relentlessly, and real estate and commodity markets have peaked. It’s a good chance to park some cash, as a lucky few did in the late 1990’s. Are bonds the answer? That’s for you to decide. But just as the Internet and e-broker platforms revolutionized stock investing ten years ago, now it’s becoming easier for individual investors to invest in individual bonds. Here’s why.

Historically, bond investing has been the domain of institutions and a handful of elite brokers. Try to buy an individual bond and you’ll be amazed at what you will - or won’t find. Wholly designed for institutional players, bond investing tools resemble a visit to the dungeon in Hogwart’s Castle: weird terminology and acronyms flying around like energized bats and a strong sense that many bond features, research or record of previous trading are forever hidden behind closed trap doors.

And if you happen to find a bond you like you won’t necessarily be able to buy it - unless some dealer just happens to have a few lying around.

As a result, bond mutual funds have been the “push” of most investment advisors. But it’s a steep 20 percent admission charge to attend the party - 80 to 150 basis points (0.8%-1.5%) in management fees on an investment designed to earn about 5 percent in the first place.

This is hardly a consumer friendly choice. I’ve always thought it odd that one of the market’s safest havens is so difficult for the individual investor - at least until now.

An Open Bond Market

For years, individuals could buy U.S. Treasury savings bonds online easily through Treasury Direct (see www.savingsbonds.gov) . But that was about it. Discount and so-called “premium discount” brokers have made what’s best described as a slow push into electronic individual bond investing. Of those I checked out, Fidelity and its Open Bond Market platform introduced in late 2004 seem to have come the farthest.

The Open Bond Market brings many of the features sought by stock traders to an individual’s fingertips: research capability, selection tools, price transparency and trading history. Further, the Fidelity platform provides liquidity by adding the inventory of some 80 plus dealers and some 10,000 issues, cutting out the painful search for a dealer with inventory at an acceptable price.

What’s Under the Hood

The Internet stock trading platforms of the late 1990’s were made possible by repackaging tools previously used by professional traders. And so it is with Fidelity and most of the others. A rapidly growing Wall Street firm known as MarketAxess (NASDAQ: MKTX) has built a electronic bond trading platform incorporating information, analytics, and price and trade history for investment grade and high-yield corporate bonds for institutional investing clients. Known as Corporate BondTickerTM, platform elements are now being adapted to retail by Fidelity and others.

The appearance of real time information has had a tremendous impact on price transparency and trading efficiency in the market. According to MarketAxess spokesman Stephen Davidson, quoting a recent study, some $1 billion in trading cost savings has been realized by institutional clients annually. He adds: “The secret is providing transparency, price discovery and superior liquidity investors seek.” MarketAxess currently handles some 90% of electronic investment-grade corporate bond trading today, of which only 8-10% currently is brought in through the retail channel. While MarketAxess itself currently has no plans to enter the retail trade, you’re likely to see a growing presence of efficient and retail-friendly e-platforms built upon new the functionality that supports Corporate BondTickerTM.

Using The Tools

I’ll be the first to point out that, even with better tools, buying individual bonds isn’t for everyone. Credit risk makes bond diversification very important. That combined with the use of laddering to spread maturities and reduce interest rate risk means that individual bond investing probably isn’t for smaller portfolios.

But if you have a larger portfolio, say $100,000 or more, it’s worth checking out these tools. Even if you’re not at that “number,” it’s not a bad idea to learn about these tools and bonds in general.

Fidelity has done a nice job of bundling the tools and making them easy to use. The Bond Selector, found at http://fixedincome.fidelity.com/fi/FISearchIndividualBonds lets you select among a wide assortment of issuers and bond types. Important features include:

• Screener. Narrows the search to certain types of bonds, yield ranges, and risk ratings. Also allows selection of Fidelity “Tier 1″ - a group of issues pre-screened by Fidelity for quality.

• Industry selector. For corporate bonds, you can choose one or more industries

• Risk-reward tools. The handy “scatter graph” lets you visually pick you spot on the yield curve. Mouseovers reveal the individual bond and agency rating for each point on the scatter graph.

• Laddering tool. Visually construct a bond portfolio to meet income needs and risk parameters over a longer term.

• Reduced commissions. Online trades cost $0.50 each for U.S. Treasuries (free for initial auction Treasuries) to $2 for corporates with a minimum of $19.95 per trade.

Anyone intending to buy individual bonds should take the time to learn bond investing techniques and strategies. E-broker educational tools are a good place to start. I also recommend the instructive American Association of Individual Investors frequently-asked-questions page, found at http://www.aaii.com/faqs/bonds.cfm.

Reinventing the Bond Market

Creating a friendlier and more level playing field for do-it-yourself individual investors is the whole idea, and there are signs it’s working. According to Fidelity Senior Vice President for Retail Fixed Income Securities Andy Wrobel, some 80 percent of Fidelity’s retail client bond trades are now done online rather than through brokers. This compares to 30 percent when the Open Bond Market started out. Customer response has been “overwhelming.”

Wrobel adds: “Our goal was to reinvent the bond market for the retail customer. The bond market was like buying a car 10 years ago; with no real time Blue Book or any other tool you never knew if you were getting a good deal. That’s changed now.”

It’s still in the early stages, and I don’t expect people to ever trade bonds like stocks. But so far as expanding possibilities for individual investors, I believe he’s right.

Reprinted with the permission of:

Jennifer Openshaw

The Millionaire Zone
6 West Putnam Ave, Third floor
Greenwich, CT 06830

http://www.themillionairezone.com/

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Both the Dow Jones Industrial Average and the Standard & Poor’s 500 stock index hit record highs this year despite concerns about high energy costs, the housing mar­ket slump, tightening credit markets, persistent inflation fears and a slowing economy. But recent sharp pullbacks left many investors wondering whether they would face a new version of what hap­pened in 2000-when the tech-stock bubble burst and a bear mar­ket drove down prices for years.

Are we facing Bub­ble II?  Recently investment strategist Edward Yardeni was asked that ques­tion, and his answer was a resounding “No!” In 2004, at a time when the stock market was strug­gling, Yardeni forecast a rousing bull market. He was right. Now he explains how 2007 is different from 2000 and why he thinks that despite pullbacks, stock prices will continue to move higher in 2007 and beyond…

Stocks are not overvalued. The price-to-earnings ratio (P/E) of the S&P 500 stocks averages 17 now, based on earnings for the past 12 months. That’s close to historical av­erages and far below the P/E of 29.4 that was reached in 2000. Reason: This bull market has been built on earnings growth, not on unreliable measure­ments of value that many tech compa­nies were inventing seven years ago.  Since then, profit growth among US companies has risen much faster than stock prices.

It’s not just tech stocks going up. The range of companies whose stock prices were soaring in 2000 was very narrow. In the current rally, stocks of all sizes and styles have risen, led by laggards of a decade ago, such as energy and commodity com­panies. This confirms that economic prosper­ity and corporate prof­itability are much more broadly based.

This bull market is global. The eco­nomic boom in the 1990s was centered around the US. The current global econom­ic expansion is more diverse and more sus­tainable than any other in the past half-century. Emerging markets now are major contributors to global economic activity. These trends are creating pros­perity around the world. They will keep US markets rising much longer than in previous eras.

Inflation is tame and will continue I to be low. It looks as if the Federal Reserve will pull off a soft landing for the economy, slowing growth to a manageable pace while staving off recession. Core inflation remains subdued at about 2% as productivity continues to grow at an annual rate of about 3%. Global competition should continue to keep a tight lid on infla­tion because products and services are available from many sources.

Easy money will continue to drive domestic and overseas markets.  Long-term bond yields remain stock-friendly. Even though the yield on the benchmark 10-year Treasury note has increased to around 5%, that’s lower than the 6.17% level at the 2000 mar­ket peak. Interest rates remain low enough to keep the economy and cor­porate profits growing.

Also, US policies concerning interest rates, government spending and trade have combined to create what may be one of the most bullish environments ever for stocks.

A significant amount of money that Americans have sent to other countries by buying their products has poured back into the US as for­eigners bought nearly $1 trillion in US stocks and bonds over the past 12 months, suggesting that they have confidence in, the US economy. S&P 500 companies have used strong cash flow to fund shareholder-friendly ac­tions-including more than $110 bil­lion in stock buybacks in just the first quarter of 2007.

Mergers and acquisitions should keep stocks buoyant. Because credit has been cheap, private-equity firms have aggressively purchased un­derperforming public companies at lofty prices.

Of course, tighter credit conditions are likely to stop most of the more speculative deals, but that is a good thing.

Activity in “strategic” mergers and acquisitions motivated by sound busi­ness goals should remain strong.

HOW TO INVEST NOW

Corrections that pull back the stock market by 10% or even more are pos­sible in any market environment. The recent turmoil in credit markets may continue to weigh on stock prices for a while longer. And a super-spike in gas prices caused by some terrorist action…or an unforeseen economic implosion in a place such as China, could have an immediate and dra­matic effect. put all the current con­ditions suggest that stocks overall will move higher and that any pullbacks will be short-lived-and provide opportunities.

While I’m not expecting the market indexes to post 20% annual gains as in the 1990s, tangible economic growth around the world will mean returns in the 10% range through the end of this decade and beyond.

Recommended portfolio allocations for small investors: 75% in stocks, with emphasis on today’s most underval­ued category, which is large-cap growth stocks…25% in bonds, with emphasis on high-quality, short-term debt, be­cause yields on higher-risk bonds cur­rently are not compelling.

SECTORS TO FAVOR

Financials. I especially like indus­tries that benefit from the increased demand for self-funded retirement ac­counts and health insurance, such as asset-management companies and health and life insurance firms.

Energy. There is plenty of upside left, although these stocks will be very volatile. I like the earnings momentum at drilling and equipment firms.

Industrials. This sector provides a good way to play the global economic boom without being overexposed to the volatility of commodity prices. I like aerospace and defense companies… farm machinery and heavy truck com­panies…industrial machinery manu­facturers…and railroads.

SECTORS TO AVOID

Utilities. This sector has had a huge move up in recent years, thanks in part to the low 15% tax rate on dividends. But it also has among the highest P/Es of any stocks in the market. With the yields on bonds (which compete with many utility stocks for investors) mov­ing higher, it’s time to lighten up on utilities.

Consumer durables. I would notbe a bottom picker here. And for now, avoid anything housing-related, such as builders and mortgage lenders.

Reprinted with the permission of:

Bottom Line/(name of publication/website)

Boardroom, Inc.
281 Tresser Blvd, 8th Floor
Stamford, CT 06901
www.BottomLineSecrets.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Three asset classes - stocks, bonds, and cash make up the investable universe of all assets. How investors choose to allocate their investment dollars across these classes can have a significant impact on the long-term return of an investor’s portfolio. The decision to hold stocks, bonds or cash and in what amounts is believed to account, on average, for the bulk of the variation (risk) in an investor’s return. For a given investor, determination of the optimal mix is what is commonly referred to as an investor’s investment policy or asset allocation policy. It is also known as the asset mix, investment mix, and asset allocation for short.

A capital investment or equity ownership in an entity, commodity or enterprise is represented by holding an ownership certificate, stock. Equity investors earn a return premium that compensates for the perceived level of risk relative to the two other asset classes (bonds and cash). Equity ownership is indefinite, i.e. return of income is uncertain. Bondholders are lenders and they purchase debentures (debt contracts), in the form of bonds, and lend cash for a predetermined period of time. In return for lending their money, bondholders earn a rent, or rate of interest on the principle balance lent. Investors in cash earn the equivalent of a risk-free rate of return on their money. Stock and bond investors typically earn a risk premium, the rate of return above the risk-free rate that an investor demands for assuming risk. The rate of return on a risk-free investment, short-term (overnight) lending, is usually equal to or less than the rate of inflation.

A risk asset is an investment whose real (inflation-adjusted) return and the safe return of principle is uncertain. On the scale of least risky to most risky, cash is least risky and stocks are viewed as most risky. This is because stockholders are second to creditors, lenders of money, in the return of capital. Bondholders get paid before shareholders. As a consequence, shareholders demand higher rates of return to bondholders and bondholders earn higher rates of return to cash investors (who face virtually no insolvency risk). Portfolios made up of different proportions of stocks, bonds and cash will vary in return and risk (defined as the variance in return). There is a tremendous difference between a portfolio whose mix is 80% stocks, 15% bonds, and 5% cash and one whose mix is 60% stocks, 30% bonds, and 10% cash.

Typically, investors are characterized as either passive or active. Passive investors construct their portfolios by buying and holding a collection of randomly selected securities, a diversified portfolio. Investments are purchased with the intention of obtaining long-term appreciation and limiting turnover and maintenance. Passive management is better known as indexing, the designing of a fund to mirror the performance of a published benchmark. Unlike passive management, active portfolio management attempts to add value through one of two active strategies, market timing or security selection. Market timing is an attempt by an investor to benefit from the divergence of the current value of an asset from its “correct” or “rational” level. Security selection attempts to add value by purchasing undervalued (mispriced) securities or emphasizing a group of securities that make up an investment theme, i.e. small capitalization over large capitalization stocks. The objective with active management is to produce better returns than those of passively managed index funds. It has been demonstrated that active management detracts more often than not from overall portfolio performance; that asset allocation plays a more important role in overall portfolio performance.

Over the years, there has been considerable debate as to the importance of an investor’s asset allocation policy. In 1986, Brinson, Hood, and Beebower (BHB)[1], three knowledgeable investment management practitioners, studied the performance of ninety-one large U.S. pension plans over the 1974-1983 period and concluded that “investment policy (asset allocation) dominates investment strategy (market timing and security selection), explaining an average of 93.6% of the variation in total pension plan returns”. Others (most notably Jahnke[2] and more recently Kritzman[3]) have argued that BHB’s original conclusions and methodology are flawed. They contend that too much importance is given to asset allocation; that market timing and security selection have been marginalized.

Without getting into the specifics, Modern Portfolio Theory describes markets as efficient (all publicly available information on an asset is incorporated in the asset’s price nearly instantaneously). If one believes markets are informationally efficient, then it would be difficult to add value from active management. The certainty of market efficiency has been brought into question by some market practitioners, and thus as well, the relevancy of asset allocation. With little uncertainty, suffice it to say that we can probably ascribe efficiency to markets over the intermediate to long-run, which after all is what we should be concerned with as investors. Conventional wisdom accepts that for the “average” investor (especially the unsophisticated investor) it is very difficult to beat the market (earn a rate of return greater than the risk premium associated with an amount of risk). As well, it has been proven, again Modern Portfolio Theory, that in the case of a specific asset class (for instance, stocks), an investor does well to invest in a diversified portfolio.

In my experience, unsophisticated investors (those who do not make a career out of stock picking) are far off better focusing on the asset allocation decision than worrying about which stocks or bonds to hold (security selection) or when to buy them (investment timing). It is clear from financial theory and practical experience that investors’ asset allocation choices should be linked with their specific circumstances or long-term financial goals. Investors determine their asset allocation policy based on their risk tolerance, their financial goals, their time horizon, their non-financial wealth (such as employment income), and the risk premiums of the asset classes.

That is not to say that certain individuals using superior research or first-hand experience cannot take advantage of unique information from time to time through active portfolio management (trading). However, it is likely that the knowledge will become known by the rest of the market, or as well, be in the possession of others, and therefore in the long-run not have any intrinsic value. Only if investors have the ability to predict expected returns in financial markets can tactical (active management) asset allocation enhance portfolio performance. Keep in mind that the degree of skill required to justify an active management strategy is very high. Investing on the basis of event driven information (such as earnings releases or change in corporate control), which may materially impact the value of an enterprise, is likely to be viewed as insider information and construed as illegal.

A better way to consider this issue is to determine whether or not having better information about the asset changes its risk profile and thus the willingness of an investor to assume risk. If so, an investor should be willing to increase such holdings in his/her portfolio. As an investor becomes more knowledgeable about the ownership of equities and more comfortable with their risk, he would then consider increasing his allocation to equities, presuming the allocation meets his risk tolerance.

A passive investment strategy (no trading) with rebalancing (resetting the asset mix to meet your specific circumstances related to return objectives and risk tolerances) is likely to incur lower costs to manage than active portfolio management (buying and selling assets based upon market timing and security selection). The BHB study found that, on average, tactical asset allocation (market timing) and security selection work to detract 1.1 percentage points from the return that would have been achieved with strategic asset allocation (a passive investment strategy) alone. Depending upon one’s time, commitment, and experience, he/she might be better off creating a diversified portfolio of stocks or bonds by choosing to use exchange traded funds (ETFs) encompassing a basket of assets that replicate a “market” portfolio.

In the BHB study, it was found that a portfolio’s asset allocation policy dominates portfolio performance, and over a period of time typically explains over 90 percent of the variation in the portfolio’s returns. However, that is not to say that within a given portfolio’s return, active management did not play a role in imparting a return that varied significantly from a portfolio benchmark. The average ten-year annual return of the 91 actual portfolios was 9.01% and ranged from 5.85 percent to 13.4 percent. Portfolios yielding returns in excess of the average in all likelihood may have been attributed to superior skill or knowledge. As well, they were likely to have been far and few between; the exception. In the long-run, due to competitive forces, the benefit of skill and predictability will average out - losing as often as winning and reverting returns to the mean. Financial theory and empirical evidence show that exposure to systematic risk (market risk) is compensated over time. Active management risk is not compensated on average (Sharpe, 1991)[4]; however, it is compensated if skill overcomes the higher cost hurdle of active management. Active management creates opportunity to outperform. However, the most important consideration is how much extra return active management can add without exposing the portfolio to unwarranted risk. Overcoming the higher cost hurdle of active management is a challenge.

As L. Randolph Hood, the “H” in BHB, stated in a letter to the Financial Analysts Journal 20 years hence first publishing their findings in 1986, “Our message today remains the same as before: Carefully consider what goal you are trying to achieve, how important it is to achieve it, and how much risk you are willing to tolerate in pursuing it. Then, create a policy portfolio (a portfolio allocated to the three major asset classes - stocks, bonds, and cash) that reflects that goal and your risk tolerance for probable outcomes - because executing that policy will have a dominant effect on your success.”[5] Investment policy (the asset allocation decision) should be addressed carefully and systematically.

[1] Brinson, Gary, Randolph Hood, and Gilbert Beebower. “Determinants of Portfolio Performance.” Financial Analysts Journal, July-August 1986, pp. 39-44.

[2] Jahnke, William. “The Asset Allocation Hoax.” Journal of Financial Planning, February 1997, pp. 109-113.

[3] Kritzman, Mark. “Determinants of Portfolio Performance-20 Years Later”: A Comment. Financial Analysts Journal. January/February 2006, Vol. 62, No. 1: 10-11.

[4] Sharpe, William F., 1991. “The Arithmetic of Active Management.” Financial Analysts Journal 47 (1): 7-9.

[5] Hood, L. Randolph, CFA. “Determinants of Portfolio Performance - 20 Years Later.” Author’s Response. Financial Analysts Journal. September/October 2005, Vol 62.

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The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

John C. Bogle is founder, former chief executive and former chairman of Vanguard Group. Inc., one of the largest mutual fund groups in the world. He helped create the first index mutual fund in 1975. He is president of Bogle Finan­cial Markets Research Center in Malvern. Pennsylvania. In 2004, Time named Bogle one of the 100 “Most In­fluential People in the World,” and in 1999, Fortune named him one of four “investment giants of the 20th century.

For four decades, Vanguard founder John C. Bogle has been a hero to small investors. He also has been a gadfly to the mutual fund industry which, he says, too often charges fees that are too high while delivering lackluster performance. Bogle, 77, has remained active on mu­tual fund issues since he retired from Vanguard in 1999. He lobbied in Washington, DC. for tighter regulation of mutual fund advertising and recently authored his sixth book, The Little Book of Common Sense Investing (Wiley).

Bottom Line/Personal asked Bogle to expand on his recent warnings to inves­tors that danger signs surround the US economy and that investment returns will drop. He also discussed how inves­tors can prepare for the future…

How do you expect stocks to per­form in the next several years?

I predict annualized returns of 7% to 8% for the Standard & Poor’s 500 stock index over the next decade. 1 know that’s not what investors want to hear, and it’s cer­tainly not what stockbro­kers will tell them. But I base my predictions on the numbers, which I call the “relentless rule of humble arithmetic.”

Stock market returns are created by the growth of actual businesses. In the past century, those businesses have paid div­idends averaging 4.5% of stock prices, and their earnings have grown an average of 5% - a total of 9.5% per year. How­ever, since 1980. the S&P 500 - my proxy for the market - has provid­ed total returns of 12.5% a year. Those extra three percentage points each year reflect a premium in the price inves­tors were willing to pay for each dollar of earnings. That increase has kept returns artificially inflated for a long, long time. In effect, investors were convinced each year that the US economy would continue to do better and better.

Why can’t returns remain high for many years to come?

There are two basic reasons. First, even if companies continue to grow their earnings at the long-term average of 5% per year, their divi­dend yields - which are part of total returns - are nowhere near 4.5% now. In fact, they average less than 2%.

Second, the current price-to-earnings ratio (P/E) is about 18. To continue to get annualized returns of 12.5% a year from stocks, the market’s P/ E would need to rise to 25. That’s just not sus­tainable. It wasn’t sustainable back in the giddy days of 1999, and it won’t be sustainable over the next decade.

How can fund investors pre­pare for years of lower returns?

For starters, they should control what they have control over when choosing mutual fund investments - costs, ex­pense ratios and tax efficiency.

Next, consider having a large chunk of foreign equity in the portfolio. I’m well known for ignoring overseas investments - I thought they were too expensive and too full of speculative ac­counting practices. However, I’m worried about the US economy now - our excessive borrowing for costly wars, an underfinanced pension system and the dollar’s weakness. In the next few years, I’m planning to put as much as 20% of my equity holdings into foreign stocks. That includes 10% in developed coun­tries and 10% in emerging markets.

Third, don’t equate simplicity with stupidity. Warren Buffett likes to say that for investors as a whole, returns decrease as motion increases. In other words, more trades won’t necessarily boost returns. In fact, the less trading investors do, the better off they tend to be.

How do you pick investments?

I allocate my assets in such a way that I have to peek at how they are doing only once a year, and I probably won’t change that formula for the rest of my life. It provides decent returns in both good and bad market years.

My portfolio now includes 60% eq­uities and 40% bonds. In the equity portion, I have 80% in Vanguard Total Stock Market Index Fund (VTSMX) and 20% in several other Vanguard funds, including Explorer (small-cap growth stocks, VEXPX)…PRIMECAP (large­-cap blend of growth and value stocks, VPMCX)…Wellesley Income (high­-yielding stocks and bonds, VWINX)… Wellington (stocks and bonds, VWELX)…and Windsor (large-cap value stocks, VWNDX). In the bond portion, I have 50% in Vanguard Total Bond Market Index Fund (VBMFX) and 50% in Vanguard Intermediate­ Term Tax Exempt Fund (VWITX).

You favor index funds, but in­dexing peaked at about 10% of all mutual fund assets in 2000. Why hasn’t its popularity grown?

Broad stock market returns have not been great, so people are not content to just match broad indices by investing in traditional index funds. There are new index funds that give more weight to small-cap and value stocks, which have had a stellar run for the past seven years - but they don’t have enough of a track record to attract many investors.

I don’t think traditional index funds need to be fixed - they’re not broken. Not only do they work beautifully in hull markets, but they also hold up well in periods of modest returns, when investment management fees, transaction costs and taxes take a disproportionate bite out of most funds. These costs don’t take as much out of index funds, because they trade less frequently.

Even though S&P 500 index funds have returned only 8.3% per year this decade, on average, they have beaten 69% of all large-cap funds. And as foreign stocks beat domestic stocks over the past five years the Vanguard Total In­ternational Stock Index Fund (VGTSX) beat 90% of the funds in its category.

But there are still plenty of ac­tively managed funds doing much better than index funds.

Agreed, but will the managers responsible for superior returns stick around for the next 10 years? Will the funds become so popular that they get bloated and their returns revert to the mean?

I tell investors who are sick of hear­ing me tout the benefits of index funds that they must, at least, be disciplined. Keep 95% of your portfolio in index funds, and use the rest to pick stocks or actively managed funds. Choose man­agers who invest in their own funds and I follow distinctive, long-term philoso­phies without hugging benchmarks.

Here are some of my favorite mutual fund families now - Dodge & Cox (800­-621 -3979, www.dodgeandcox.com)… Oakmark (800-625-6275. www.oakmark.com)… Royce (800-221-4268, www.roycefunds.com)…Torray (800-443-3036, www.torray.com)…Tweedy, Browne (800-432-4789, www.tweedybrowne.com)… and Weitz (800-304­-9745, www.weitzfunds.com). Make a 10 year commitment and don’t hail out if your managed fund underperforms its benchmark index in any given year.

Reprinted with the permission of:

Bottom Line/(name of publication/website)

Boardroom, Inc.
281 Tresser Blvd, 8th Floor
Stamford, CT 06901
www.BottomLineSecrets.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Before you all start rolling your eyes at me for stating the obvious, hold on and hear me out.  It is one thing to say don’t lose money, it is quite another to do it.  Long-term investment success depends on not losing, i.e. not taking major losses.  If you focus on the downside (risk), the upside (profit) will take care of itself.

Too often investors get caught up in the thrill of victory focusing their attention on big gains and “making a killing” in the market.  Slow and steady wins the race.  Speed kills. Even though we know that accidents most often happen to drivers that are speeding and going too fast, the allure of fast money and the quick buck can lead to straying from a disciplined investment approach and taking long shot wagers.  When this happens, you have left the realm of investing and entered the arena of gambling (speculation).

Large losses are forever. A 50 percent loss requires a doubling in value of the asset just to get back to even. Ask yourself, how often have you known an asset to double in value and in what time frame? It takes roughly seven years for an investment to double in value earning a 10% annual return. By avoiding large losses (play defense), the winnings will have every opportunity to take care of themselves. Manage your downside. Play good defense. Avoid big mistakes. In investing, as in sporting competition, learn to cut your losses (eliminate mistakes) and the winners will follow.

In an article published in the Financial Analysts Journal (1995), “The Loser’s Game,” Charles D. Ellis writes convincingly about the inability of professional money managers to “beat the market.”[1] He sites a study conducted by an eminent scientist, Dr. Simon Ramo of TRW.

Ellis writes, “Simon Ramo identified the crucial difference between the Winner’s Game and the Loser’s Game in his excellent book on playing strategy, Extraordinary Tennis for the Ordinary Tennis Player. Over a period of many years he observed that tennis was not one game but two. One game of tennis is played by professionals and a very few gifted amateurs; the other is played by all the rest of us.

After extensive scientific and statistical analysis, Dr. Ramo summed up his findings this way: Professional tennis players win points; amateurs lose points. Errors are seldom made by professional players. Expert tennis is what Ellis calls a Winner’s Game because the ultimate outcome is determined by the actions of the winner. On the other hand, the amateur duffer seldom beats his opponent, but he beats himself all the time. The victor in this game gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points. Professional tennis is a Winner’s Game - the final outcome is determined by the activities of the winner - and amateur tennis is a Loser’s Game - the final outcome is determined by the activities of the loser.

The ordinary player can win games and matches again and again by following the simple strategem of losing less, and letting the opponent defeat himself. The way to avoid mistakes is to be conservative and keep the ball in play, letting the other fellow have plenty of room in which to blunder his way to defeat. An opponent who tries to win a losers game will try to beat you by winning, but he is not good enough to overcome the many inherent adversities of the game itself. The situation does not allow him to win with an activist strategy and he will instead lose.”

This unfortunately is the same situation you face as an investor. In the long-run, you can not win with an activist strategy (market timing/security selection). Sure, every once in a while you will play a “hunch” and be rewarded, but this will only foster a false sense of confidence in your ability to repeat your good fortune. That is a trap and will come back to haunt you. In time your efforts to “win” will only increase your error rate. Over time you will start to underperform the market. This is how the ordinary investor loses in the Loser’s Game. According to Ellis, Ramo instructs in his book, the strategy for winning the Loser’s Game is to lose less. Avoid trying too hard (or in the case of the market, invest in an index fund that correlates well with the market and avoid trading, i.e. timing the market). In brief, as Ellis puts it, by losing less become the victor. If you can’t beat the market, you certainly should consider joining it. An index fund is one way.

Five Ways to Win the Loser’s Game:

1. Know Thy Self. What are your financial objectives? Are they achievable and realistic given your tolerance for risk? What is your risk tolerance? Can you stomach short-term fluctuations in wealth to achieve long-run investment success? Are you willing to put forth the work needed to be successful? Do you have the necessary skills and know-how to be a winning investor.




2. Define Your Long-Run Objectives: Set wealth goals. What are your financial needs? How much income will you need in retirement? Are you saving to provide for your children’s college education? Do you have the discipline and patience to pursue a long-run investment strategy? Plan the race that is right for you. Run your own race to achieve your own realistic objectives.




3. Do Not Try to Beat the Market: Forget about the notion of beating the market in the long-run. At best, you can hope to replicate the performance of the market. How do you expect to beat the market when it is made up of so many professionals? Professionals armed with vast resources. More resources than you can ever hope to have. Eventually, if you own enough stocks and hold a diversified portfolio, you will be the market, i.e. you can expect your portfolio to generate market returns. Oh yeah, every once in a while you will have a winner that makes you think you’re smarter than everyone else and that you can earn out-sized returns (get rich quick). Just remember, a baseball player with a .200 batting average will hit a home run every once in a while as well. That doesn’t mean he all of a sudden has acquired the skills to be a .350 hitter.




4. Diversification: Countless academicians and investment professionals have confirmed and endorsed the benefits of diversification (spread your risk over many bets; don’t put all your eggs in one basket). Stock portfolio (a portfolio made up of individual stocks) diversification can be achieved through the random selection of a number of stocks (usually 30 or more on an equally dollar weighted basis).The primary benefit of diversification is that for a given amount of risk, investors can expect to achieve a higher rate of return from an efficiently constructed portfolio (where the holdings in the portfolio are sufficiently uncorrelated). The basic concept that an investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated (diversified) derives directly from the principles of Modern Portfolio Theory.




5. Have an Investment Policy: Investment policy (or more commonly, asset allocation - the division of investable funds among investable assets i.e. stocks, bonds, and cash) has been shown to account, on average, for 93.6% of the variation in total return in a sample of portfolios (corporate pension plans) studied.[2] In the past, criticism was directed at the study - or more accurately, its interpretation by the industry - and raised doubts about its applicability to general investors. Twenty years since being published debate continues over the importance portfolio policy (asset allocation) plays in the construction and subsequent performance of an individual’s set of investments. However, it would be hard to find any investment professional who would disagree with the notion that the initial decisions made regarding portfolio policy will play an important role in the outcome of any long-term investment strategy.

The market is dominated by institutional investors. Consequently, investing today is a Loser’s Game. You can’t win at investing by trying to “beat the market.” You simply must avoid losing.

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[1] “The Loser’s Game,” Charles D. Ellis, Financial Analyst Journal / January-February 1995: 95-100. Reprinted from FAJ (July/August 1975): 19-26.
[2]” Determinants of Portfolio Performance,” Gary P. Brinson, L. Randoph Hood and Gilbert P. Beebower, Financial Analysts Journal, (July/August 1986):39-44.

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds.   InvestingMinds did not prepare and does not endorse such content.  Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments.  No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Breaking with tradition, I’ll give you the moral of the story first: “Slow and steady wins the race”. Like you didn’t know that? But do you really understand it? The Greeks were pretty sophisticated mathematicians so it’s entirely possible that the concept of compound interest was already well understood when “The Tortoise and The Hare” was written. However, had they been sophisticated marketers the famous Aesop’s fable would have been converted into a 60 second spot for the local bank because it serves as a great example of how perseverance and responsible behavior really pay off when it comes to investing. And apparently we all need a 60 second spot like this to remind us of something that, at one level, is intuitively obvious.

I guess I needed to be reminded as well. Despite my quantitative background and the fact that I know all the formulas for calculating compounding it wasn’t until I read a Wall Street Journal article a couple of years ago that I finally put two and two together and realized the simple implication of compounding for investors: Start saving early.

Since a picture is worth a thousand words let’s do a simple example involving twin brothers Tory and Harry. Tory is the responsible one that starts an IRA at the age of 22, squirreling away $2,000 per year while Harry waits 10 years, figuring that he will quickly catch up to his brother by saving $4,000 per year. After all, it can’t be that hard to catch up to someone who only has a $20,000 lead, right?

So, to make the calculations easy let’s assume that the savings are invested at the beginning of each year and return 10% each year - reasonable assumptions. Here are the results over Tory and Harry’s lifetime:

Guess what? Harry never catches up - and for a simple reason. The income that Tory earns on his $20,000 head start exceeds the extra $2,000 that Harry is saving each year in perpetuity. By the time they both reach 65 Tory’s nest egg has grown to $1,435,810 while Harry’s account is a paltry $1,080,097. In fact, if Harry wants to have even a prayer of catching up he needs to start no later than 7 years after his twin brother. It’s no wonder that Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time”.

I was lucky in that I instinctively saved everything I could from an early age despite not fully appreciating what I was doing. But suppose you have followed Harry’s strategy for most of your life and now you’re looking at this example and you’re thinking it’s too late? Well, you can’t do anything about the past but every minute that goes by without a mid-course correction is another minute wasted. Start saving as much as possible right now! You can start by cutting back on the Starbucks. That has to be worth at least $1,000 per year.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Dollar cost averaging is an investment “strategy” that is credited with almost magical abilities by many investment advisers. The argument goes something like this: You can’t pick the highs and lows of the market so just invest a constant amount in regular intervals and you will buy more shares when the market is lower and fewer shares when the market is higher. Thus your average cost per share will be lower over time. Well, something has always bothered me about this argument but I could never quite put my finger on it. The idea of a mindless process producing better than average results over time just didn’t sit well - not to mention that this argument sounds vaguely like the crazy practice that some people engage in where they buy more of a stock that has moved down from their initial purchase price only because that will lower their average cost (like they still aren’t in the hole on the original purchase?).

Don’t get me wrong; there are clearly a few benefits to dollar cost averaging, not the least of which are psychological. First, with a disciplined investment strategy you won’t be tempted to time the market. Second, when prices drop the blow is softened by the belief, rational or not, that you now get to buy more shares at a lower price. But aside from the psychological benefits there is also a savings discipline that comes with dollar cost averaging. Your income is earned in a relatively steady stream and dollar cost averaging forces you to save it as it is earned.

But this notion of being economically better off simply by spreading out your investments over time just doesn’t hold water. All you really need to know to see the fallacy of this claim is that the market tends to move up over time - i.e. it has a positive expected return. Therefore, the faster you put your money in the faster it’s going to grow. So, if you’re sitting on a pile of money the smartest strategy is actually to invest it all as soon as possible in one big lump sum. Sure, it may go down shortly after you invest but it’s just as likely to go up. End of discussion.

Well, there are probably a lot of advisers out there that aren’t satisfied with this explanation and that’s why Dr. John Greenhut, an Associate Professor of Finance in the College of Business and Technology at Texas A&M University, wrote a rather comprehensive expose on Dollar Cost Averaging. His article, Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work, appears in the October 2006 issue of The Journal of Financial Planning.

In his article Dr. Greenhut exposes the mathematical illusion that seems to produce stellar results from dollar cost averaging. As he points out, the apparent success of this technique often results from unfair or flawed assumptions about stock price movements that work in favor of dollar cost averaging - namely, that assumptions are often made that stock prices vary around a mean by constant dollar amounts when in fact the variation actually tends to occur in constant percentage terms. Dr. Greenhut provides ample illustration that these assumptions are flawed and he proves that lump sum investing is at least as good as dollar cost averaging. However, he then goes on to argue that since the market is always expected to drift upward lump sum investing is actually superior to dollar cost averaging and he cites the academic research that supports this conclusion. He even goes so far as to examine historical data on over 1600 companies and empirically demonstrates that dollar cost averaging is only superior if a stock is in a downtrend.

Since you don’t know ahead of time if the market or an individual stock is going to be in a downtrend and since your best guess at any point in time is that an investment will drift upward you might as well invest your money as fast as possible and forget about dollar cost averaging - unless of course you need a little psychological boost.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.