Reprinted with the permission of the American Association of Individual Investors

Why is it that bright, educated people who come across stocks that could make them wealthy for life, so frequently fail to capitalize on golden opportunities—not enough brains or education?

No, not even close.

Two things are responsible: Beating ourselves, and a lack of knowledge. Beating ourselves is mainly emotions, meaning too much fear or greed. Normally those things take control when investors lack knowledge—they do not know what they own and why they own them in enough depth.

Investing is actually common sense along with a focus on the key factors that drive the greatest stocks.

In fact, investors need focus on only four factors that seem to be common, identifying traits of the greatest companies and stocks, in my experience. I have termed these four factors BASM:

• Business Model: How the company plans to grow, be profitable and protect itself from competitors.
• Assumptions: The key assumptions the company makes about their markets upon which they then develop the business model.
• Strategy: This is simply the plan the company develops to implement the business model.
• Management: These are the actual people who create the great business models, assumptions, execution and all the rest. Great management is also needed, over time, to adjust business models for competitive situations.

One item not mentioned here is earnings. So, what about earnings, you ask?

Earnings are part of the metrics you use in evaluating a company—gross margin, net margin after taxes, and return on capital are just some examples of other metrics. These tell you a lot about the competitive position and how well the company is managed. But these are report-card issues. While you do learn something about management from them, the report card does not tell you about vision and fixing problems.

In short, earnings are the golden eggs that drive stock prices, but BASM is the golden goose that lays those golden eggs—it is the engine of earnings.

The Business Model

The business model is the core of how a successful company operates. But most investors cannot tell you much or anything about their best investments and the business models. So let’s start here—on the first big element in BASM.

A good company normally describes and discusses their business model in several places including what they file with the Securities and Exchange Commission when they go public or have successive stock offerings, and the annual reports, all of which are easy to access from the company and the Internet. Here are the three elements of a strong business model:

1) The company describes how they are going to make a lot of money (or why they already are). If they are young and embryonic, they describe the specific path to get to great profitability.

2) The company describes how they will grow for a long time in the future, and how they will retain great profit margins and overall profit growth.

3) The company describes how it will protect itself from the competitors that want to get a piece of their markets and profits. They must talk about competition and how they will compete, protect and win—in other words, how the first two things in the business model will stay that way and not fall prey to strong competitor companies that may come along.

That’s it, and as simple as this is, it is amazing how many companies overly complicate it or write a poor business model and show us that they may not be going great places.

Thus, if an investor does not see anything of a clear, straightforward business model in filings or the annual report, he or she will have spent five minutes wisely, but then can move on and not bother with anything else.

One of the best examples of a great business model is Home Depot. When Home Depot came public, many people said it was just another big discount retailer. Many others challenged Bernie Marcus’ (co-founder) plans to pay workers in his stores more and spend more than competitors on training. Bernie understood that discount retailing was going to be dog-eat-dog competitively, and yet there could be ways other than price to differentiate between companies.

The big thing for Home Depot was a business model that was designed to attract customers on the basis of customer service while being price competitive. Low prices often meant that people felt adrift and could not get enough help to purchase anywhere near what their potential might be.

Well, paying help more than the minimum wage and the extra spending on training as part of the do-it-yourself business model concept of Home Depot did bring them the customers, and that eventually was reflected in the stock price.

Assumptions

Any strategy that a company settles upon to achieve its business plan is built on a set of assumptions, or projections, about how big a market is for a company or a product. Assumptions also must be made concerning anticipated competition and demand over the next year or three years. The assumptions part of BASM is best illustrated with an example.

Bill Gates came into the software spreadsheet market facing skeptics who told him that, since Lotus Development had 70% of the spreadsheet market, he could do nothing, and it was already “game over.” (“Game over” is one of the great syndromes of ordinary investing that ignores the elements of BASM.) So Lotus ran the hot product race without any real worries about Microsoft.

But Gates made huge assumptions about the way people and companies would buy and use software.

His biggest assumption was that customers would have a critical need for standard software—in other words, consumers were looking for uniformity and continuity in software so they would not have to relearn everything from ground zero when new products came out.

Gates also assumed that consumers would stay with one company’s products cycle after cycle if those products met their needs and were competitive in new technologies.

Setting standards and achieving early domination flowed from those assumptions as the core company strategy was formulated.

Eventually, Lotus lost, and Microsoft (need I add?) won. Now it really is “game over.”

Strategy

Management may have a great business model, but it has to have a strategy to execute the details of its plans.

Operational differentiation and excellence are concepts that apply to many great companies.

For instance, Intel has excelled over the years by continually coming out with the best new microprocessor chips to serve as the brains for personal computers. But aside from great product research and development, Intel spends a fortune on research and development in production methods and systems.

To reach back a bit further, McDonald’s is one of the truly great companies. And it is clear the core secret to McDonald’s great management success was operations. In fact, the McDonald’s business model went into great detail about how consistency and quality would flow from great operations management, and those factors would bring in the customers and control costs—and it did work, just as the company said.

Management

The best management demonstrates that it can envision a great future for the company and articulate a cohesive and logical strategy for getting there. The strategy cannot be pie in the sky—it has to be based on resources—human, financial, technological—within the grasp of the company.

Management also has to show it can execute the details, so you must watch carefully.

Great managers make promises and projections to you, the stockholder, that they can deliver on. They are driven to stay ahead of the pack and understand how to lead. While they truly want to win, they are realists in terms of the goals they can execute.

Lastly, great managers admit mistakes early and move aggressively to fix them.

Investing for the Big Money

Most investors spend too much time chasing the wrong information.

Focus is the key, and the simplicity and focus of BASM really has worked to develop some of the greatest all-time investment records and wealth for many people. They do not always call it BASM, but they concentrate on what the golden goose is that creates the golden eggs of earnings.

Great Business Model Descriptions: eBay vs. Google

How does eBay differ from Google?

They are both the darlings of our time, very successful, and both household words.

But eBay has a great business model in which—instead of concentrating on the powerful technology that was making them the best—they concentrated on a way to build true community and bring in all the customers and retain them. That was all spelled out in the prospectus they printed when going public. Google, on the other hand, was fuzzy about their business model. We know it was a great buy on the technology lead and popularity. However, they are now experimenting with so many things at once, and yet still derive almost all of their revenues from search engines that will be further assaulted by competition.

These differences could be seen by investors who scrutinized the public offering documents. eBay had great business model descriptions when it went public; Google did not.

Here is how eBay described their strategy at the time of the initial public offering (IPO):

“The Company’s objective is to build upon its position as the world’s leading online person-to-person trading community. The key elements of eBay’s strategy are:

“GROW THE EBAY COMMUNITY AND THE EBAY BRAND. The Company believes that building greater awareness of the eBay brand within and beyond the eBay community is critical to expanding its user base and to maintaining the vitality of the eBay community.

“Although the Company’s historical growth has been largely attributable to word-of-mouth, the Company intends to build its user base and its brand name aggressively…

“BROADEN THE EBAY TRADING PLATFORM. The Company intends to pursue a multi-pronged strategy for growing the eBay platform within existing product categories, across new product categories and internationally. The Company will target key vertical markets in its user programs and marketing activities.”

There are many more details and components of the business plan, but the key thing was that they all held together logically. They described in straightforward terms how they would grow and make money, and they presented something of a roadmap for both the company and its investors. This is what you want to find.

Google, in contrast, seems to have a good model for generating advertising revenues on its search pages, and it is very profitable. Moreover, the marketing and mind share aspect of its ubiquity, such that people use “Google” both as a verb and a noun—“googling” is a part of the language these days––means that Google has some major assets as it strives to become a dominant leader.

So, Google does have the first part of a good business model, the profitability. But it lacks the second and third parts of a great business model—a plan for growing the profits into the future and protecting them from competition. On these parts there is a blank slate.

Interestingly enough, the filings from its 2004 public offering contain language that concedes that Microsoft will be a competitor to contend with. But also very important is that those filings—unlike eBay’s filings—have very little in them about competitive strategy and the details of the business plan.

Even in late 2005, Google was still adding to what their core service had been. This only makes it a bit tougher for management to define their ultimate strategy and business plan.

The stock has done well, but the jury is out—and based on the BASM yardsticks, the clarity of strategy when they went public is lacking.

Fred Kobrick managed mutual funds for Wellington Management and State Street Research & Management before founding his own firm in 1998. Under his management, the State Street Research Capital Fund was ranked by USA Today as one of the top five performing funds over a 15-year period. He currently provides investment advice to nonprofit institutions and lives in Sudbury, Massachusetts. His book, “The Big Money” (Simon & Schuster, 2006), provides case histories, written to teach the simple guiding principles from which his investment record was generated.

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.

Reprinted with the permission of the American Association of Individual Investors

What can you learn from three decades of monitoring investment newsletter performance?

Plenty.

It was nearly three decades ago that the Hulbert Financial Digest (HFD) began independently monitoring the performance of investment advisory newsletters. I’m devoting this column to a couple of the most important investment lessons that emerge from the list of newsletters that dominate the rankings of top performers.

The investment world today couldn’t be more different than the world that existed when the HFD set out to track newsletters, in mid-1980, at least on the surface. Back then, for example:

• The Dow Jones industrial average stood below 900—lower than where it had stood in 1966, 14 years earlier;
• Gold bullion, on the other hand, was just coming off a high of just under $900 per ounce—a record level that remains unbroken today, more than 27 years later (though gold is getting close);
• Inflation was in the double digits, as was the interest rate on long-term government bonds.

Given this stark contrast, it would seem that caution should be exercised in drawing any investment lessons based on which newsletters have performed the best since 1980. Why should anyone think that strategies appropriate to the investment world in 1980 would be appropriate today?

But I would argue that a closer look shows that, on average, the period encompassing the nearly 30 years since 1980 is not really all that different than what came before.

Down Memory Lane

Imagine, if you will, that you have traveled back in time to the early 1980s, and you are perusing the data in the 1980 Ibbotson Associates yearbook. This firm was created in 1977 by Professor Roger Ibbotson, and its yearbooks of historical data have become a must-have for financial planners and advisers. Those yearbooks, of course, contain the year-by-year performances back to 1926 of stocks, bonds and Treasury bills, and inflation rates.

What conclusions would you have reached? Here are two:

• Over the period of 1926 through 1979 (the period that would have been covered in the 1980 yearbook), stocks provided a handsome return, in both nominal and inflation-adjusted term;
• In addition, there was a healthy equity premium—that is, stocks outperformed bonds, compensating investors for the additional risk associated with investing in stocks.

But these same conclusions hold for the period since 1980, as is illustrated in Table 1.

To be sure, stocks in recent decades have produced higher returns (both in nominal and inflation-adjusted terms) than the returns they produced before 1980. But the real difference is not stock performance but rather bond performance—bonds did much better after 1980 than they did before. Because of this, the equity premium since 1980 has actually been less than the longer-term average, despite stocks themselves providing better overall returns.

This stock/bond relative performance difference between these two long-term time periods indicates, to me, that any “lessons learned” from the list of long-term top performers would have questionable relevance to the future if any of those top performers were highly ranked because they were heavily invested in bonds.

However, this is not the case—none of the newsletters at the top of the HFD’s rankings for performance since 1980 (see Table 2) derived a significant portion of their investment earnings from bonds.

All of which leads me to be fairly confident in drawing the following lessons.

Lesson 1: Long-term investors need not lose sleep over the markets’ short-term gyrations because the markets’ long-term patterns will eventually assert themselves.

To be sure, I am under no illusions that my drawing of this lesson will change many investors’ behaviors. For whatever psychological reasons, many are obsessed about the short-term and therefore can’t imagine not paying it the closest of attention.

What my data show, however, is that investors need not focus on the very short term to perform very well over the long term, thank you.

Consider The Prudent Speculator, the newsletter in first place on the HFD’s ranking for performance since mid-1980. Of any of the newsletters I monitor, this service has been the most buffeted by short-term market gyrations. And yet, none surpasses it in its willingness to either ignore or tolerate those gyrations.

Consider what happened to it in the crash of 1987, which just celebrated its 20th anniversary. On that day, according to the HFD’s calculations, the newsletter’s model portfolio lost 57%. And yet, far from panicking, Al Frank (the newsletter’s editor at the time) maintained his fully invested (and heavily margined) posture, patiently faithful that the stock market’s long-term uptrend would eventually win out. The newsletter’s long-term top ranking is a testament to that faith.

Lesson 2: Worrying about the short term can work against you.

Another lesson that emerges from my tracking of investment newsletters is related to the first: Constantly monitoring your investment performance can cause you to unnecessarily reduce the amount of risk you are willing to incur, causing your long-term performance to suffer.

According to behavioral finance researchers, constantly looking at how your portfolio is performing is not a benign act. It leads you to focus more of your attention on the short term than you would otherwise, leading you in turn to miss the veritable forest for the trees.

One researcher who has extensively studied this behavioral pattern, Richard Thaler of the University of Chicago, calls it “myopic risk aversion.” He hypothesizes that the more frequency with which an investor re-evaluates how he is doing, the more frequently he will experience loss, since any risky asset will not infrequently be exhibiting a short-term losing streak. No investor (except the occasional masochist) enjoys the experience of loss, and most investors prefer to avoid losses; therefore, this greater frequency of re-evaluation will tend to cause investors to own less risky assets and avoid stocks.

To test this hypothesis, Professor Thaler and fellow researchers several years ago constructed an elaborate simulation that imitated the many decisions that investors make over their lifetimes. One group was able to look at how they were doing every month, another group every year, and the third group got to take a look just once every five years. Just as Professor Thaler hypothesized, the investors who re-evaluated their portfolio every month had the lowest average equity exposure.

So, why does my own newsletter that reports investment newsletter performance come out monthly?

It’s a good question. The problem, of course, is that I wouldn’t be in business if I had a subscription product that came out infrequently. But the tension exists nonetheless.

One way I try to resolve this tension is by focusing my monthly newsletter on long-term performance. For example, none of the performance rankings in my monthly newsletter cover periods of less than five years. And most of my scoreboards cover much longer periods.

My hope is that, in the very act of responding to investors’ desire for constant re-evaluation, I can get them to focus on the long term. After all, a ranking covering performance over the last five years, or especially the last 10 or 20 years, doesn’t change that much from month to month.

Conclusion

If investors nevertheless want to obsess about the short term, they can be my guest.

But these short-term traders shouldn’t fool themselves into thinking that this obsession is necessary to build long-term health. On the contrary, it is probably standing in their way.

Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter that ranks the performance of investment advisory newsletters. It is published monthly and is located at 5051B Backlick Rd., Annandale, Va. 22003; 703/750-9060; www.hulbertdigest.com. This column appears quarterly and is copyrighted by HFD and AAII.

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.

Individual investors seeking to asset allocate and build a diversified portfolio are likely to not find any better investment product to serve their purpose than ETFs. As the name implies, Exchange Traded Funds (ETFs) are investments that combine the advantages of index funds with the trading flexibility and continual pricing of individual stocks and bonds. Over the past several years, ETFs have become a very popular and inexpensive way to “trade” the market or buy specific asset classes. However, and more importantly, ETFs are an excellent way to asset allocate.

Although not without its critics, it is common wisdom among investment professionals that asset allocation is the most important investment decision. The vast majority of variation in returns can be explained by asset allocation.[1] (For more on this subject, see my article, “Asset Allocation: A Most Important Investment Decision.” posted here.)

Since Brinson et al published their landmark study, numerous academic studies have largely reached the conclusion that professional money managers add very little value by their selection of individual stocks or attempts at market timing. However the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the classes.

Increasingly ordinary investors accept those findings. Contrary to the constant admonition from professional money managers that “it’s a stock picker’s market”; picking stocks is often a fool’s errand. ETFs allow you to easily target an asset class, with more flexibility and accuracy than either index or actively-managed mutual funds, and often cheaper as well. That is why they are soaring in popularity among small investors.

There are more than 400 ETFs listed in the U.S. and more likely to be offered. Some might call this overkill. Typically, most ETFs are passively managed and set up to track major market indexes (The Dow, The S&P, and the Nasdaq or some subset thereof). In most cases (there are exceptions), ETFs seek to achieve the same return as a particular market index. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. Index funds, such as those available through such mutual fund companies as Vanguard, were predecessors to today’s ETFs.

In many ways, ETFs incorporate the best features of all investment funds. ETFs offer investors an inexpensive way to index. Investors can purchase and sell ETFs through a broker at any time of the trading day and employ stock-trading techniques, such as limit orders, buying on margin (with borrowed money), and selling short (selling borrowed shares). Unlike index funds or mutual funds, investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. Because your broker will charge a commission, trading costs may offset other cost advantages of ETFs. However, when designing an investment portfolio with a long-term passive investment strategy, and using a discount broker to buy the shares, the cost is nominal and far less than the costs associated with competing methods (mutual funds or buying individual stocks).

The emergence of ETFs are the latest in a long list of solutions to the problem “Main Street” (individual) investors faced in building a diversified investment portfolio of risky assets efficiently and economically. The mutual fund industry essentially grew up out of the need by individuals to achieve portfolio diversification economically. At the time when mutual funds were entering the investment scene, brokerage commissions were prohibitive for the amount of money available to individual investors to build diversfied portfolios. Since mutual fund companies could get the benefits of scale and transact at wholesale rates, they could pass the savings onto their investors. Individuals were willing to pool their assets in these funds.

With advances in electronic trading and the demise of fixed rate brokerage commissions, online discount brokers have emerged significantly reducing the cost to transact on the various national exchanges. At the same time, individual’s assets have grown while mutual fund expense ratios have remained relatively unchanged. In addition to fund expense ratios, mutual fund investing can include other costs such as distribution, marketing and sales charges. Relative to the index they are designed to track, the performance for funds that are passively managed (strive to track certain market indexes), has been at best marginal primarily due to excessive fees.

Due to the nature and construction of mutual funds, shares can only be purchased and redeemed by the fund. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV). When mutual fund investors want to sell their fund shares, they have to sell them back to the fund at their approximate per share NAV. The investor only gets the end of the day closing price for their shares. Conversely, ETFs can be bought and sold in the secondary market at any time throughout the trading day.

Mutual funds are managed by investment advisors. These advisors pick and choose when and what goes into the portfolio. Though managers often strive to balance individual share gains and loses in the fund, the distribution of gains can trigger untimely tax events for investors. For tax-exempt accounts, such as IRAs and 401K plans, this has not been a problem. As IRAs and 401K plans have grown to be the primary retirement vehicle for Main Street investors, mutual funds have emerged as the principle investment product for retires. With ETFs, investors have the option to choose when to buy and sell giving investors control over timing gains and losses.

With mutual funds, investors have very little say in directing investments. As individual investors have become more knowledgeable in the ways of managing their personal assets, and as those assets have grown both inside and outside their retirement accounts, they have become more interested in managing and constructing their own portfolios. As a consequence, ETFs have emerged as an efficient and inexpensive way to manage and build an investment portfolio. In addition to building “market” tracking portfolios, investors are also interested in targeting specific investment themes. As financial commentator Jennifer Openshaw (The Millionaire Zone) points out, the real story for ETFs lies in the growing sophistication and new investor choices that result. Openshaw correctly informs that “ETFs are rolling out with more specialized and strategic designs as they sail beyond traditional index-fund roots towards the horizon of true active management. Until recently, ETFs only gave the ability to buy a broad industry or sector as defined by broad S&P or Dow Jones Sector Indexes like Technology, Consumer Cyclicals, Energy, Biotechnology, etc. You were out of luck if interested in Canadian oil sands energy exploration, but now there’s the Canadian Oil Sands ETF ( CLO: TSX). If you think water is the next oil, check out the PowerShares Water Resources Portfolio (PHO: AMEX).”[2]

Below is a list of advantages for using ETFs in place of mutual funds and stocks:[3]

• Tax efficiency

• Lower costs (ordinary brokerage commissions apply)

• Transparency

• Buying and selling flexibility

• All day tracking and trading

• Diversification

• Dividend opportunities

• Wide array of investment strategies

  • Core investment

  • Portfolio diversification

  • Hedging

  • Cash management

  • Rebalancing

  • Tax loss strategy

And where do you look to learn more about ETFs? The Yahoo! Finance ETF Center is an excellent place to start. The Yahoo! Finance ETF Center contains an extensive list of listed ETFs along with performance history. You may find it helpful to check out the ETF Education Center at Yahoo. Other sources of information can be garnered at ETF manager sites - iShares, PowerShares, Rydex Investments, and Claymore. Each of these sites contain tons of information on ETF basics and the use of ETFs as an asset allocation tool.

A word of caution. Not all ETFs are created equal. It is important to read the prospectus and understand the basket of stocks or other assets that underlie a particular ETF. As well, shorting, hedging and buying and selling options on ETFs is not advisable to the uninitiated or novice investor. Many of the newer ETFs (especially those managed by Proshares, Rydex and Claymore) use leverage and sophisticated trading strategies designed to achieve a certain trading or investment objective (such as shorting oil, currencies, or emerging markets). Some ETFs are designed to perform in the inverse direction of the underlying market they track. For instance, the Proshare Short S&P 500 make money in a declining stock market and lose money in a rising market. Thus, if you think the market is primed to decline and you want to hedge your portfolio for a decline in the market, you would buy (yes buy, not sell) the Proshare Short S&P 500. Remember, in the case of the Proshare Short S&P 500, the value rises when the market falls. You might ask, why would you want to buy a Proshare Short ETF when you could just short the index itself using SPDRs (SPYs), an ETF on the S&P 500. Well as it turns out, it is not possible to sell short in some retirement accounts such as IRAs so buying a Proshare Short ETF is a good way to hedge your stock portfolio from market risk in an IRA. For more on this topic, take a look at the following article at SeekingAlpha, “A Closer Look at the Proshare Inverse ETFs.”

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Tax efficiency
ETFs, like index funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.
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Lower costs
Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed. And, since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. Of course, an investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions.
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Transparency
ETFs generally are designed to correspond to the performance of their underlying index or commodity.
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Buying and selling flexibility
Because they are exchange traded, ETFs can be:bought and sold at intraday market prices

purchased on margin

sold short

traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade
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All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day. And because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain up-to-the-minute share prices from their broker or financial adviser.
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Diversification
Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Additionally, the expanding universe of ETFs available at the American Stock Exchange offers exposure to a diverse variety of markets, including:

• broad-based equity indexes (such as total market, large-cap growth, and small-cap value)

• broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)

• industry sector-specific equity indexes (such as healthcare, energy, and real estate)

• U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)

• commodities (such as gold, silver, and oil)
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Dividend opportunities
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis. Of course, not all companies will pay dividends. Based on past performance, few, if any, distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
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Wide array of investment strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.

Core investment-Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.

Portfolio diversification-ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market and commodities, providing an easy and convenient way to adjust the investment mix of a core portfolio.

Hedging-Exchange traded funds can be purchased on margin and sold short, which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements. To view a list of ETF options that are listed at the Amex, click here.

Cash management-ETFs have often been used to “equitize” cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.

Rebalancing-Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, usual brokerage commissions will apply.

Tax loss strategy-An investor can sell a security that is under performing and claim a tax loss but retain exposure to its sector by investing in an ETF. Consult a tax advisor about a tax loss strategy.
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[1]Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986.
[2]ETFs: From Niche Market to Supermarket
[3]American Stock Exchange, Education, Individual Investors

 

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.

Why not just buy low and sell high? That’s easy enough, right? The classical answer is a resounding no and there are reams of analyses to prove that it’s not a good idea to try to do this. Most arguments against timing make the case that the market is extremely volatile and impossible to predict. It’s extremely easy to miss the best performing days and if you do you will have substantially worse performance than if you had stayed in the market the entire time. I’ve seen many variations of the following analysis [1] over the years:

The bottom line of this analysis is supposed to be that unless you have a crystal ball you are going to miss major upward market moves and you will seriously undermine your returns. In fact, in 1975 William Sharpe published a seminal article on this topic: “Likely Gains from Market Timing”. In this article Sharpe demonstrated statistically that in order to benefit from a market timing strategy you had to guess right 74% of the time. [2]

Historic performance data seems to confirm this conclusion. When Brinson, Hood, and Beebower conducted their analysis of the performance of 91 pension plans from 1974 to 1983 they determined that market timing had detracted from performance by .66% [3]

So maybe we should just end the article here. Why go on? Maybe because everyone believes that they are above average and people don’t like the idea of a passive strategy. More importantly, these analyses don’t tell the entire story.

First, every anti-timing analysis that I have seen, such as the first example given, focuses on the performance of binary strategies – you switch from being 100% in the market to being 100% out of the market. A more prudent strategy, and one that is actually practiced by portfolio managers, involves moderately adjusting your market exposure depending upon some appropriate signal. However, I have not seen this examined in the research.

Secondly, bubbles do occur and after the fact everyone clearly sees how overvalued the bubble assets were. There are historic patterns and there are limits to what is a reasonable price for any asset. If we can learn to leverage this knowledge then perhaps we can boost our returns.

I skimmed through parts of Graham (In case you didn’t know, Benjamin Graham was a young Warren Buffet’s mentor) and Dodd’s 1934 classic book, Security Analysis, in early 2002 and was awe struck by the timelessness of their writings. Considering the parallels between 2002 and 1934, I had to keep reminding myself that the book had been written almost 70 years prior. Let me share a montage of interesting quotes from the book (italics theirs): “…the prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers…a conservative valuation of a stock issue must bear a reasonable relation to the average earnings. In addition, it must be justified by whatever indications are available as to the future. This approach shifts the original point of departure, or basis of computation, from the current earnings to the average earnings, which should cover a period of not less than five years, and preferably seven to ten years…But it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay with the bounds of conservative valuation. We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase of a common stock…it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price. It would be acceptable only in the expectation that future earnings will be larger than in the past. In the original and most useful sense of the term such a basis of valuation is speculative.” [4]

Notice that Graham and Dodd heavily discounted expectations of future earnings. Maybe they were from Missouri and they never had to figure out what Google was worth but frankly I agree with their approach. It’s hard enough to know what a company really earned over the last 10 years, let alone project future earnings.

Fast Forward to February 2006 at The CFA Institute Risk Symposium and Yale professor Robert Shiller discusses the characteristics of bubbles and how they propagate. He also presents a few compelling market valuation indicators. [5] (Shiller is famous for his 2000 book, Irrational Exuberance, named after a term used by Alan Greenspan in a famous speech. Interestingly, Shiller had discussed the impact of market valuations on returns with Greenspan 2 days prior to the famous speech.) First, he examines the S&P P/E ratios from 1881 - 2005, calculated as Graham and Dodd would have them calculated. The graph below, from Shiller’s Web site, is the same one used in his presentation but is updated through February 2007.

As you might expect the graph shows massive fluctuations, with the most prominent peaks in 1929 and 2000. Of course there are two ways that a high P/E can come back down to earth – either the E can go up or the P can go down and you would have no way to know in advance which was going to occur. However, Shiller analyzed the relationship between the P/E and the subsequent 10 year return. Although the relationship would not make for a very good regression it clearly shows that a high P/E results in lower returns over the next 10 years. In particular, after the lows of 1919 the market averaged more than 15% per year and when the P/E was 20 – 25 the subsequent returns were near zero. So it would appear that Graham and Dodd were correct and that P/E is a valid indicator of fair value. By the way, as of February 2007 the P/E was at 30, which is not a positive indicator.

Shiller also presents his Valuation Confidence Index, which he has calculated since 1990 and which reflects the percentage of investors that believe the market is not overvalued.

Interestingly, the index bottomed out at around 30% right before the market peak in early 2000, which begs the question “if investors believed the market was overvalued then why didn’t they sell?” Maybe they didn’t believe in market timing. Unfortunately, his data only goes back to 1990 so we can’t be sure that this is a valid market indicator but it certainly bears watching. Note that by this measure the market is not currently at risk for a pullback.

In 2002 Pu Shen, an economist at the Federal Reserve Bank of Kansas City, took the P/E indicator a step further and empirically examined the performance of a signaling tool similar to the Fed Model. For the period from January 1962 to December 2000 he tested buy/sell decisions based upon what he calls the “short spread” between the S&P earnings yield and the yield on 3 month treasuries (E/P – 3 month treasury bill yield). (He also looked at the “long spread”, based upon the 10 year yield but that was not as powerful.) He used the tenth percentile of the spread as the signal – i.e. when the spread dropped below the tenth percentile it was time to get out of the market and into 3 month treasuries and when it rose above the tenth percentile it was time to get back into the market. (Note that this is one of those binary strategies.) The idea here is that when the earnings yield on stocks is too close to the yield on 3-month treasuries stocks are not a very good investment. Seems reasonable.

Here is a summary of the important findings from his 39-page paper:

• The buy and hold strategy returned 1.117% per month over the test period while the switching strategy returned 1.322% per month.
• On an annualized basis that amounts to 14.26% vs. 17.07%.
• Whether or not you consider this difference to be statistically significant depends upon how you frame the analysis. I did not find this part of the paper particularly enlightening.
• The switching strategy resulted in a less risky portfolio over time. The Sharpe ratio of the switching portfolio was 0.205 vs. 0.13 for the buy and hold strategy.

Seems like it would be hard to pooh pooh these results. However, Pu also tested switching strategies based upon just the earnings yield and just the 3-month yield and concluded that almost all the predictive power was in the 3-month yield. His interpretation of this result is that trading based upon the 3-month yield keeps you out of the market during inflationary periods, which are not good for the market. I think it’s just as valid to view this from the perspective of higher yields mean a higher discount rate on stocks, which gives lower stock valuations.

While I think this study raises some interesting possibilities, I do have one major concern. Given the amount of historical data available and the varied economic environments that the market has encountered I don’t think 39 years is a long enough time period for this kind of study. In fact, Robert Shiller pointed out that “Since 2000, [the Fed Model] has broken down, and also before 1970, there really was not a correlation. Thus, people seem to have been exaggerating the impact of interest rates on the stock market.” [7] Clearly he is of the mindset that we should focus on the P/E ratio alone and from my perspective there is good reason to believe him. Interest rates are going to go up, they are going to go down, they are going to oscillate around some “normal” level, and you can’t very effectively predict where or when they are going to move. So you might as well take a long-term perspective and focus on the P/E ratio alone. Unfortunately, Shiller did not do nearly as rigorous an analysis as Pu.

A similar analysis from Ned Davis Research shows that extreme values of the S&P P/E can be effective predictors of future stock returns. Analyzing the period from March 1926 to June 2006, using trailing 12 month earnings, they point out that the average P/E has been 15.9 and they have set buy/sell triggers at P/E ratios of 9.3 and 20.2. (I was unable to discover how they determined these thresholds.) 24 months after responding to these triggers the median return of the S&P has been 27.5% after a buy signal and 0.8% after a sell signal.

So where does all this leave us today? The current trailing P/E ratio of the S&P 500 doesn’t look so bad at 15.6. However, based upon Shiller’s 10 year trailing analysis above which shows the February P/E to be 30, it’s clearly north of 30 now, which is darn high. The reason for the big difference is that S&P earnings have been on a rocket since 2002. As long as you have confidence that earnings won’t retreat then maybe valuations aren’t so out of whack. However, consider the data over the past 135 years:

Using Shiller’s entire data set I have determined that the historic earnings growth rate has averaged 1.45% per year and earnings are currently well above the trend line. Picking different time periods than the last 135 years can give slightly different results for the average earnings growth rate but nothing dramatically different. For instance, in a 2002 Yale ICF working paper Ibbotson and Chen stated that earnings have grown at a 1.75% annual rate since 1926. [8]

Each time that earnings have shot well above the trend line in the past they have eventually regressed back to the trend line. There are several reasons to expect that to occur. First, as Ibbotson and Chen point out, earnings just can’t grow faster than the overall economy unless equities are becoming a larger factor in the economy. While the factor share of equities has grown it is not a huge effect. Therefore, one would expect earnings to grow at about the rate of productivity growth, which has been about 2% per year. [8]

Second, market forces also throttle earnings growth. Extraordinary profits invite additional competition, greater employment levels eventually cause labor rates to rise, and high production levels bid up energy and raw material costs. With unemployment at a 6 year low and rising commodity prices we’re already seeing evidence of this.

My belief is that we have been experiencing an earnings bubble – perhaps driven by huge liquidity injections and lax home mortgage originations. It would seem that profits are destined to go down. If that’s the case then Graham and Dodd are correct to be looking at the longer-term earnings average. We could very well be at a market peak right now and, while a complete withdrawal from the market might not be prudent, reducing one’s exposure to stocks might be wise.

[1] ING Special Report: Market Timing, July 2005
[2] William Sharpe, “Likely Gains from Market Timing”, Financial Analysts Journal, Vol. 31, No. 2, March-April, 1975, pp. 60 - 69
[3] Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, Vol. 51, No. 1, January-February, 1995, p. 135
[4] Benjamin Graham and David Dodd, Security Analysis, 1934, pp. 452 – 453
[5] Robert J. Shiller, “Irrational Exuberance Revisited”, CFA Institute Conference Proceedings Quarterly, Volume 23, Number 3, September 2006, pp.16 – 21
[6] Pu Shen, “Market-Timing Strategies That Worked”, Research Division, Federal Reserve Bank of Kansas City, May 2002
[7] Robert J. Shiller, “Irrational Exuberance Revisited”, p. 19
[8] Roger G. Ibbotson and Peng Chen, “Stock Market Returns in the Long Run: Participating in the Real Economy”, March 2002

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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.

Authors note: I thought it would be appropriate to keep this article short so if you want some detailed information on how shorting works check out this entry in our encyclopedia.

There comes a time when you may want to take a short position and when that time comes you need to be aware of some of the potential pitfalls and how to avoid them.

First, why would you want to do something like this? Let me give you a few sample scenarios, though there are many others:

1. You are convinced that a particular stock is overvalued and you want to profit when everyone else figures out what you’ve known all along. A side benefit of doing this is that if the company goes bankrupt you never have to close out the short position and thus you avoid paying income taxes.
2. You want to hedge your investments. You like your individual stock selections but you’re nervous about the direction of the market so you sell the market short. Shorting one of the many ETFs that represent various indices will eliminate that market risk from your portfolio.
3. Perhaps you’ve sold a put option on a stock but want to insure yourself against the possibility that the stock will decline. Of course, in this case you will lose if the stock moves up.
4. You find a closed end fund that is selling at a substantial premium and there are comparable closed end funds or ETFs that are selling at net asset value (NAV) or below. You can short the fund trading at a premium and buy the fund trading at NAV.

Aside from the inherent risk of unhedged shorting (like having unlimited downside), there are several other ways you can get stuck with the short end of the stick if you don’t know what you are doing. Let’s start with how shorting is executed and who gets what out of the deal. Your broker borrows a client’s stock and sells it. First and foremost that means that the stock has to be available for shorting. If the stock is not widely held there is a very good chance that your broker can’t find a position amongst all of their clients from which to borrow. Without a lender you cannot execute a short transaction. I’ve run into this dilemma many times. However, your broker has a stock lending department that can help in these situations. They can go outside of their firm and find the shares. For this service you pay a small fee. Fidelity charges 2.5% of the average short value per year.

The next problem you will encounter is that you are now liable for paying the dividends on that stock to the lender. Seems reasonable, right? Yes, but there’s one small problem. You have an investment expense and guess what? You don’t get to deduct it as an investment expense. You see, our government, in their infinite wisdom, taxes you on any dividends you receive but doesn’t let you immediately deduct the cost of any dividends you pay. Instead you are supposed to add the dividend payments on short sales to your tax basis, so you don’t get the tax benefit until you close the position. One would think that a dividend you pay would be like a negative dividend that offsets any dividends you receive, but the world we live in is not symmetrical. (I have no idea what happens when you short against the box and you receive dividends that you simply turn around and pay back out but we can all guess how that story probably plays out.)

As if all this wasn’t bad enough there’s also the small issue of the cash generated from the sale of the stock. I think this is one of those dirty little secrets. When that stock is sold cash comes in the broker’s door, which generates interest. Who gets the interest? There’s only one possibility – the broker quietly pockets the money. I once brought this up with a trader who actively shorts stocks and he uncomfortably admitted that this is something that you can negotiate with some brokers. He claimed to have worked out a deal with his broker to give him a portion of the interest. I tried bringing this up with Fidelity and they acted like I was from another planet. So I just accept this as an unfair cost of doing business. This is just another glimpse into the asymmetrical world we live in: sell some stock and get interest on the proceeds; sell someone else’s stock and you don’t get interest on the proceeds.

Finally, shorting is not even an option in your IRA. I guess it’s viewed as too risky for retirement money.

Given all these problems what do you do? As a first step, before you short something (as in the case of a hedge) look around for alternative plays. Is there something else you can sell that will allow you to get interest on the proceeds? For example, you might be better off selling your GE stock, which is closely correlated with the S&P 500, rather than shorting the S&P 500.

Another alternative is to buy one of the recently introduced short funds (also known as bear or inverse funds). These are ETFs that move in the opposite direction of their corresponding target index. It would seem reasonable that the pros managing these funds have access to techniques that you or I don’t, which allows them to more efficiently take a short position. I just checked the prospectus for the Short S&P 500 ProShares fund (SH) and discovered that they basically have two holdings: S&P swaps via UBS and cash. So instead of shorting the index they’ve essentially achieved the same effect by entering into an agreement with someone who wants to bet on the S&P rising. When the index goes up ProShares pays the counterparty and vice versa. This structure has a benefit to the party taking the long position: they take a long position without tying up cash. So there is an inherent efficiency in this structure, the benefits of which you would expect to be shared by ProShares. In addition, ProsShares earns interest on all the cash that they receive from selling the fund.

The other advantage to these short funds is that you can purchase them in your IRA, which is a bit ironic since they don’t want you taking short positions there.

So, owning this short fund might be better than taking the short position yourself. To check this I compared the two alternatives during a time period between dividend payment dates (to make it easy) when the S&P changed by its maximum amount. From March 27, 2007 to June 4, 2007 the S&P Depository Receipt (SPY) went up 7.87%. Had you shorted it and held cash in the amount shorted (since you didn’t use cash to buy the short fund) you would have lost 7.87%, offset to some extent by interest of .95% (assuming your money market is returning 5%) for a net loss of 6.92%. During this same time period the Short S&P fund went down by only 5.93%. So it appears that during this period of rising stock prices owning the short fund was a better alternative. What I can’t tell you is what would happen during a period of falling stock prices, since these short funds haven’t been around long enough for us to measure that. Perhaps this fund just doesn’t track the index that well. I’ll be keeping an eye on this since I recently purchased the short fund.

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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.

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.

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.