IFA Radio - Show Notes

IFA Radio's Episode 100: Airs 11/27/11

IFA Radio — Wed, 23 Nov 2011 00:00:00 GMT

Are fees the most predictable measure of performance?

IFA Radio's Episode 99: Airs 11/20/11

IFA Radio — Fri, 18 Nov 2011 00:00:00 GMT

Watch the IFA.tv Episode:

Listen to the IFA.tv Episode:

Look at the Long Term

One of the things, unfortunately, you need to ignore most of the time is the popular media because they tell you something that HAS been good (may not be good in the future). And often times their comparisons aren’t really that sound. A recent article from Bloomberg that makes that point showing that if you invested in long term government bonds 30 years ago you did better than investing in stocks. It does not tell the whole story. That’s the unfortunate part of the popular media.

We like to tell people, “Odds are you don’t know what the odds are.” You need to have access to the data so you can see how rare this is and whether that’s an investment strategy you would like to rely on for your future. So first of all, in that study they looked at the S&P 500 which is just maybe 20% of our full equity portfolio that we would invest our client’s assets in. If we look at the chart below, it asks the question: does it pay to extend your bond maturities much past 5 years? And so normally what we tell investors, if you took this incremental risk of going for long term government bonds, did it really pay off to do so?

What you see in the chart is it’s about the same return as 5 year bonds and it really doesn’t behoove you to do this when you have to take all this incremental risk. So how is it that this occurred? What you see is once you have this huge variability of return at an average of about 7, every once in a while you’re going to get an outsized return way up here of about 11.6%. It’s just randomness.

If you bought and held the S&P 500, yes, you did do better with long-term bonds. (By the way with a lot of volatility) The reality is if you built the right equity portfolio you actually did better than being in bonds.

Part of our job is to help you navigate the treacherous waters of investing. One way you do that is by avoiding the investments that can take you under water in a lot of ways. One of those recently has been Fidelity Magellan. Fidelity Magellan was THE mutual fund in the 1980’s. Peter Lynch was managing this. If you owned one fund, that was the one to own. It had good performance for a long time. And now it has gone underwater, into the depths, Davy Jones' Locker. This is a mutual fund that went from 100 billion dollars under management to now it has about 16 billion.

The market is unbeatable. Just let go that you're going to find some guru that has a crystal ball. Invest, but never speculate.

IFA Radio's Episode 98: Airs 11/13/11

IFA Radio — Fri, 11 Nov 2011 00:00:00 GMT

Passive Investing Applies to Bonds

Many bond fund managers made bad bets and underperformed the fixed income benchmarks in 2011. What’s the lesson to be learned when we read about big names in the bond fund field who have really stumbled in 2011? We can capture a market rate of return for bonds by buying an index fund that captures different markets. So let’s say you wanted to buy in the general municipal debt market – municipal bonds, maybe on a national scale. If that’s your market, the best way to invest in those is to buy all of them, buy the index of them, because betting has a zero expected return minus the cost of the bet. That’s what’s happening to all these managers. Somehow they think that it’s not a bet for them. They think they know the price is wrong, but a fair bet means it’s just as likely to go up as it is to go down. Fair bets are the result of people gambling in free markets where prices are expected to be fair. They’re fair, because they have lots of willing buyers and sellers negotiating to find a price that works for both of them (and that’s basically what a fair price is). And from there, it should be just as likely to go up as go down around an appropriate return for the risk. So let’s focus on the risk, the benchmark, the market rate of return, that’s what all those are. The question I have is: Why is it you want to take the risk at additional risk of a manager who might underperform? They don’t always outperform. It doesn’t matter if you’re buying a stock or a bond, they’re all priced in a free market. Everybody has access to the same information. The beautiful thing about that price is that it collects everybody’s knowledge.

John Bogle, founder of Vanguard, who has been a longtime proponent of index funds, is someone who has made sure people understand the bottom line on both equities and bonds, and especially with fixed income – and that is that the difference over time is how expensive those funds are. That’s the differentiator when it comes to performance. That’s the lesson that John Bogle wanted to impart. See the chart below to compare bond fund managers versus indexes.

For more information on active bond traders, see the article, "Bond-Fund Stars, Dimmer. They’re fallen stars."

If you’re considering using active management for your bond or stock portfolio, consider this quote from Nobel Laureate William Sharpe: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

This is key to what we’re trying to lay out on this show. We want you to believe the academics over the folks on Wall Street. Why? Two simple words: Peer Reviewed.

IFA Radio's Episode 97: Airs 11/6/11

IFA Radio — Fri, 04 Nov 2011 00:00:00 GMT

Shocktober

Out of nowhere, October was an amazing month for stocks. We had a horrible August and a horrible September, and then stocks up about 10% in one month. Just another case of a random walk down Wall Street.

I love the quote from Mark Twain. “October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” Mark Twain also said, “There are two times in a man’s life when he shouldn’t speculate: when he can’t afford it and when he can.” Just like that Chinese fortune cookie I picked up 8-10 years ago, “Invest, but never speculate.”

You just don’t know when the market is going to surge ahead. To throw out another quote, J.P. Morgan was once asked what the market was going to do. His response was, “It will fluctuate.”That’s all we really know. It will fluctuate, in the short term. Over the long term though, we have a different purpose to be an investor, and a really good reason to be an investor. On average, the corporations we invest in make a profit. If we look at last year in 2010, the 12,000 plus companies that we own actually had a total market value of about 34 trillion. They had sales of 31 trillion, and they had profits of 2 trillion. Why would you want to give up on that? Two trillion dollars a year in profits. That’s why, on average, the market goes up over periods of 10 years or more. I can already hear people yelling, “Wait a minute! What about the lost decade?” That was the S&P 500 that lost money during that particular 10-year period. But if you had been more diversified in a small value tilt portfolio, then at least in the last 50 years, we don’t have a 10-year period where you lost money. For example, our high risk Portfolio 100 actually earned 3.5% in the worst 10-year period out of 490 10-year periods.

At the end of the day, we want people to have the proper exposure to the right stocks for the long term. We don’t want you to try to market time because that’s a loser’s game.

Show Segments

Segment 1: Out of nowhere..October, an amazing month for stocks

-Why value companies will beat growth companies

-Why your mutual fund fees barely budge

Segment 2: A month to remember for stocks...

-A Month to Remember for Markets - WSJ Article

-We hope many of you didn't miss it

-Why timing is so difficult

-Why you need proper exposure to stocks all the time

Segment 3: Why Value will beat Growth...in the long term.

-Why Value Stocks Will Beat Growth Stocks - WSJ Article

-What are value stocks?

-How should you buy them?

-What part of your portfolio should be committed to value stocks?

Segment 4: Step 6: Ignore Style Drifters.

-Step 6: Style Drift

-What are "styles?"

-Why do managers change styles?

-How to build your personal best portfolio...

Segment 5: Watch your costs...Why fund fees barely budge.

-Why Fund Fees Barely Budge - WSJ Article

-How to select funds with low costs.

-What fund companies offer the lowest expenses

IFA Radio's Episode 96: Airs 10/30/11

IFA Radio — Fri, 28 Oct 2011 13:06:19 GMT

Good Times Ahead?

A recent article by Gail MarksJarvis entitled, “If this is a bear market, the mauling will end” basically gave the advice that “Yes, you get in these bear markets. They last about two years, but if you’re properly positioned for good and bad times, you should be OK.”

This always reminds us of Step 4 in our 12-Step Program: Time Pickers, also known as market timers.

IFA Radio's Episode 95: Airs 10/23/11

IFA Radio — Fri, 21 Oct 2011 08:47:21 GMT

Are Stock Pickers Really Just Now Having Problems?

An article this week by a fellow named Matthew Lynn in MarketWatch says Stock gurus aren’t what they used to be. He laments the fact that John Paulson who made a lot of money in the subprime debacle a few years ago has lost a lot of money this year.

This whole issue brings up lots of concerns for these myths and the poor investors. It misleads them even further when Matthew Lynn finally got around to explaining why he thought these stock market gurus could no longer consistently beat the market. First of all, let’s back up and try to determine if in fact they did statistically beat the market on a statistical significance level. I have a lot of doubt about that. More importantly, I have a number of studies that would take issue with this. Let’s start with a study we did recently. We just completed this study last week here at IFA.

We went to our data base called Morningstar Direct which is sort of a main line into the Morningstar database. It keeps a record of all the returns of all the mutual funds and all the managers for a long period of time. So it allows us to finally get some information and some data on the record of stock pickers. Before we had companies like Morningstar, most investors were subject to their stock broker’s characterization of an investor’s skill, or lack thereof. If they were a broker, they usually explained they had a lot of skill. But now we can go back and look at the data.

I want to give our listeners some tools that they can use when they are having conversations with investment professionals about this idea that their manager should be able to beat the market in the future. You can’t buy yesterday’s returns. You’re investing in a fund with a hope they will do as well in the future as they did in the past. This is really a big problem because investors constantly chase the past returns of managers in hopes they will continue. The record shows that has been a bad mistake for investors.

IFA Radio's Episode 94: Airs 10/16/11

IFA Radio — Mon, 17 Oct 2011 08:49:25 GMT

Past Success Does Not Guarantee Future Results

Part of human nature is to look at what has worked and be a part of that. One of the things people do often times, especially in tough markets, is ask the question what were some of the stocks that worked really well last year in 2010? Why don’t I buy some of those? Those have got to be successful. How about Netflix? It was the number one stock in 2010, rocketing up 219%. But if you bought it and held it this year through the end of September, you suffered 36% loss.

There are lots of strategies that don’t work for investors. In fact, most of these so called strategies are mostly based on some sort of a trade and do not work for one simple reason: a fair price is determined by a willing buyer and a willing seller and when they conclude on that fair price (and millions of people are watching that price with lots of information accumulated from all over the world) the chances of the market going up or going down are now 51% to the up and 49% to the down over the next day. So it’s a little like a coin flip with a SLIGHT advantage for the risk owner because they should be rewarded for the risk they take. That’s the only thing the investors should rely on. This nonsense of looking at what had the highest return last year like Netflix being up 219%, and then you piling on with all these other investors and running that stock price up is just crazy. Will investors ever learn?

Stock prices in the future are unpredictable because they reflect the news events that are random and unknowable. With individual stocks, just about anything can happen. Over the past four years, the top S&P 500 stock each year lagged the market the following year. There is a lot of randomness in owning individual stocks. This is not a good way to be using a scientific approach to build the correct portfolio.

If you visit Step 8 on our website, you will learn about the factors that actually are good estimators of future returns. And one of those factors is you tilt your portfolio mix, your mix of 13,000 stocks in a globally diversified portfolio, you tilt that mix that are value priced not growth priced.

IFA Radio's Episode 93: Airs 10/09/11

IFA Radio — Fri, 07 Oct 2011 00:00:00 GMT

Dealing with the Dive

How do you deal with stocks diving and suffering the worst quarter since going back to the 2008-2009 financial crisis?

Well, first of all I don’t like div-ing because that sounds like stocks are continuing to go down, when in fact, every time we adjust the price for stocks we reset the odds to be 50/50 around an appropriate return for the risk of the investment.

As many of you know, this was a very difficult third quarter for stocks. Here are some of the numbers. The Dow Jones Industrial Average fell 12% for the quarter. The S&P 500 lost 7.2% for the month of September and lost 14% in the three months since June. NASDAQ, the technology firms, shed about 6.5% for the month and 13% for the quarter. Many people are struggling with all this.

I want people to focus on their knowledge not their feelings. In times like this, a lot of people resort to what feels good. And what feels good in investing is rarely profitable for investors. So this is the time when I want investors to tie themselves to the mast. Resist the temptations to run from a scary market, and if anything, I would want you to rebalance your portfolio. That’s one of the key premises of a buy and hold investing strategy. Every once in a while you get back to the mix of investments you determined was appropriate for you when you first started out. Let’s say you took the Risk Capacity Survey, you scored a 40, which means you have a portfolio that’s 50% stocks and 50% bonds, and you take a look at that after this recent quarter and it turns out that now your stocks are not 50% like you started with, now they’re down to 40% stocks. What would you do? I would suggest we sell some of those bonds and buy a little more stocks and get back to that 50/50 mix that’s appropriate for you.

Here’s the other thing. I like to remind investors where they sit historically compared to other times the markets have had these kinds of adjustments. One way we would do that is go to one of our portfolio pages at IFA.com and slide all the way down to Figure 9. In Figure 9, we can look at the historical returns from lots of different time periods. We can look at one month, three months, six months all the way out to 20 year holding periods. Below is the chart you will find on all our portfolio pages.

In other news…

Recently, an article was written as to whether or not a hedge fund can survive a change in managers? I want you to go to caxton.com. That is the website for Bruce Kovner who this article is mostly about. Supposedly he’s a skilled trader and supposedly he’s had this great return. They claim he’s had this 21% return. By the way, I don’t even believe that. I’d love to see an actual accounting of those returns over all of those years. In fact, he doesn’t say how many years. But even more important, forget all that, go to their website and there is like NOTHING THERE. There’s a paragraph and a link for clients to log in. Where are the disclosures? How do I know what you are going to do with my money? What kind of risks are you going to take? What kind of returns should I expect? How has that worked over long periods of time? I want to see the data! This is the problem with all of this active management nonsense. Most of them cannot provide you statistically significant data of what they’ve been doing in the past. If they can’t do that, why should you believe what you would expect in the future? This is all about expectations; both expected return and expected risks of investments into the future.

IFA Radio's Episode 92: Airs 10/02/11

IFA Radio — Fri, 30 Sep 2011 00:00:00 GMT

A Lot of Brokers Fear Fiduciary Duty

Brokerages would have to reorganize their businesses if they were to be held to a fiduciary standard. It would create a little bit of havoc for them. The revenues they have been making - the billions of dollars they make from this industry and from investors would be highly curtailed because they would be forced to really disclose the fees that they charge right up front so they can live by their fiduciary standards. That would be a huge revamping of what goes on in this business. I’ve often said for the brokerage industry to act as your fiduciary would be the equivalent of basically shutting down these firms. They would no longer be able to sell their product. They would no longer be able to take a share of the trading commissions. They might be able to find a way around that, but since trading is hazardous to investors’ wealth, it would be very difficult to build a fiduciary standard around the fact that you’re trading in a client’s account.

I want you to open up a new window, Google “fiduciary” and click on the link that takes you to Wikipedia. Read the high standard set [by a fiduciary].

“A fiduciary duty is the highest standard of care at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom he owes the duty (the "principal"): he must not put his personal interests before the duty and must not profit from his position as a fiduciary, unless the principal consents.”

That last line can be a little complicated in our business because in our industry you could get the consent of the client because it’s so complicated and there are so many hidden fees and so many ways these so called Silent Partners can extract money from your accounts.

When I started looking at this business back in 1997 and 1998, I was just shocked and floored at the hidden costs and all of the ways brokerage firms can make money from their clients which were completely unclear to the overwhelming majority of the clients of these brokerage firms. I was one of those clients. When someone becomes a fiduciary, the SEC holds the individual accountable, and it’s not up to the investor to figure out all the ways that firm may be acting in their own interest instead of the client. Fiduciaries have compliance departments who have to test to make sure everything is being done right. When they are inspected by the SEC, the SEC carefully combs through their documents to make sure they always did what was in the best interest of their clients. I can’t imagine there’s any better way for investors to be protected than to invest with an individual who is held to this fiduciary standard.

IFA Radio's Episode 91: Airs 9/25/11

Fri, 23 Sep 2011 00:00:00 GMT

Luck or Skill: The Difference Between $100 Billion and $17 Billion

“All the time and effort people devote to picking the right fund, the hot hand or the great manager, have in most cases led to no advantage.”

-Peter Lynch

Fidelity Magellan was once the world’s largest mutual fund at $100 billion in assets under management. It is now at about $17 billion.

Fidelity recently got rid of Harry Lang and replaced him with Jeff Feingold who was the manager of the Fidelity Friend fund, another mutual fund at the company. The curious thing is it didn’t get much attention.

At IFA we devote an entire step of our 12-Step program to Manager Pickers - those who are investment advisors or stock brokers who are hopefully acting in the best interest of their clients when they go and pick a new fund manager who will beat an index fund or the market in their particular area of investing. There’s an enormous amount of money and effort and time devoted to this. We have the Morningstar ratings of these funds. You get your five stars or your one star. If you’re five stars everyone is real excited and wants to pour money into your fund, and when you are down in the one star category people take their money out. (Fidelity Magellan is a one star fund now.)

The big question that is asked by the academic community when looking at the data is could we contribute these past performances to luck or to skill? There are a number of statistical tests statisticians use to sort this out. But I’ve spent some time over this past weekend thinking of how we could put this in plain English for our listeners. How would we test the claim that managers can beat the market? There are many markets out there. There are emerging markets, there are international small value markets. There are small cap stocks here in the U.S.

The first thing we would want to determine is how much better have they done than their market and with what regularity? No matter what we do, it will be rare that the manager beats their benchmark every year.

Once we have these two data points (the average excess return above their benchmark and the regularity of that particular excess return), we can go to a chart on our website which is in Step 8, Page 5. It’s a chart that tests statistical significance. Now let me put this in plain English for you. It’s something that would give you some feeling of confidence that the manager can actually beat the market in the future. That’s what you are looking for. They use a test of the data called a t-stat. It stands for test statistics. We take the average return plus the variation or the irregularity of the return, and then use the chart to find the answer.

IFA Radio's Episode 90: Airs 9/18/11

IFA Radio — Fri, 16 Sep 2011 11:10:07 GMT

Geo-political factors in our investing

People need to get a solid education about risk. This is why we earn a return. I think it was Evel Knievel that said, you know risk is good, you just have to learn to take it in the proper doses and that’s what we’re all about here at IFA.com, is a risk capacity analysis and then find a risk exposure that matches up with that risk capacity and focuses really on these systematic risk factors that are often called macro-economics or the age of macro-investing, this is the age of it, that’s Jason Zweig’s line. We’ve always had these types of risk but listen, if we can get our listeners to hop over to my favorite website; IFA.com.

Go to Step 8 where we describe the language of risk or “riskese”, as I like to call it. Go visit your lawyer; we’ll be having Dan Solin on the show in a little bit. Dan likes to speak “legalese” in his practice and then he comes over here and he speaks “riskese”, he spends a lot more time speaking “riskese” than “legalese” these days. We have on page 3 of Step 8 on IFA.com a section here that is called “What is Risk?”, Section 8.2.6, and we go through a few definitions of what risk is and then if you scroll down a little bit you’ll see in Figure 8-10 where we break down risk into pretty much 2 areas; one that’s called the unsystematic risk and a cousin that is concentration risk and then on the other side we have what’s called systematic risk. So let’s talk about this systematic risk factors as Jason Zweig has talked about that we’ve listed right here. We call it the “Market Wide Risks” and they include things like war, recession, inflation, government intervention, in fact the acceptance of different economic systems within the government and we remind investors that you cannot diversify your portfolio any further to minimize these risks, in fact I think of this as the risk of Capitalism in its totality and that is why we earn an expected return for our investments because we subject our investments to this uncertainty about future returns. Why should you earn a return investing in certainty? If I owned an investment, certainty, and you wanted to buy it from me, let’s say I knew it was going to earn 10% a year for the next 5 years, and you want to take that away from me and now you’ve got basically a low risk investment with a 10% return because we knew with certainty, believe me I’m going to charge you for that 10% per year over the next 5 years right now. Now maybe I’ll discount it because it’s a little ways off into the future but you’re going to pay substantially all of the expected returns for the next 5 years to the degree we have certainty and I’ve said it’s certain. And guess what, now what’s your expected return? It’s zero for 5 years. So how do we earn returns, we subject our capital to systematic risks.

Now on the other side of that equation, just to further dig into this is the unsystematic risk often referred to as companies specific risk and that might have to do with lawsuits with individual companies, with fraud within the management firms, it might have to do with the management skills of these various managers and all the unique circumstances that impact each company. And we think of this as an unrewarded risk because all of that information is fairly well known by investors and what the academics like to tell you is if you can diversify it, it basically does not have an expected return. So we can actually eliminate this unsystematic risk by owning more stocks, by owning more industries and by owning more countries and even by owning more asset classes like stocks and bonds.

IFA Radio's Episode 89: Airs 9/11/11

Fri, 09 Sep 2011 17:01:04 GMT

Anniversary of the Index Fund

The 35^th anniversary of the index mutual fund is a huge deal because when Jack Bogle started this way back in 1976 they called it “Bogle’s Folly” because everybody thought that was just the dumbest idea you could ever think of and man has he proved the world wrong, or at least the investment world wrong.

An index mutual fund is basically an investment of any kind, this happens to be a mutual investment, there are also exchange traded funds that are also index funds but I want you to think of it as an investment that has a set of rules of ownership that are held constant regardless of market conditions. Now that leaves a wide open view or a wide open landscape of various index funds. I’ve seen index funds based on the Fortune 500 largest company list; I’ve seen index funds out of Wired Magazine, so a handful of technology funds, I’ve seen index funds based on Orange County based companies. There are index funds based on small companies that are value priced. So whatever criteria a manager or an academic or some kind of researcher may want to use as a yardstick or a measuring stick can be an index and the manager’s job of that fund is to then buy all of the companies, whether they be stocks or bonds that meet the criteria that was established and then basically turn off the news and hold those stocks regardless of market conditions. So we’ve had all this volatility lately, people I see moving around their stocks back and forth, even managers of funds who might claim they have some fixed criteria, like an actively managed fund that buys large growth stocks may get very nervous and then start style drifting and moving over and buying some large value stocks or some small stocks and then he has broken a rule that was established for his criteria but by the way his prospectus allows him to do that, and that’s the real difference. When the manager can move around, it’s not an index fund. It’s a lock down.

An index mutual fund takes away the guess work, the mistakes, the fees, the taxes associated with simply moving around your stocks within your portfolio, let’s say it’s an equity mutual fund, and it instead focuses on what I like to call a “bucket of risk”, what’s so important about that is we could take that “bucket of risk” and look at 50 years of how that “bucket of risk” has performed on a returns basis as well as a variability of return and I know people, I can already hear them saying, “I don’t have 50 years, what do I care about 50 years ago, that’s got nothing to do with today, this time is different”, over and over, well let me make this really clear for you, what’s not different is the ability of a free market to price those news events or price the risk of those news events and that’s why things aren’t different. By definition the news is going to change, we’ve got an iphone, we’ve got a Blackberry, and we’ve got all kinds of different technologies. We have hyper trading computers and of course all those events are going to change but the reason that market returns are somewhat reliable over long periods of time, those are real hedge words but that is all you can really say about it, the reason that it is reliable, somewhat reliable, is that you have a group of traders who are looking at the same news, some of them think it’s a buy, some of them think it’s a sell, and the price that they strike which is called an equilibrium price between supply and demand basically prices those investments for number one; a positive expected return that’s there for the risk and then puts you in a position to earn a return that half the time would be greater than that expected return and half the time would be less and most of the time you probably will earn the return that is appropriate for that investment but the other really good thing is that the further away your return ends up being from what you expected the less likely it is to occur. Now we’ve kind of gotten off the top a little bit but those are a lot of the reasons.

IFA Radio's Episode 88: Airs 9/4/11

IFA Radio — Fri, 02 Sep 2011 00:00:00 GMT

Is Stock Picking on Its Last Legs?

A recent article on CNBC.com exposes the record breaking correlation between individual stocks in the S&P 500 and the index itself. “The correlation for the S&P 500 and its members is at 0.73, according to Goldman, meaning that the majority of stocks move in lockstep with the index on a daily basis.” This essentially means that a stock picker trying to beat the S&P index by consistently picking only the winners within the index is facing a near impossible challenge. It was enough for the active leaning CNBC to title the article, “End of Stock-Picking: S&P Stocks in Lockstep With Index.”

Allow us to play our worlds-smallest-violin for the stock pickers around the world. IFA has known of this for years.

As you can see, the expected return of one stock is the same as the expected return of the index it resides in for any asset class. The thing that changes drastically is the risk you take by owning only one stock as opposed to the entire index. By diversifying, you slide down in risk level as more stocks are added to your portfolio.

With one stock your risk sits at 50%. By adding a second stock your risk drops dramatically down to below 40%. Add one more and your risk sits just above 30%. Follow that line all the way down to the entire S&P 500 and your risk is less than half of what it would be if you were to place all your eggs in one basket. But why stop the diversification there? After all, you still have only large, U.S. based companies in your portfolio. Why not add small companies, value companies and international companies like we have in our IFA Index Portfolio 90? Not only does your risk go down with the extra diversification, but your expected return goes up due to the higher risk compensation of these other asset classes.

Unfortunately, you cannot eliminate all risk. Systematic risk cannot be diversified away. These market-wide risks are tied to large scale risks like the risk of capitalism being a viable economic, social system. Things like war, famine, and inflation are uncontrollable.

But at the end of the article, CNBC reverts back to catering to their many sponsors who pay their bills. “To be sure, this record correlation could open up an opportunity for astute stock pickers if it breaks apart, leaving those that bought the right stocks during this period an opportunity to be rewarded when their individual fundamental stories become recognized.”

I guess some people never learn.

IFA Radio's Episode 87: Airs 8/28/11

IFA Radio — Thu, 25 Aug 2011 00:00:00 GMT

Active Management Brings Anger Management

A recent article by Jason Zweig in The Wall Street Journal entitled, “Too Flustered to Trade: A Portrait of the Angry Investor” may sound like a good thing to the passive indexer. If someone is too angry to trade, at least they are buying and HOLDING. Unfortunately, it’s not a simple case of investors being upset with their broker ringing up fees and commissions at their expense. The lack of movement is based more on the sheer horror of investors who are generally giving up on their hard earned cash doing anything in equities. As Jason Zweig put it, “People seem to feel like bystanders in their own financial lives—almost as if they were spectators at a racetrack equally incapable of stopping an impending car crash and of tearing their eyes away from it.”

In a recent survey led by Paul Slovic of Decision Research in Eugene, Oregon, investors were probed to see how the recent financial turmoil of the last couple weeks affected their financial mindset. When asked how angry they were about the financial challenges facing the country, 59% said they were “moderately” or “very” angry; with 52% saying they were “moderately” or “very” fearful. The reason for this anger and fear is no doubt due to the fact that only 11% of these respondents felt they had a strong control on their financial lives.

So what can be done to ease investors’ minds? At IFA, we realize some people are more comfortable with risk than others. That is why our investors take the Risk Capacity Survey in order to find the risk level comfortable for them. By placing an investor at the right risk level, they are better equipped to withstand the ups and downs of the market. They can roll with the punches the market invariably dishes out.

If a person understands the risk they are taking, they are less likely to be part of that 59% who identify themselves as angry. An educated investor who has taken the risk capacity survey can look at the recent drops and contextualize them in relation to the history of the market. If a person were to get a score of 43 on the Risk Capacity Survey they could be placed in an IFA Index Portfolio 43, at which point they would know all the historical returns of that portfolio. If you click on this link and proceed to click on the number 43 ball at the top of the chart, you would find that the worst one year rolling period over the last 50 years, 7 months is -26.61%, and that happened during the crash of 2008-2009. But as you scroll down the worst rolling return periods, you quickly realize that at no point did someone hold onto this portfolio for over 6 years and NOT make money. Obviously past success is no guarantee of future results, but it can give you a better idea of the risk you are taking, and create a calmness when you feel investment rage building in the pit of your stomach.

Being placed in the right IFA Index Portfolio is not a random decision. It is a calculated placement based on your personality and your finances; a placement that will also give you an education in what you can expect going forward. When other people are reacting emotionally, you will be able to react rationally. There are times in life where it’s beneficial to follow your heart or your gut. Your nest egg is not one of those times.

IFA Radio's Episode 86: Airs 8/21/11

IFA Radio — Fri, 19 Aug 2011 00:00:00 GMT

A Call for Sanity

"Hint: money flows into most funds after good performance, and goes out when bad performance follows."

-John Bogle, "The Little Book of Common Sense Investing.” 2007.

David Swensen has run one of the most successful university endowments in the country at Yale University. A while back, he was asked to write a book for the individual investor. After copious amounts of research he discovered the principal of passive investing and wrote the book, “Unconventional Success: A Fundamental Approach to Personal Investment.” His conclusions were essentially the same as ours here at IFA: Buy and hold a diversified portfolio of index funds, and rebalance as needed.

Mr. Swensen decided recently that enough was enough, and he penned an op-ed piece for the New York Times entitled, “The Mutual Fund Merry-go-Round.” David has some harsh words for the mutual fund industry. “For decades, the mutual fund industry, which manages more than $13 trillion for 90 million Americans, has employed market volatility to produce profits for itself far more reliably than it has produced returns for its investors,” Swensen wrote. At IFA, we feel the mainstream press does not have enough articles that take the mutual fund industry to task. So when one of the world’s preeminent investors calls the entire industry to the mat in the nation’s preeminent newspaper, we have to stand back and applaud.

IFA echoes David’s sentiments throughout the article, essentially calling the active mutual fund industry a waste of money and a waste of time. But it’s more than that. Remember that over the long term, it’s not what your funds do, it’s what you do. You can have a perfectly risk adjusted portfolio of index funds, but if you let your emotions take control and you start trading, you are going experience the same losses an active manager punishes their clients portfolios with. Like Swensen says in his article, “As stock prices have gyrated wildly, many investors have behaved in a perverse fashion, selling low after having bought high.” Emotions usually lead an investor to jump in once they feel safe. In order to feel safe, most investors need to see the market experience gains for a sufficient amount of time. This means they are buying when the market is already well up the mountain. Emotions also cause the investor to sell after the market starts to take a dive. Unfortunately, it’s usually after two or three colossal beatings like what took place last week. Instead of buying low and selling high (the inexplicably “sage” advice that’s been around for decades despite the sheer impossibility of foretelling the future), most people are following their emotions and buying near the top and selling after a large drop.

David Swensen crystallizes the mutual fund industry by saying, “This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.” Only in a properly diversified, risk adjusted portfolio that is bought and held with the occasional rebalance can an investor avoid the vicious cycle of buying low and selling high.

IFA Radio's Episode 85: Airs 8/14/11

IFA Radio — Fri, 12 Aug 2011 00:00:00 GMT

Is it Really Different This Time?

"The four most dangerous words in investing are, it’s different this time."

Sir John Templeton, Legendary Investor. Money Magazine, Fall 2002, p. 25

Due to the lack of economic growth, the Federal Reserve announced last week that interest rates will remain low for the next two years. How will this affect the market? As always, there will be ups and downs like a teeter totter. One shouldn’t expect anything different. The line you don’t want to swallow is the commonly bantered about mantra, “This time it’s different.” This line, like most apocalyptic investing advice, creates a buying and selling frenzy that puts commissions in the pockets of money managers. It’s really why most of the financial media exists. They endure to make you trade; to move around your portfolio and try to beat the market. This is folly.

The Hebner Model explains why the “It’s Different This Time” crowd tends to fall off the see-saw.

At the heart of the Hebner Model lies Eugene Fama's Efficient Market Hypothesis. Simply put, it says market prices are fair, meaning the price fully reflects all available information or news. This includes economic uncertainty, new information concerning the investment, and the predictions of the company’s future.

To visualize how markets work, picture the expected return for any given investment sits at the fulcrum of the teeter-totter. The uncertainty of the expected return would be on the left side and the price would be on the right side. The price is moving inversely proportional to the uncertainty of expected returns. When price has fallen by two or three percent, it stands to reason that uncertainty likely went up by two or three percent. Transversely, when the price increases, uncertainty falls. This allows the investors expected return to remain constant at any point they purchase the investment.

The stock market’s recent trip to Six Flags was a result of the credit downgrade by Standard and Poors. Everyone in the financial media is screaming, “This time it’s is different!” While the root cause may be “different” than previous swings, the nature of the markets remains ingrained in the bedrock that is capitalism. For over 80 years, the stock market has proven to be like Rocky Balboa. It may get knocked down, violently at times, but history shows equity markets will resume their upward climb. The vast majority companies throughout the world will earn profits. Instead of following the mantra, “This time it may be different,” one should heed the age old advice of, “Those who don’t know history are doomed to repeat it.” That pertains to financial history as well.

IFA Radio's Episode 84: Airs 8/7/11

IFA Radio — Fri, 05 Aug 2011 00:00:00 GMT

How to Make Sense of All the Bull

How safe are safe havens in a U.S. debt crisis? That is the question posed by Deborah Levine in a new MarketWatch article. The recent slides in the stock market have led to investors fleeing equities into safer assets. In Step 10 of our 12-Step Program for Active Investors we encourage our investors to determine their Risk Capacity; their ability to ride the bull.

There are primarily five different ways we evaluate which bull you should be riding. Risk is defined as the possibility of loss. The people fleeing equities due to the recent economic unrest were not prepared for the losses they suffered. One of the ways IFA evaluates a person’s risk capacity is by assessing a person’s attitude towards risk. IFA’s investment strategy is built on the bedrock of buy and hold. In order to strengthen that foundation, it is vital to incorporate a person’s attitude towards risk in their portfolio selection. Without an understanding of your attitude towards investment risk, you are being set up to fail.

A long term investor who has a high Risk Capacity should be matched with a portfolio that is commensurate with that level. Historically, the more risk you take the greater your return. If an investor is willing to take a high level of risk, and they have the stomach to ride the wildest of bulls, they would be cheated out of exceptional returns if improperly placed in a low risk portfolio. Transversely, if an investor can’t handle high portfolio volatility and is put in a high risk portfolio, they will pull out of the portfolio, likely when it’s most disadvantageous. As has been discussed here many times, the emotions of active investors have a nasty habit of leading investors to trade at precisely the wrong times.

Another important aspect in determining your Risk Capacity is your knowledge of how markets operate. A person who knows the correlation between risk and return is more likely to ride the bull that’s a bit wilder. It is only through the knowledge that prices have all the information already baked into them, or the knowledge that willing buyers and willing sellers go to the market to agree upon a price for each security that you can look that bull straight in the eye and jump on without trepidation.

What does the downgrade of the U.S. credit rating from AAA to AA by S&P mean? The cost of capital goes up for the United States. This means the treasuries a person buys will yield a higher return because they are viewed as being riskier.

Many investors have been left reeling these last few days, contemplating their portfolio’s allocations. At IFA we encourage you to take our Risk Capacity Survey in order to optimize your investing experience. If you have never taken our Risk Capacity Survey, it can provide valuable information, and may shed some light on why you feel the way you do today as our economy remains in flux.

IFA Radio's Episode 83: Airs 7/31/11

IFA Radio — Thu, 28 Jul 2011 00:00:00 GMT

IFA Radio's Episode 82: Airs 7/24/11

IFA Radio — Thu, 21 Jul 2011 00:00:00 GMT

The Turn of the Tide

Is there change on the horizon? A recent article in Bloomberg Businessweek by Charles Stein details the disenchantment investors are experiencing with stock pickers. Mutual funds that invest in domestic equities have experienced a mass exodus of around $8 billion in redemptions this year alone through June 29^th. That type of loss has them closing in on an unprecedented five straight years of withdrawals. This is according to the Investment Company Institute.

But while investors are fleeing the active managers, index funds that invest in U.S. stocks have had a positive influx every year since 2001 according to Morningstar. This growing problem of people evacuating mutual funds appears to be sitting solely in the lap of the active managers. At IFA, we don’t see this as a problem. We view it as an awakening.

Articles like this one are rare indeed. In April 1999, an anonymous writer for Fortune magazine wrote, “"By day we write about "Six Funds to Buy NOW!"... By night, we invest in sensible index funds. Unfortunately, pro-index fund stories don't sell magazines." At IFA, we have active managers as clients. It seems as though they know the right way to invest, but alas, the right way doesn’t make them money.

The trickling of funds from active to index isn’t the only transformation taking place. According to the article, investors are also investing more of their assets in international companies. The problem is most investors don’t know which of these countries is the right one. Is Germany ready to take off? Is Brazil the next emerging market power? Have I missed the boat on China? Turkey? Argentina? If people can’t predict which way a stock will move in the U.S. with any certainty, why would anyone be able to do so with international stocks? Like domestic equities, international stocks have everything baked into the price. The price on international equities is agreed upon by a willing buyer and a willing seller, the same way domestic stocks are agreed upon.

Below are dynamic charts that shows just how random returns across various asset classes and countries actually are.

Borrowing the definition from a recent Vanguard study,

"Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances among different asset or sub-asset classes."

To put it more succinctly, TAA is simply market-timing but with only a set portion of the whole portfolio. For example, an institution may have an SAA of 60% equities and 40% fixed income, but utilization of TAA may allow the equity allocation to vary between 50% and 70% and the fixed income allocation to vary between 30% and 50%. This is equivalent to saying that 80% of the portfolio will have a 60/40 allocation while market-timing (or style-picking) will be performed with the remaining 20%. For institutional investors, TAA occurs at two levels: Investment consultants allocating funds among different asset class managers and investment fund managers allocating funds among different asset classes and sub-asset classes.

It is IFA's position that TAA is a futile exercise because market-timing and style-picking are unproductive at best, and potentially quite destructive at worst. TAA is merely one more attempt by active consultants and managers to deliver the ever-elusive alpha, which as shown in a previous article, has not been reliably achieved through security selection.

So while people continue to stumble in the dark through the active investing landscape towards the light that is passive, IFA will keep talking people home every step of the way. And fortunately, it appears people are beginning to walk towards the light rather than shielding their eyes from it.

IFA Radio's Episode 81: Airs 7/17/11

IFA Radio — Thu, 14 Jul 2011 00:00:00 GMT

The Verdict is In

When grading active managers it’s important to view them in the way we view our justice system. Much in the same way someone is innocent until proven guilty, it must be assumed managers have a lack of skill until proven otherwise. At the heart of this dilemma, one that IFA tries to help investors solve, is getting an investor in a position to determine whether an active manager has skill or not.

At IFA, we pride ourselves on our ability to identify these doubts for investors so they aren’t suckered into paying people to gamble with their money. Just like a jury better be sure someone is guilty, you better be sure they can beat the market.

As we discussed last week, simply taking an active manager’s word for it, and accepting their fund should be compared to a certain index, is not only dangerous, but it should leave you with a reasonable doubt as to whether they are beating their benchmark. It is imperative that one must run it through a 3-factor regression to identify the amount of exposure to the market, size and value risk factors. In doing so the investor can determine whether the mutual fund manager beat their benchmark due to being compensated for taking more risk, or if they beat their benchmark due to reasons that cannot be explained by exposure to the 3-factors.

When undertaking this 3-factor regression analysis, one very important quantity produced is the t-statistic of alpha which provides a measure of the probability the alpha could have occurred from chance alone. For the most part, a positive alpha with a t-statistic greater than two indicates a 5% or lower probability that the excess returns are due to luck. The interactive chart below has the formula for a t-stat of 2, based on return and risk values built into the chart. As you roll your mouse to a coordinate of return and risk, the line that highlights represents the number of samples needed to obtain a t-stat of 2. A data box representing each point on the line provides the 3 values for that position.

We recently conducted our own study of 602 US equity mutual funds with ten years of returns data. Our two requirements stipulated that at least 90% of the fund’s holdings be in US equities and the prospectus objective concur with the size/value style of the fund’s holdings (to minimize the impact of style drift). The results are shown in the figure below.

Although a few managers appeared to deliver alpha, we need to caution investors that because there are so many managers, it virtually guarantees there will be some who appear to have demonstrated true skill. Unfortunately, the number of such managers is no greater than what we could expect if all of them were monkeys throwing darts at the Wall Street Journal. With so few beating the benchmark, the question you must ask yourself is, “Why don’t I just buy the benchmark?” At IFA, we give you the opportunity to do just that.

IFA Radio's Episode 80: Airs 7/10/11

IFA Radio — Thu, 07 Jul 2011 00:00:00 GMT

“A Diamond in the Rough” is an expression used regarding something unsightly that turns out to be beautiful. Amongst other things, it is used to describe people, restaurants, athletes and of course investments. General Managers of baseball teams search for that breakout star with awesome potential, but may be a little rough around the edges. In the same way, active money managers search for stocks that are undervalued, but will end up surging faster than their corresponding index.

One accurate way to see if active managers have been successful picking out diamonds in the rough in the past is by measuring their alpha. Alpha is essentially a fund manager’s return above their fund’s benchmark return. That benchmark is typically an index of a comparable risk level to their fund. If a manager has an alpha of 1.0, they outperformed their benchmark by 1%.

The ability to determine if they are properly benchmarking their mutual fund against the correct index is a complex puzzle active investors must dig through. The question is if a money manager oversees a large-cap fund, how can it go about achieving a return in excess of its large-cap benchmark? It would have to take risks different from the benchmark. Now, occasionally (and as we would expect) a small handful of managers are able to beat their benchmarks through luck alone. Fama and French call this “unexplained” above benchmark returns, and found that about 3% of managers can make this claim. Understand, “unexplained” means just that. Another way of looking at that 3% is just pure luck of being in the right place at the right time. Caution, however, luck is not a repeatable skill.

The best way to measure a stock picker’s or fund manager’s success is to not simply compare it to the basic asset class or style that it has perhaps and ambiguously fallen into, but rather to run it through a 3-factor regression to identify the amount of exposure to the market, and to size (Small minus Big) and value (High minus low) to determine whether the mutual fund manager was simply compensated for the risks he took, or if he has some excess returns that cannot be explained by the exposure to the 3-factors. This is the true test.

As you can see, despite the fact that we would expect a small number of managers to, by random chance alone, deliver excess returns, diamonds in the rough are truly rare, indeed.

A recent article in the Wall Street Journal provides more daunting news for stock pickers. Over the first six months of the year, the average large-cap fund had a return of 4.52%. But the S&P 500 had a return of 4.96%. While this comes as no surprise for the passive investor, the active investors are a tad perplexed. Earlier in the most recent economic upswing, several active investors were complaining it was impossible to pick stocks due to the whole market churning along in unison, thus making almost all stocks closely correlated. But now that stocks are not holding hands running towards the finish line, and each are running the race on their own, investors still can’t pick the winners.

Active managers are handsomely paid for their speculation—a tough gig to let go easily, to be sure. Upton Sinclair’s comments should serve as an admonishment to manager pickers everywhere: "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

IFA Radio's Episode 79: Airs 7/3/11

IFA Radio — Thu, 30 Jun 2011 00:00:00 GMT

The late B.C. Roman Statesman, Marcus Tullius Cicero once said, “Time destroys the speculation of men, but it confirms nature.” This simple truth has never been as evident as it is with what we witness in the stock market. Speculation is defined as a guess or a message expressing an opinion based on incomplete evidence. In essence, it’s an attempt to tell the future. If a person could actually tell the future, and they could pick which stocks were going to take off and which ones were going to take a nosedive, why would they tell anyone? When a boxer is going to throw a fight, the people who know about it want to keep it secret. The more people who catch wind of it, the more worthless the information becomes. So you have to ask yourself, if stock picking gurus were really that confident in their picks, why would they broadcast it on the airwaves to millions of people? Unlikely. The more probable scenario is they would keep the information to themselves so they could maximize their profits. We wouldn’t even know who they were because it would be easier for them to operate in anonymity.

As Cicero points out, time destroys speculation. People typically don’t observe the long-term track records of stock picking gurus—and for good reason. Over the long term, these records are obliterated because they were a function of pure luck, not skill. Luck is not a repeatable skill, nor is it something anyone should invest in.

Just in case one questions this simple fact, check out cxoadvisory.com’s gurus section which provides data on stock picking gurus’ histories. Some are startlingly low with success as low as 23%. And although it wouldn’t be a very scientific study, a quick calculation of the average for the stock pickers who have a percentage listed next to them is about 48%. So as fair price contends, it appears they are right slightly less than they are wrong.

Cicero points out that time confirms nature. The nature of the market is one of efficiency and long term growth as shown over long periods of time. At IFA, we encourage investors to look at the nature of the market and time and invest in a risk appropriate blend of index portfolios.

IFA Radio's Episode 78: Airs 6/26/11

IFA Radio — Fri, 24 Jun 2011 00:00:00 GMT

“Where is the smart money being invested? Where can I invest my money and get nice, juicy 20% returns?” These are the burning questions so many investors lob at the experts day after day. Unfortunately, an investment with a 20% return is very, very, very risky. So risky in fact that 99.9% of investors probably wouldn’t want to hold onto it. The volatility probably resembles the results of a con artist taking a lie detector test more than the long term returns of a stock. Of course the 20% could be an investment someone has inside information on. But if you want to go down that road, I hope orange jumpsuits are in style this fall because that’s what you’ll be donning.

If there was an investment that could legally give you a 20% return with little to no risk, do you honestly think someone would sell it to you? If you were the owner of a small pharmaceutical company that discovered the cure to an incurable disease, are you going to sell that company? Maybe, but not until you have calculated the colossal expected return for the next 10 years into the asking price. And in factoring that return into the sale price, you have lowered the buyer’s expected return to zero.

Don’t expect to earn 20% because you swindled someone into selling you a golden goose investment, and don’t expect to earn this due to speculation. You are not Jack and those beans are not going to turn out to be magic. A massive 20% return comes from a massive amount of risk. When 20^th Century Fox and other investors greenlit “Avatar,” it wasn’t the no brainer it seems like now. Some reports had the movie costing upwards of 500 million dollars. At the time there was an inordinate amount of risk involved with the movie. It could have turned into another “Cutthroat Island” and lost people hundreds of millions of dollars.

So is there an asset class that can make astronomical returns? What if you were willing to take on the world’s wildest bull? Well the asset class with the highest historical return is Emerging Market Value. This asset class is made up of companies located in small or developing countries around the world like Indonesia, Hungary and Argentina that have large amounts of political instability, sometimes corruption, and even bad accounting practices. These countries build a large amount of risk into their companies making the price lower. But when these companies produce, the return, because of how much you spent to purchase them, is higher than that of a stable company in a stable country like Google or Apple. Even with all the risk corrupt governments, shady accounting, and anti-capitalistic regimes create, the 20 year return ending on 5/31/2011 was only 16.72%. But the standard deviation…25.88%. Compare that with the relatively safe US Large Cap index. The 20 year return ending 5/31/2011 was 9%. But the risk drops significantly down to about 15%.

It’s important you invest in the risk level that is right for you. At IFA, we match people with portfolios. We discover how wild of a bull you are willing to ride, and match you up with him. Take the Risk Capacity Survey now to find your risk level.

IFA Radio's Episode 77: Airs 6/19/11

IFA Radio — Mon, 20 Jun 2011 00:00:00 GMT

Each day, we hear the question: “Is the market going up, or is the market going down.”

There is no known direction of where the market is heading, and past movements have no bearing on future movement. Prices constantly change so that the future odds of the market direction essentially are the same as a coin flip. When we look at long-term data, we see that about 51% of the days are up and 49% are down. Back in 2008, when the market plummeted 37%, it was not a freefall all 365 days. In fact, there were 126 days of positive returns and 126 days of negative returns. It comes as quite a shock to people since most are under the impression the entire year was a bloodbath.

This little known tidbit ties into the current market modus operandi that has investors scattering as equities HAVE BEEN (note the past tense) pulling back as of late. But before you start pulling out of stocks, you should know how stock prices are determined. When a person decides they don’t want a stock anymore it doesn’t disappear from their portfolio and dwell in stock jail until someone else wants it.

Each share has a willing buyer and a willing seller. If you want to sell your share (s), you need to find someone to pay you for it. That’s why you go to the exchange. Multiply this transaction times the thousands of people trying to sell or buy the same stock at the same time, and a price point arises that is agreed upon by several different individuals, usually all very intelligent and very educated individuals. So with all these intelligent individuals with access to the same information making these trades, how is someone supposed to pull the wool over someone else’s eye? How do you fool a person when everything the world legally knows about a company is already baked in the cake?

Can one person fool another? Sure; even more than once or more people than one. But for a person to fool thousands of investors who analyze companies from every conceivable angle—this is highly improbable. Of course, there’s always inside information, but that is not a game you want to play unless you think jail is a good option for you.

One bad day or even a week doesn’t make a bad market—despite whatever CNBC might predict. Ever notice how they talk about “June gloom” or “dead cat bounces”? These may be catchy, but they’re otherwise nothing more than poor prediction or cheesy attempts to create a story where there is none. Our society tends to sensationalize things in all walks of life.

Consider what CNBC would do if they had no stories to sell, I mean tell…

IFA Radio's Episode 76: Airs 6/12/11

IFA Radio — Thu, 09 Jun 2011 00:00:00 GMT

Don’t just do something—SIT there.

Most people feel an overwhelming need to do something when they see the market going one way or the other. Unfortunately, most of these same people act on these impulses which runs contrary to the history of stock market returns. A Dalbar study showed that a person who invested in the S&P 500 for the last 20 years ending in 2010 would have made 9.1%. The average active investor? Well, they made 3.8%. To be clear, IFA’s strategy does not promote a simple buy and hold ONLY the S&P 500 index.

Contrary to what most active investors would have you believe, buying and holding the S&P 500 is not the road the intelligent, passive index investor takes. Quite the contrary. The S&P 500 is merely a group of American large company stocks. IFA’s strategy promotes wide diversification. For this reason, IFA’s portfolios are built with indexes from around the world. Our aggressive all equity portfolio made 11.69% over the same period, and an all equity portfolio at roughly the same risk level as the S&P 500 garnered 10.66%.

What’s the reason behind such an ill-fated approach? In a recent Barclay’s study covered by the New York Times, Greg B. Davies, the head of behavioral and quantitative finance at Barclays Wealth, said, “This trading paradox exists, to one degree or another, everywhere in the world,” and he continues, “Not everyone is prone to frequent trading, but among those who feel that they must trade frequently to do well, there is a substantial proportion who are troubled by their behavior. This is a novel finding for me.”

So not only do investors, even affluent ones, practice frequent trading, they actually feel guilty for doing so. On top of that, the affluent investors contradict themselves. The study revealed that almost half of the investors who said “you have to buy and sell often” to do well also said “I buy and sell investments more than I should.” How can you explain the apparent contradiction? I’ll give you a hint. IFA has a recovery program that helps cure it. The study found “the basic problem is that investors feel they need to engage in active trading, but they cannot then control how much they do it.”

At IFA, we are here to help investors control their emotions. The Barclays Study suggests delegating these decisions to others like a professional advisor. On our home page at IFA.com, we have a list of 14 things we provide our clients. The #1 thing at the top of that list? Emotions management! Reducing the temptation for investors to trade. What kind of results can this type of emotion management have? The proof is in the pudding.

IFA Radio's Episode 75: Airs 6/5/11

IFA Radio — Fri, 03 Jun 2011 00:00:00 GMT

Living on the Ledge

According to a recent article in the Wall Street Journal, public pension funds are slowly moving their money back into hedge funds. The idea behind a hedge fund is you will make good money in good markets and you won’t lose as much in bad markets.

We like to call them ledge funds because they fall off the ledge when a bad market hits. Many of these hedge funds are leveraged 5 to 1. This means when the market drops 20%, you lose all your money because the money owned by the investor is 20% as opposed to the bank’s 80%. Guess what happens when the fund drops 20%? The bank is liquidating the fund before any of their money gets flushed. Your share of the hedge fund is the first to leap off the ledge.

At IFA.com, Table 9-5 in Step 9 compares various types of private equity strategies for the period ending December 31, 2005.

According to the study, venture and private equity strategies did perform well for the most part. But, the premium relative to public securities appears rather small considering the higher risk, investment concentration, absence of liquidity, transparency and daily pricing.

According to the article in the Wall Street Journal, the hedge fund returns were 6.8% over the last decade. This article portrays the 6.8% return as if they are making a killing. But what if we were to take that same period and input it into our IFA calculator with our Emerging Markets Value index? The return is 22.36%. If you were to merely take one of our middle of the road Index Fund Portfolios like our Portfolio 50, it still beats these hedge funds over the same period while taking FAR less risk. Why would someone take an inordinate amount of risk to achieve smaller returns? Because they don’t have the data!

IFA Radio's Episode 74: Airs 5/29/11

IFA Radio — Fri, 27 May 2011 00:00:00 GMT

Buy the Beaten?

Is it a good idea to load up on bankrupt stocks? No. A recent article in Businessweek talks about the danger of buying bankrupt stocks and how people ignore the odds and hope for leftovers after all the bankrupt company’s debts are paid.

The article tells the story of an “investor” who decided to invest in the much maligned Blockbuster Inc. "It's a different category than normal risk," said Jon Becker. "If it's foreseeable shares would go to zero, I would think the powers that be would flash something—some kind of warning.” Mr. Becker’s rationale for rolling the dice on Blockbuster? "My thought was, this is Blockbuster, it will come back." Mr. Becker did sell his stock. He sold at 7 cents after buying it at 10 cents a share.

Joseph Schumpeter described capitalism as creative destruction. In his book “Capitalism, Socialism, and Democracy,” he says “Capitalism, then, is by nature a form or method of economic change and not only never is, but never can be, stationary.” Blockbuster was the place to get your videos. They were the giant that put all the Mom and Pop video stores under. They were the unrivaled king. But slowly, as the internet grew, someone got creative. In 1998, Reed Hastings founded Netflix, and the creative destruction of Blockbuster started to unfold.

Creative destruction illustrates the folly of stock picking perfectly. While Blockbuster was once a titan in the entertainment community, loading up on any stock is never a sure thing. Look at the chart below.

Out of the 500 companies in the S&P 500 in 1957, only 74 remained over four decades later. So how many of the original 500 beat the evolving S&P 500’s overall return? As you can see, only 12 companies were so fortunate. Never assume the investment you make will not go out of business. Look at the 10 biggest bankruptcies of the past three decades.

Imagine the thought of some of these mega companies going out of business just a few years ago. Lehman Brothers, Chrysler, Enron, WorldCom, Washington Mutual…No company is safe. But what if you were to buy the entire S&P 500; buy an S&P 500 index fund? What are the chances of the entire S&P 500 going under? It’s probably as likely as capitalism itself getting abolished. Both are almost virtually impossible. And let’s face it. If capitalism goes belly up, and communism takes over, your money will be worthless any way. So stop trying to pick stocks you believe will give you a greater return. Buy the market. It’s not going to go bankrupt.

IFA Radio's Episode 73: Airs 5/22/11

IFA Radio — Fri, 20 May 2011 00:00:00 GMT

"The investor's chief problem - and even his worst enemy - is likely to be himself."

-Benjamin Graham, "Security Analysis."
New York: McGraw-Hill Companies, 1934.

A new piece in the Wall Street Journal examines the recent trend of how investors are trading out of the hot growth stocks and into the safe, secure umbrella of utilities, healthcare and telecommunication stocks. Is it really time to move into the safe stocks? Is there a storm on the horizon that the “experts” see? While a storm may or may not be coming, the “experts” certainly do not know one way or the other. Truthfully, there is no way to know with any degree of certainty either way.

There are several reasons why jumping in and out of different sectors continues to be a bad idea for investors. Before an investor can even consider the prospects of one sector rising and one sector plummeting, they must first take into account the hole they will have to dig themselves out of by simply making the switch. First, in order to get out of these hot growth stocks and into the safe stocks, one has to trade. Brokers thoroughly enjoy charging extremely high fees for this. So the very act of launching this mislead transition puts someone in the red. Then there is the issue of capital gains. This bull economy has likely resulted in at least some gains for an investor who has spent any extended amount of time in the market which means taxes! Uncle Sam and the State Treasurer love active investors because it transfers more money into their pockets…which they have shown to be very adept at spending. And the short-term capital gains accrued by the active are the most delicious flavor for the government as they can be taxed as high as 40%.

It all harks back to people’s emotions handicapping their ability to make rational decisions as it pertains to their investments. People fear risk and try to avoid it at all costs. Yet risk is the source of returns. People packing into these safe stocks and jumping out of hot growth stocks exhibit an emotional response to what should be a rational decision. Investors want to feel comfortable while receiving high returns, but as Robert Arnott once quipped, “In investing, what is comfortable is rarely profitable.”

One of the foundations of capitalism is an investor should be rewarded for taking risk, not avoiding it. So it stands to reason, if an investor thinks the hot growth stocks are a bad sector to be invested in, and they scramble to get out, who is the buyer of the sector they are unloading? Someone who is willing to take risk because it provides the prospects of a higher return.

If you click on this link, you will come across a section of our website entitled, “Active Investors Lose.” In this section, we highlight the behavioral gap between what the average investor in a fund earns and what the fund itself earns in a given period. It is easily one of the most abstruse lessons we need to teach our clients or perspective clients. Charles Trzcinka, a Professor of Finance at Indiana University put quite succinctly what the effects of these emotions have on investors.“The sheer magnitude of the difference we discovered between the total returns earned by funds and the results captured by the average shareholder is shocking and tragic." [over 4 years: Funds = 5.7%, Investors = 1%]

As you can see, the emotional pendulum of the active investor seemingly swings the wrong way at the wrong time. So ill-timed are the emotions of the active investor, one has to wonder why they continue to invest at all? Investing does not need to be an emotional, gut-wrenching experience to be sure. It simply takes a willingness to do the research and realize the best way to invest is to relax while doing it.

IFA Radio's Episode 72: Airs 5/15/11

IFA Radio — Thu, 12 May 2011 00:00:00 GMT

“Now is the time to invest in stocks!”

“Now is the time to get out of the market and buy T-Bills!”

With our airwaves disseminating a 1,000 ingredient casserole of financial opinions, it can be quite difficult to differentiate which signs a person should look for when deciding on what to do with their investments. The problem is at any given time, you can have tons of “signs” to get in the market, or tons of “signs” to run for the hills.

DFA’s Weston Wellington was recently on IFA Radio giving his frank and enlightening take on the market. Being in the investment business for 35 years he said, “I don’t think I can recall any time when there wasn’t something to get either positive about and get excited about investing, or something that was negative and make it very apprehensive to be an investor. And this time is no different.”

Weston talks about some of the negatives that have been plaguing the market over the first few months of 2011. “Looking over the course of the events in just the first few months of this year we’ve had skyrocketing prices for oil and gasoline as anybody with a gas tank can attest to. We’ve had gold prices going up sharply. We’ve had housing prices plunging. We’ve had countries like Portugal apparently unable to pay their debts, and we’re even hearing about a possible shutdown of the US Federal Government as politicians argue about how to solve our budget problems. We’ve had a distressingly persistent high level of unemployment at home and in many other countries around the world.”

But Wellington continues with the contrasting positives that can be ascertained by dissecting the news. “But at the same time we’ve seen retail sales generally perking up at even stronger than expected levels. We’ve had any number of industrial companies, particularly in the manufacturing area, recovering very smartly. We’ve seen huge, very economically sensitive companies, like the big railroad firms…Union Pacific, CXS Systems…substantially increasing their dividends; reporting big profits. Many of the traditional ‘Steady-Eddie’ companies, ya know, Exxon, Johnson & Johnson, Procter & Gamble; the long list continuing to raise dividends as they have for many times 30 and 40 years in the past.”

What’s Wellington’s conclusion? “So when you try to put it all together, there is always some good news that seems to be worth focusing on and some bad news worth focusing on. And sorting it all out, year-to-date, a broadly diversified equity portfolio is up about 7%. So if you’d taken a nap starting on January 1^st and just woke up and looked at your portfolio performance, you’re probably wondering what all the stress is about.”

Invest and Relax? How can one just “take a nap” with their financial future? Well, capitalism has a long history of behaving precisely how Weston Wellington portrayed on our show. There is good news. There is bad news. But over time, capitalism drives upward. By picking stocks or jumping in and out of the market, you aren’t siding with capitalism’s long track record of success. You are siding with the crowd that believes capitalism is flawed and does not work. How is that crowd doing?

They seem to be lagging behind a tad. Stop trying to beat capitalism. Own capitalism with a well diversified blend of index funds. Maybe once people realize history has shown capitalism to be an unstoppable force, active traders will stop aspiring to be the immovable object.

IFA Radio's Episode 71: Airs 5/8/11

IFA Radio — Thu, 05 May 2011 00:00:00 GMT

Milestones Abound

Recently IFA has reached an astounding milestone. Since the company’s inception in 1999, Index Funds Advisors reached $1.5 billion dollars in assets under management. With the majority of IFA’s existence occupying what has been called the “Lost Decade” by most investing pundits, how was IFA able to grow at such an exponential rate?

IFA has taken the approach of emphasizing education. Education through a comprehensive website; education through a beautiful book. While sales has certainly been a part of it, a superb investing education allows our investors to understand the process through reams of academic research, time-tested data, and artistic representations of the different aspects of the market. Our clients get this education before they make the decision to let us guide them through their investment lifetime.

Another important milestone is the Center for Research in Security Prices (CRSP) is celebrating 50 years. The reason this is so vital, not only to IFA, but also the investment community at large, is because it is through the research of CRSP the investing community has a preponderance of quality data chronicling the market’s past. While some investment companies tend not to care or pay attention to this data, IFA uses it to ascertain the future risk of investments. The larger the data set, the more comfortable someone can be when assessing the probability of returns for a security. CRSP provides so much data, they are a veritable treasure trove of investing knowledge.

The thing the investors tend to overlook the most is getting a large enough sample size to determine the expected return and the uncertainty of that return going forward. Back in 1959 they did not have a way to figure out what the returns of the stock market had been up to that point. So the University of Chicago took 3 years collecting and cleaning up the data of all the stocks movements from 1926-1960. They estimated that between two and three million pieces of information were entered onto magnetic tape.

After all that research from 1926-1960, they figured out the average return for equity investors was around 9 ½%. Now, what if you were to take the data from 1926 and bring it all the way to today? The average return for an equity investor is still hovering at around 9 ½%.

CRSP continues to accumulate data on a regular basis. With a $180,000 grant from Dimensional Fund Advisors in 1984, data dating from January 1972 from NASDAQ markets was added. "If I had to rank events, I would say this one (the original CRSP Master Fuel) is probably slightly more significant than the creation of the universe," said Rex Sinquefield, former co-chairman and current director of DFA. "The entire field of finance has been changed and developed through that database."

But while CRSP gave us a tremendous amount of information, the 9 ½% return of equities points out a depressing thread throughout the history of the market. In a 20-year Dalbar study ending in 2008, it was determined the average equity investor only gained 2.2% of the S&P 500’s gain. Because investors jump in and out of the market at typically the most inopportune times, that easily attainable 9 ½% ends up being pie in the sky for most investors. This is why it is so important to invest in capitalism through a portfolio of index funds, and to stay in that portfolio through the ups and downs of the market.

IFA Radio's Episode 70: Airs 5/1/11

IFA Radio — Thu, 28 Apr 2011 00:00:00 GMT

Big or Small, You Need Them All

Over the history of the stock market, small company stocks have provided a larger return than large company stocks.

Recently, Jonathan Cheng wrote an article in the Wall Street Journal called “Are Small Caps Too Pricey?” In the article, he unveils what he perceives to be a growing trend: “The market's smallest stocks are commanding the largest premiums—and some of their biggest fans are becoming alarmed.”

So should investors be forsaking small companies and jumping head first into the S&P 500? Not hardly. Investors must remember is to stay diversified. In the short term, we have no idea which asset class will be the next winning style. This is well covered in Step 6 in our 12-Step program, “Style Drift”. Just like stock picking, trying to concentrate your assets into a specific sector based on “gut feelings” is once again speculation.

The fund company we overwhelmingly recommend to our clients is Dimensional Fund Advisors (DFA). At DFA, their entire company is founded on the preponderance of academic research that small companies are riskier than large companies, and therefore have a higher expected return over time.

At IFA.com this page breaks down the different dimensions of stock returns. What you learn is for investors to get those juicy returns they must sit through higher volatility. There is no free lunch in investing. The lower the risk, the lower the expected return; the higher the risk, the higher expected return. You can either look at the reams of academic research and statistical data supporting this fact, or you can just use logic and common sense: Why would someone sell you an investment that would deliver a high rate of return with little to no risk? They wouldn’t. They would keep it for themselves.

Going back to DFA’s philosophy that small companies outperform large companies over time, look at the chart below.

As you can see, the smallest companies (the companies occupying the smallest 10% as it pertains to size) over the history of the market have a significantly higher return than the largest 10%; over a 4% difference in fact. But look at the standard deviation (or risk). The smallest companies carry over twice the standard deviation of the largest companies.

So the response to Jonathan Cheng telling us to bail on small companies is this: No! You need small stocks in your portfolio. You need to keep your portfolio diversified. In the end, the question one should really be asking themselves is, “How conceited is Jonathan Cheng for thinking he knows more than the millions of traders who have agreed on a fair price for these small companies?” The harsh reality is he is simply guessing. Throwing his money down on a number on a craps table; hoping the dice don’t come up snake eyes. And if they do, no one will remember. But if he hits it big, don’t worry, he’ll be sure to remind everyone.

IFA Radio's Episode 69: Airs 4/24/11

IFA Radio — Sat, 23 Apr 2011 00:00:00 GMT

The Risk You Take Determines the Return You Make

The first thing anyone thinks about when they are ready to invest is the return they will be receiving on that investment. But where does that return come from? How is the amount determined? By focusing solely on the return, you are putting the cart before the horse. The first thing one should focus on is the risk they are willing to take because it is from that risk the returns are derived.

Investing is all about risk.

In Step 10 you learn what you have to do in order to quantify how much risk is right for you. By taking the Risk Capacity Survey, you learn how your views and tendencies line up with the Five Dimensions of Risk Capacity. The Five Dimensions of Risk Capacity are:

TIME

What is your time horizon? How long until you will need this money? How long can you leave it in the market? Those with a small time horizon are likely to take less risk than those who have a long time to invest.

KNOWLEDGE

How well versed are you in riskese? How familiar are you with the mountains of academic research proving active management does not work? A good understanding of these things will make you more likely to resist trading.

ATTITUDE

What is your attitude towards risk? How much of a loss could you stomach and still sleep at night? If you are a risk taker, you will likely be placed in a higher portfolio than those who are more conservative.

NET INCOME

What do you make? What does your spouse make? Your ability to accumulate money may shift the amount of risk you have to take in order to achieve your financial goals.

NET WORTH

How much do you already have right now? If you are starting off with very little or quite a bit of money, it could shift you one way or the other down the risk capacity scale.

Through these five dimensions, we are able to match you with the risk exposure best suited for your risk capacity. Those who accept a greater amount of financial risk have a greater expected return over an appropriate holding period. Risk exposure describes the 100 different levels of risk our investors can invest in. And within those 100 levels we have made it possible to invest in environmentally conscious or socially responsible companies, matching you to not only your risk capacity, but your values as well.

Once you have figured out your risk capacity and matched it to a portfolio with the proper risk exposure, you are able to invest and relax.

IFA Radio's Episode 68: Airs 4/17/11

IFA Radio — Sun, 17 Apr 2011 00:00:00 GMT

The Prediction Addiction

The idea of the 12 Steps came from a great deal of research in the late 1990’s. Mark was floored by the mountains and mountains of evidence that was freely available to the general public; overwhelming evidence that active management does not work, and in reality, it does more harm than good through high fees and emotional reactions. Why are these smart people…people who often graduated with honors from Stanford or Duke or prestigious Ivy League institutions…trying to time the market, trying to pick individual stocks, trying to drift in and out of styles? What drives people to practice this type of behavior?

Well, since the price of a security at any given time is usually set at a fair price, it is a 50/50 proposition that the stock will go up or down in the future. In Las Vegas, the reason they have betting lines on sports teams is one team is usually better than the other so in order to make it close to a 50/50 proposition, one team gets points. Mark concluded that at the heart of this inconceivable behavior there were varying degrees of a gambling addiction. Like all addictions, one of the best ways to navigate through its debilitating grip is through a 12 Step program.

"By far, the most gambling performed in the world is performed in the stock markets," said Paul Ashe, president of the National Council on Problem Gambling. And Marvin Steinberg, a psychologist specializing in the treatment of compulsive investment gamblers, said, "More money is lost in the stock market than in legal and illegal casino gambling combined."

Jason Zweig of the Wall Street Journal wrote a fascinating book called Your Money & Your Brain. In the book, he teaches us that “scoring” financially is almost indistinguishable from scoring a hit off of an addictive.

If you practice any of the active management traits listed in the 12-Step program, you should stand up right now and say, “My name is _______, and I’m an active investor.” It is the first step towards a better investment experience.

IFA Radio's Episode 67: Airs 4/10/11

IFA Radio — Thu, 07 Apr 2011 00:00:00 GMT

Recently Dan Solin wrote a fantastic article about IFA’s new Monte Carlo Simulation. For most people, the words “Monte Carlo” are synonymous with where gamblers come to play; be it the glitzy resort on the Las Vegas strip or the picturesque city on the Mediterranean Sea in Monaco.

But for people in the financial world, the words “Monte Carlo” are synonymous with a simulation used to figure out odds using past data sets. At IFA, this method simulates 10,000 portfolio outcomes an investor may experience based on 83 year or 50 year historical risk and return data starting from one of 100 IFA Index Portfolios, with a Glide Path option.

When planning your retirement, it’s important for you to take into account the wide range of possible outcomes that are based on the large historical datasets provided by the stock market’s history. With the crash of 2008, so many investors pulled out all their money as the market dropped below 10,000 and never got jumped back in until recently, essentially losing 1/3 or more of their portfolio. Too many Americans are now left with the possibility of outliving their money.

I would urge you to go to IFA.com and click on the 4th button on the top row of the navigation bar entitled “Retirement Analysis.” This will take you to our Monte Carlo Simulation page where you fill out all the pertinent information. We will contact you with your analysis. Once you get your results, you will be able to see why it is important to look at the big picture (50 or 83 year data), not small increments of time when trying to figure out your portfolio’s long term future.

Small increments of time can be very deceiving. Let’s take a look at the first quarter of 2011. Stocks did very well, up about 6% for the 3 month period. What was the news that drove stocks higher?

Severe unrest in Egypt leading to an overthrow of a president who had been in power for three decades
Unrest in Libya leading to a NATO coalition sending in fighter jets
A catastrophic earthquake strikes Japan, resulting in an even more catastrophic tsunami and a potential nuclear disaster; the damage done is already being dubbed the most expensive in history, to say nothing of the tragic loss of life
Oil prices shooting through the roof
Debt crises in multiple European nations
Gridlock in Washington with a very real threat of government shutdown

If I would have alerted everyone that all those things were going to happen over the next three months back on January 1^st, 2011, people would have been scratching and clawing to get out of the market as fast as they could…and come March 31, 2011, they would have missed out on about 6% return.

The market goes up and down over such a large myriad of issues; no one can predict its future fluctuations with any certainty. That is why it is important to buckle up and hold on, so as the rollercoaster that is the stock market dips and dives and twists and turns, you are there in the end to reap the returns of capitalism.

IFA Radio's Episode 66: Airs 4/3/11

IFA Radio — Fri, 01 Apr 2011 00:00:00 GMT

Index Funds Day

April 1, Index Funds Day, is the ideal time to draw attention to the differences between active investment management and indexing – to illustrate why it is a fool's game to think one can outperform a market average or index given the unpredictability of news and randomness of stock market prices.

A consortium of top fee-only financial advisors, with almost $2.5 billion under management, has formed an alliance to declare April 1 Index Funds Day, and to expose what they believe is the biggest hoax played on investors every day – one to rival the BBC's 1957 Swiss Spaghetti Harvest hoax. The active money management "you can beat the market" hoax, however, is far more dangerous because it has fooled investors into thinking that their money managers can beat the market by forecasting the next news story that will move market prices. The fact is, news is random and cannot be predicted. Likewise, stock price movement is volatile, so picking stocks is largely a matter of luck, and success cannot be sustained over time.

Led by Mark Hebner, founder of Index Funds Advisors, Inc., the alliance is using this April Fools Day to showcase the foolishness of stock picking over index funds. Hebner points out that decades of research by top academics and Nobel laureates in the country continue to prove that index funds, which are based on efficient market theory, will preserve and enhance an individual's portfolio over the 30 to 50-year average investment lifetime. This is in direct contrast with stock picking which may deliver good returns in the short run but seldom, if ever, over time.

Consider this – research has shown that only 3% of active managers beat an appropriate index over a period of 10 years or more. In fact, Dalbar Research's 2009 Investor Behavior report showed that the average equity investor earned 1.87% a year, a sharp contrast to the 8.42% annualized return of the S&P 500 Index. This paltry return for the investor was actually -0.97% when inflation adjusted (inflation = 2.84%), and even worse if one considers that taxes owed on actively managed funds equal about 2% of the fund value. Do the math, it isn’t pretty.

Efficient market theory coupled with a careful matching of risk capacity and risk exposure, are the keys to successful investing, not speculation, Hebner notes. Active investors need to be aware that the expected long-term return on speculation is zero more often than not, minus their costs, which include commissions, management fees, margin costs, stock randomness and more.

History has shown that a diversified, tax-managed small-value-tilted portfolio of index funds will have better results than actively managed investments, which are higher risk and deliver lower returns over a portfolio's lifetime. Why is this important? Because close to 90% of individual investors actively manage stocks they pick themselves or they buy mutual funds where stocks are picked for them.

Most active investors don't think that gambling on tomorrow's news can be hazardous to their wealth, nor do they think seriously about the risks and costs associated with playing the market. They don't understand the free market principles that are the cornerstone of capitalism, or the important role that diversification plays in reducing the uncertainty of expected returns. Concentrating investments in one industry or country only adds risk and does not increase returns.

IFA Radio's Episode 65

IFA Radio — Fri, 25 Mar 2011 00:00:00 GMT

Playing the Odds

When it comes to retirement, too many people across this country are playing a game of roulette. A broker walked into their company’s 401(k) meeting one day with a claim similar to, “Put away 5% of your paycheck and you’ll be a millionaire by the time you retire.” Sounds great, but what are the odds of your success? As Gary Belsky says, “Odds are, you don’t know what the odds are.” Do you have any idea how you will be able to live in retirement? Do you know the chances of running out of money before your retirement is over?

What about Inflation?

A recent survey found only 72% of pre-retirees and 55% of retirees are calculating the effects of inflation on their retirement. It’s a startling statistic, especially considering all the speculation being bandied about as it pertains to hyper inflation.

It’s confusing for investors because it seems almost unfathomable that a $45,000 withdrawal at the beginning of their retirement may need to be $200,000 by the end in order to maintain the same purchasing power. Most of the retirement planning software available does take inflation into consideration. Unfortunately, the investors typically don’t sit down with an advisor to figure out what it means to them. They need an analysis that takes into account several factors including amount saved, age, current annual income, and other pertinent factors.

IFA is pleased to announce that it has a retirement analysis available that looks at the vital factors of a person’s retirement. At IFA.com, on the top bar of our navigation menu, there is a Retirement Analysis button that will bring you to our Monte Carlo Simulation.

The Monte Carlo Simulation Method produces thousands of estimated portfolio outcomes (adjusted for inflation) that an investor may experience over a designated period. Each of these simulations is an investment lifetime of normally distributed random returns. The scenarios are presented in terms of statistical probabilities by using random number generation from 83 or 50 year periods of historical data sets and assumptions provided by you, the investor. These assumptions include such things as your age, household income, expected retirement age and what portfolio our Risk Capacity Survey placed you in.

When the simulation is compiled and analyzed, you will have a report that gives you the probabilities of a successful retirement based on the history of the stock market and your assumptions. If the results are not what you hoped, it will allow you to tweak your assumptions in order to figure out how to get your retirement back on track.

One common theme I see in all retirement analysis is none of them are including the superior Dimensional Fund Advisors (DFA) funds. The analysis says nothing of a small-value tilt in International, US or Emerging Markets, and it says nothing of our recommended mix of short holding periods for bonds. With the help of DFA, we have now constructed a methodology to obtain a quality analysis built on the superior portfolios of DFA. This allows you to see where your retirement is heading, and where you may need to make some tweaks along the way.

IFA Radio's Episode 64

IFA Radio — Thu, 17 Mar 2011 00:00:00 GMT

It is Always the Right Time to Invest the Right Way with the Right Advisor

Indexing is on the rise—and for good reason. Exchange traded funds (ETFs) and easy to own Vanguard index funds have made indexing accessible to individuals. Back in the day, indexing was only feasible for big institutions.

While indexing permits individuals the ability to buy a market in a low-cost way, the attempt to time markets still plagues investors—causing them to underperform the true buy and hold approach. John Bogle has admonished investors on several occasions: “Don’t forget the hold.”

Sometimes, investors buy ETFs because they want to hop on the next hot country or sector, they are completely missing the point—and the benefits—of purely passive index investing. The key to index success is broad diversification that amounts to an investment in global capitalism in accordance with your risk capacity. From there, buy, hold, rebalance and tax loss harvest. (Tax loss harvesting will help to ensure that you get to keep more of what you earn).

Click here to see how tough it is to time markets, industries and countries: Can you find the next big winner?

So, broad diversification is key. But, even die-hard indexers can struggle with the temptation to sell amidst the plethora of seemingly smart people who warn of troubled times ahead—times which they say may wreak havoc on an investor’s ability to profit. Today’s current crisis is a very telling example: Japan’s nuclear crisis has just been labeled “Grave”. Potassium iodine pills are sold out in many areas of California. Oddly enough, as this article is being written, the DJIA is up 106 points. Why is this? Because everything we know about the world, the economy, the price of oil, the situation in Libya, the crisis in Japan, etc., is already baked into the Price Cake, making the current price the best estimate of a share’s value. This means that the best time to buy is when you have the money, and the best time to sell is when you need the money.

A recent article in the New York Times entitled, “When to Buy or Sell? Don’t Trust Your Instincts” describes a study by Philip Z. Maymin. It shows the brutal impact of following the “gut”. The study affirms the findings of this IFA article which details the true value of the right financial advisor. Which investment recommendations the advisor makes matters, but not nearly as much as the advisor’s ability to advise their clients through very troubled times—the type of times that can be so gut-wrenchingly painful that the personal need for flight is pulling at their every fiber. Borrowing from Ulysses, we refer to this sort of “hand-holding” as tying our clients to the mast and protect them from the Siren Songs of active trading. The study sheds light on how destructive the behavior can be, and why you need a passive investment advisor who actively pursues your best interests for successful investing.

Passive Investors Need Active Advisors

Just because an advisor buys, holds and rebalances investments does not mean that they should invest client assets and hit the green—not by a long-shot.

At IFA, we know it takes a whole lot of trust, time, analysis, and commitment to ensure our clients can truly invest and relax. A passive strategy is relatively simple, but adhering to it over the long haul is certainly not easy. We know our clients are human beings who are not wired to “don’t just do something, sit there.”

Some passive advisors may be too passive about their own clients, failing to realize the full negative impact of the emotional trigger—the one that says “Fire! Ready, Aim.” They might say, “With my passive approach to investing, there is no need for hand-holding.” As a result, they likely make little, if any, investment in infrastructure to implement accounts with minimal mistakes, or generate the rigorous analysis that goes into calming the concerns of clients. At IFA, we know this effort results in data that can literally talk clients out making impulsive decisions they may regret later.

Some passive advisors may be blasé about the importance of investing in technology and client management systems that they run their business from their homes, as one-man operations whose doors close completely when they take a vacation, or heaven forbid, become ill.

At IFA, we know from experience that investors appreciate and need the ability to pick up the phone and have a real conversation with an advisor; to express concerns, new developments in their lives or share ideas. Every client has their own advisor to stay with them through the ups and downs of the market. And every advisor has a team of highly skilled professionals supporting them. At IFA, we match our clients with portfolios, we provide rigorous data to support the advice we give, and we are there for them every step of the way.

IFA Radio's Episode 63

IFA Radio — Thu, 10 Mar 2011 00:00:00 GMT

Go Big or Go Home? Not Necessarily with Stocks

Recently, money has started to flow back into stock mutual funds. The interesting dynamic to this flow is the propensity for investors to dump most of their assets into large companies, also known as large-growth stocks. At IFA, we construct our portfolios around the idea that small companies and value companies produce higher returns over the long term. That idea is the premise of the Fama/French asset pricing model. So is there something the general public doesn’t know?

Gary Belsky and Thomas Gilovich co-authored a book called “Why Smart People Make Big Money Mistakes.” In it, they explain that foolish and costly money mistakes are the result of this simple truism: “Odds are you don’t know what the odds are.”

True enough, investors don’t really know, let alone, understand the types of bets they make on the market. Shoveling money into large company stocks like those in the S&P 500, means that an investor is making a bet that now is a good time to invest in large companies.

The chart below allows you to interactively compare IFA indexes during different rolling periods. The chart begins on small value vs. large growth. Click on the LC (large cap) and SC (small cap) buttons (the 1^st and 3^rd button across the top). Then go to the bottom left and click on the 83 years button.

Over a short one-month period, it’s nearly a 50/50 proposition -- essentially a coin flip. But, when longer time periods are examined—as much as 83 years—we see that 80% of the time small cap does better than large cap.

Think of the stock market as one big casino. Gamblers would not darken the doorstep of a gaming casino if they only had a 20% chance of winning every game, but when the odds are close to 50/50, gamblers start to feel that they have a real chance at beating the house. Over time, however, the house’s slight, but constant edge compounds, creating an enormous gap. This is precisely why it’s important to not get caught up in the moment.

There was an article recently on Market Watch entitled, “The Four Most Dangerous Words in Investing.” The article is referring to the words, “It’s different this time.” When you really understand how markets work, this phrase loses its substance (and fear factor). Back in the 1960’s, Eugene Fama emerged on the scene with his Efficient Market Hypothesis, drawing from the Random Walk Theory. Markets collect a wide, diverse set of information from a wide, diverse population around the world. All of this information is quickly digested and embedded into the price. This means that, at every step along the way, the markets are absorbing and incorporating every piece of information, every nuance that has been uttered and every analyst report or whisper number that has been uttered. There is no opportunity for a cataclysmic market to arise from old information. The only thing that can create such a huge shift is the news that has not yet been known because it has not yet happened. Case in point, the horrific events that we have all watched unfold in Japan have had a significant impact on the global markets. The market has been incorporating the news as it continues to unfold, and the markets are continuing to price the risks associated with investing against the backdrop of the news we are witnessing.

IFA Radio's Episode 62

IFA Radio — Fri, 04 Mar 2011 00:00:00 GMT

Investors really want to do what feels good. As much as we hate to say it, risk does NOT feel good. Portfolios have dropped 30-50% for a lot of people depending on their asset allocations. That hurts. But the reason these drops happen is the same reason you get returns from investing: you EARN them by bearing risk. There’s going to be some pain that comes with the gain. There is no free lunch in investing. If there was no potential for loss in an investment, who would be stupid enough to sell it to you?

Warren Buffett’s mentor Benjamin Graham once famously said, “The investor's chief problem - and even his worst enemy - is likely to be himself.” Their emotions rule how they will invest their money, and unfortunately for most, that emotion runs counter to the stock market. They buy when they “should” be selling, and they sell when they “should” be buying. You should buy whenever you have money and sell only when you need money.

A lot of the investors who are gobbling up equities right now are those who unloaded their portfolios in late 2008 or early 2009. Of course, the problem with this is the people doing this sold off their portfolios real low and are now buys the stocks again as they approach their peak. They miss all the returns in between. These three charts are perfect example of the emotional swings of investors and how they usually run counter to the reality of the market itself.

Money Magazine recently talked about spotting some tell-tale signs of a bad investment. One of the sure fire ways to find one is if they tell you it’s a little riskier, but provides a much larger return. This is impossible since return is directly correlated with risk. You can’t increase your risk a little and your return by a lot. If someone tells you about an investment and your pulse increases, it’s likely a bad sign because that is a natural reaction of your body when it feels it has found a way to cheat risk. Do you think that’s an exaggeration? Check out these brain scans.

Investing in a passive manner provides freedom from stress, anguish and the panic of active investing. It’s easier to keep your emotions in check once you have learned the truth about returns. Remember, indexing is not a magic bullet. It also does not have the sizzle that active trading flashes around. But it does have the steak.

IFA Radio's Episode 61

IFA Radio — Fri, 25 Feb 2011 00:00:00 GMT

IFA Radio's Episode 60

IFA Radio — Fri, 18 Feb 2011 00:00:00 GMT

It Seems We Need Insurance for Insurance

“These [index annuities] have really high hidden fees. That’s why they’re terrible for older people even though they’re peddled to them.” That’s a pretty damning statement on indexed annuities—even more damning when it comes out of the mouth of Kent Smetters, a former U.S. Treasury Department economic policy official.

Why do people buy annuities? Mostly because people (unsuspecting, believing people) are sold annuities. The insurance industry positions annuities as a safe, easy way to get money. However, the cost of buying them is quite high, the lock-down provisions are quite strict, the penalties seem punitive, and the returns? Nothing too special.

A recent Bloomberg article described a retired teacher who put roughly $1 million into index annuities. The annuities delivered a 3% from 2003-2008 while the S&P returned 6%. Commissions on such instruments can be as high as 12%. A lock down provision prohibited her from accessing her own money without a 15% penalty off her existing balances.

An independent study by William Reichenstein examined historical returns on four equity index annuity contract designs and 13 contracts for 1957–2008, the period since the S&P 500 began. None of these contracts could match returns on one-month Treasury bills.” So the one month T-Bill, the quintessential short term investment, did better than the four index annuities observed.

IFA Radio's Episode 59

IFA Radio — Fri, 11 Feb 2011 00:00:00 GMT

Of Mutual Fund Accolades and Ripped-Off Investors

Barron’s released their best mutual funds of 2010. To the surprise of quite a few people in the industry, Dimensional Funds finished in the top ten. "What was important last year was to stay fully invested," explains David Booth, chief executive and co-founder of DFA. "We take diversification very seriously. We tend to be more global than other fund families. We emphasize small-cap and value stocks globally, and in emerging markets. Those factors paid off last year." Each year there will be a small handful of money managers waltzing with Lady Luck. Unfortunately, Lady Luck is a finicky maiden who chooses her partners randomly. Therefore, we do not know who the hot-handed managers will be from year to year.
Dan Solin’s blog “Miracle on Wall Street” tells of a widow who had just $315,000 to last her the rest of her life, so she told the broker not to engage in any risky investments. So, the broker felt he had the perfect investment option for her, and he convinced her to place 50% of her assets in one stock: G.M. preferred. This stock lost about 80% of its value leaving the woman in dire straits. She attempted to sue her broker, but mandatory arbitration provisions subjected her to an industry tribunal. While she was able to recover some of her losses, the costs of lawyers and other fees along the way robbed her of a significant slice of her retirement assets.
The standard deviation for a single stock where the broker placed that poor widow is 40%! The highest standard deviation we would put someone in is around 20%, and that’s a portfolio of all stocks with no fixed income.
Dan Solin and Eddie O’Neil conducted a study that covered 10,000 arbitration awards over roughly a 10- year period. If a major brokerage firm is sued for more than $250,000, the most statistically likely award is approximately 12% of expressed damages. Almost assuredly, plaintiffs will not be adequately compensated for losses no matter how egregious the broker’s practices were. Work with a fiduciary who will put your best interests above all others—even his own.
Need another heartbreak? A broker allegedly bamboozled a conservative investor who was invested exclusively in bonds. The broker recommended the investor use the bonds as collateral (buying on margin) and buy stocks with the proceeds of the loan. The stocks went down and the equity of his account plummeted from $3.6 to $1.3 million. The broker turned his account over a mind-boggling 30 times – racking up $807,000 in margin interest and $500,000 in commissions. The panel gave him a decent award, but it was nowhere near the place where he should have been.
If we were to take his $3.6 million over that same period and put it in an Index Portfolio 40, and glide path it so it went down an index portfolio every year, his ending balance would have been $5,047,983.59.

Click here to see the calculation.

IFA Radio's Episode 58

IFA Radio — Fri, 04 Feb 2011 00:00:00 GMT

Fair Prices & Nobel Prizes—Another Great Week for Capitalism

What makes prices fair? When you go to buy something, you likely ask yourself, “Am I paying a fair price?” How can you tell? The stock actually makes this really easy. Consider this: For every willing buyer there must be a willing seller. Buyers don’t want to pay too much and sellers do not want to accept too little. So, when transactions occur, sellers and buyers are coming together to agree upon a mutually agreeable price that factors in everything that is known about a company. Every analyst report, every competitive threat, balance sheets, the local and global economy. If you multiply that times all the millions of willing buyers and willing sellers around the globe for a particular security, you are getting it at a fair price – the free markets ensure this. Do you think tons of people are knowingly allowing themselves to be ripped off?
From the fair price, a security is just as likely to go up as it is to go down around an appropriate number for an investment. What does that mean? It means that prices are set so that the next price has an equal probability of going up as it has of going down. Again, fair price.
What about hedge funds? Those super secret, super cool sounding investment pools that tell the world you have “arrived.” Arrived at what??? is the main question. It turns out that hedge funds can be really big gambles for really big suckers. Out of luck alone you will find huge hedge fund winners. Like in Vegas, the bigger the bet, the bigger the winner. But the other side of that coin is the bigger the bet, the bigger the loser. Want the real story on hedge funds, check out http://hf-implode.com/ . Instead of reading solely about hedge funds who bet big and won big in publications like Forbes or Fortune, study the cold hard truth behind these glorified crapshooters.
Here’s a great tip for the day (and every day): Invest in capitalism. On average, companies make profits. The profits are the driving force behind the market’s steady climb over the last 83 years. By buying low-cost, globally diversified index funds, you own capitalism. By the way, the markets are priced to have a positive expected return every year. That doesn’t mean that you always get that positive return, but the expectation is always there, and on average, capitalism has rewarded investors, on average, about 9% a year.
Why are investment books such a chore to read? “A Random Walk Down Wall Street” by Burton Malkiel is one great book with powerful lessons for a lifetime, but it’s tough slugging. In order to make this subject matter easier to digest, “Index Funds: The 12 Step Program for Active Investors” uses beautiful paintings by the very gifted artist, Lala Ragimov. Left brain, right brain, art and science – all coming together to make it easier for you to invest right and sit tight.
Speaking of paintings: one of my favorites is “Who do you Trust?”. It shows well-dressed Wall Street types trying to lure investors towards their products while academia tugs at them trying to pull them into education.

Who Do You Trust? Ask yourself: What’s motivating your advisor? Does your advisor have an incentive to sell you something that pays a commission? That’s a serious conflict of interest. What’s good for your broker may not be good for you. You and your advisor should be on the same team. Better yet, hire a fee-only fiduciary.
How about listening to Nobel Prize winners? They’re not making money off of you. The Nobel Prize is an extremely difficult award to attain. It is a significant achievement that represents the pinnacle of success in a field and it is awarded by industry peers and fellow Nobels (other uber smart people). This is a big honor and should never be overlooked. One of our favorite Nobel Laureates is our very own Harry Markowitz who won his Nobel Prize in 1990 for his work on Modern Portfolio Theory. What did he earn his prize for? Quantifying the relationship between risk and return. Don’t tell me you got a great return…show me that great return against the backdrop of how much risk you took to get that return. Was there another investment that could have given me the same return for less risk? Or could I have taken the same risk, and gotten a better return. Important stuff to know when you want to maximize your return for the risk you are able to take. Thank you, Professor Markowitz!
What if it sounds too good to be true? Then it probably is! If someone tells you there’s a low-risk investment out there promising a 12-14% return, ask yourself “Who is the knucklehead willing to sell this investment to me?” Someone would have to be real stupid to sell off an investment that will make 12-14% per year with little to no risk. Remember, willing buyers and willing sellers. What willing seller would let go of that investment? Would you sell an investment that was going to guarantee you 12-14% per year? Not unless the buyer was willing to pay that interest up front. But if the buyer pays for those returns for the foreseeable future up front, the expected return of the investment is now ZERO since the return just went out the door with the seller. So remember, when you buy a security, the future earnings are already baked into the price, and there are no risk-free returns lying around for you to scoop up.

IFA Radio's Episode 57

IFA Radio — Fri, 28 Jan 2011 00:00:00 GMT

Market Timers Beware

“Here come the sheep, just in time to be shorn,” wrote Jason Zweig in a recent Wall Street Journal article: “Will Small Investors Ever Warm Up to Stocks Again?” Investors really need to learn that timing the market doesn’t work. The best time to be in the market is when you have the money to invest, and the time to be out of the market is when you need the money. History shows it is not about timing the market, but time in the market that rewards investors.
"If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market," said legendary investor Benjamin Graham. Someone should tell that to the investors who just poured $3.8 billion into the market the week of Jan. 12 –the highest level of inflows since May 2009. Market timing doesn’t work. Take a look at the success of market timers in the past.

What do investors really want, anyway? Meir Statman just wrote a great book dealing with the emotions of investors called, “What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions.” IFA highly recommends this book to learn about behavioral finance.
Think it’s easy to let go of your emotions when investing? Not so. It turns out that your brain is hard-wired to pursue the thrill of the score. See this link and watch the video. It’s pretty tricky to let go of your emotions when you’re investing. But, the more you learn about stock market history, the more you begin to learn is that there is no better way to undermine your investment performance than to heed your emotions.
Is your advisor a true fiduciary? Stock brokers cannot be fiduciaries. A fiduciary must do what’s in the best interest of their client even if it’s against their best interest. Because most active managers get paid more for trading more, it creates a blatant conflict of interest. Do you feel comfortable putting your retirement in the hands of someone who has no obligation to put your needs in front of their kickbacks?
Want to send more money to the government? Easily done—just buy an actively managed fund. On average, the typical active fund has a 90% turnover rate. Active managers stare down some substantial costs of turnover that make it harder to keep a profit. Even if they enjoyed nice gains on the stocks that were sold, they pay costly short-term capital gains taxes. High federal taxes, high state taxes mean that about one-half of a highly turned over fund returns end up in the government’s pockets, not yours. Do you need an extra partner sucking the returns out of your portfolio in the background?
Want to keep more of your money from the taxman? Consider, the IFA Tax Advantage: Index fund portfolios minimize short-term capital gains. Because of the buy and hold strategy, index funds are subject to long-term capital gains which carry with them a much lower percentage and are paid far less frequently. Taxes are an important part of the investing process. Not only are index funds tax advantaged, but DFA’s funds go a few steps further making them the optimal investment choice.

IFA Radio's Episode 56

IFA Radio — Sun, 23 Jan 2011 00:00:00 GMT

Blowing the Lid Off Index Annuities

Indexed annuities promise investors the returns of the market without any of the risk. Sounds pretty great, right? The problem is that the commissions on indexed annuities can be very high, sometimes around 9-10%.
Index annuities are not regulated by the Securities and Exchange Commission (SEC). Somehow these got pulled out of the investment category and they now fall under insurance laws. It’s not going through the usual scrutiny that a mutual fund or investment advisor goes through. The SEC puts constraints on what you are allowed to say about your investments and what they offer investors. What’s to stop the people who sell these index annuities from promising the moon?
You need to look for a fee-only advisor because they frequently act as fiduciaries. If they are not fee-only, it means they are being compensated by the products they sell—a conflict of interest. A broker ,must always battle the temptation to put you in the investments that pay him the most? These insurance salesmen selling index annuities are getting huge commissions to sell you their product. Do you really want someone who gets paid commission to make important recommendations to you? Even if he is your “buddy,” never tempt an honest man.
Money magazine looked at the averages of these index annuities over the last five years. The return was 3.9%. That’s worse than the average return of bonds over that same period.
IFA analyzed Fortune’s “Ten Most Admired Companies” (2001) as a whole portfolio and as individual companies, comparing them to the 20 IFA Index Portfolios for the 9-year, 11-month period studied (2/19/01—December 2010)¹. The results are in the chart below.

Ex-Stock Broker Mark Dempsey wrote a book called, “Robbing You Blind: Moneymaking Strategies for Today’s Investor.” It goes into the backroom type deals brokers make with investor’s money to get the highest commissions possible for them.
Investors need to take responsibility for their investments. The best way to do this is to read one of the many books IFA recommends, or read “Index Funds: The 12-Step Program for Active Investors.”

IFA Radio's Episode 55

IFA Radio — Tue, 18 Jan 2011 00:00:00 GMT

Celebrate Capitalism

Ever wonder why stocks go up before you buy them and then drop as soon as you get in? It’s because our emotions work against us when it comes to investing. Many studies show that, on average, investors react emotionally to the stock market, piling into particular types of assets at precisely the wrong time. Save your emotions for Valentine’s Day, and invest according to science, not speculation.
What’s the next hot sector? It’s virtually impossible to predict—and if you’re right, it’s likely due to luck, not skill. Investing isn’t about jumping in and out of different asset classes—that’s gambling. Investing is about figuring out how much risk you can take and finding the lowest cost way to implement that risk level. What’s your risk capacity? Find out now, by clicking here.

Talking Bonds:
Two important factors in bond returns: Term and Default.
Long-term bonds carry higher risk than short-term bonds, but over the long term, they do not reward the holder of the bond with proper reward for the increased risk. Keep bond terms lower than 5 years and put that extra risk into your stock investments which actually have an expected return to go with the risk.
Bonds stabilize the portfolio in turbulent times, and they provide for short-term liquidity needs. If you know you’ll need money in the near future, you can put it in bonds to avoid losing it in short-term stock market cycles.
Got the Speculation Blues? (Link) The stock market gamble can be an addiction, you’ll search, but won’t find that winning prediction.” Jason Zweig’s Your Money and Your Brain tells the story of two brains: one brain expecting drugs, the other expecting lots of money with low risk. The same area of the brain flared up.
The markets are efficient. What does this mean? Fair markets price stocks fairly to get a fair return over a fair period of time! Fair enough? Looking for efficiencies? Don’t roll the dice with your retirement.
Buy gold now? This is the latest mantra, but is it wise? If you bought a gold bar in 1930, it would be the same size today. Gold is not organic. It does not grow. Contrast that with capitalism. Capitalism is thousands of companies that grow by opening more factories to make a profit. That is why capitalism continues its upward climb.
When you own a globally-diversified portfolio, you own commodities because the companies you are invested in own commodities on their balance sheet.
Celebrate the price! The market has already baked all the information into the price. You are not going to be smarter than all the investors in the world who are contributing to the price.

IFA Radio's Episode 54

IFA Radio — Fri, 07 Jan 2011 00:00:00 GMT

2010 was a banner year for stocks. We witnessed what some would consider historic returns. Of course there’s only one problem. The data suggests that many people missed out on those returns because they were flowing out of equities and into bonds. Looking back at the 1980’s, there are some incredible years of stock market gains, but it was supremely difficult to stay in the market back then. It takes a certain amount of guts and character to stay the course.

In 10 or 20 years, how many people will be viewing 2010 the same way we view some of those strong years in the 80’s? On the surface, most will probably wonder why everybody wasn’t scooping up equities anywhere they could find them. But when they look closer they will see why people were mistakenly flowing into bonds. In May, we had a flash crash where the DOW plummeted about 1,000 points in a matter of minutes. We saw an oil rig spill countless gallons of crude oil into the Gulf of Mexico, crippling a region that was still recovering from one of the most destructive hurricanes on record. We watched riots in the streets of Europe as sovereign debt crises struck multiple countries. One of the bitterest battles in recent memory erupted in Washington over healthcare reform. The unemployment rate hovered around 9% the entire year. The powers that be in Hollywood decided that the American public needed to have Saw 3D and The Last Airbender. But through it all, IFA’s Portfolio 100 was up 22.87% over the course of the year.

Emotions can destroy your portfolio. As people watched the horrible events of 2010 unfold, fears of a total economic apocalypse began to take hold. These fears were not helped by some experts predicting the DOW would fall to 5,000 or 6,000 before the year ended. The emotions of active investors go up and down like a roller coaster, leading them to negative returns on average, after expenses and taxes are deducted. In a hypothetical 5-year period, you could probably expect investor emotions to look something like the chart below.

In IFA’s experience, the two most prevalent “emotions” are fear and greed. And these two emotions are perfectly suited to spring a trap on the investor. People get greedy when they see stocks going up. They want a piece of the action and react. Unfortunately, that means they are often buying when the equity is at or near its peak. People become fearful when the market is plummeting. This often results in the investor selling low.

As a contrast, passive investors invest whenever they have the money to invest, regardless of market conditions, as seen below.

It’s a given that at times they will buy when the market is at its peak, but they will also buy when the market is low. As long as the money they invest is relatively steady, dollar cost averaging will dictate that more shares are purchased when prices are low and fewer shares are purchased when prices are high, thereby giving the investor a lower overall cost for the shares purchased over time.

You often hear people use the expression, “It’s nothing personal, it’s just business.” The reason this expression is used so often is most people realize it is important to separate your emotions from a business decision. Investing is a business decision, and like any other business decision, it is important to check your emotions at the door and let the numbers and facts guide you.

IFA Radio's Episode 53

IFA Radio — Thu, 30 Dec 2010 00:00:00 GMT

IFA Radio's Episode 52

IFA Radio — Thu, 23 Dec 2010 00:00:00 GMT

Financial Advice for the Coming Year

With the 2011 fast approaching, it is imperative you take a close look at your financial dealings. Where are some areas you can improve? What are some of the holes in your day to day spending? At IFA, we want to help you with some of the basics. These are steps that can be accomplished easily without having to sacrifice much of your short-term comforts.

Contribute at Least Up to the Match

While it’s not as common in today’s economic climate, a lot of companies still take part in a 401(k) match. This means that up to a certain percent, your company will match dollar-for dollar your contributions to your 401(k). I understand that times are tough right now, and you are possibly your family’s only source of income. But if it is at all possible, invest up to the match. It’s free money. If your employer were to have a 5% match and you get paid $50,000 a year, by investing up to the 5% threshold, you are essentially getting paid $52,500 a year. At IFA, we recommend contributing 10% of your salary to your 401(k). For a lot of people, especially in today’s economy, we realize that may be unrealistic. But it should be your goal so if you fall down to 8% you can still be OK.

Save Your Year-End Bonus

If you get a year-end bonus, you may be tempted to spend that money on Christmas presents for the family, or you may even want to go buy some cool gadgets that are on sale due to the holiday season. But it is important you put at least some of this away. The reasons for saving up money should be fairly obvious. You do not want to have a massive drop in your quality of life as you enter your golden years. At IFA, we calculated that if you start saving 8% of your income in a 401(k) at age 22, and you start at a $37,000 a year salary with 3% annual increases to stay up with inflation, you will be able to retire at the same comfort level you lived your life. Any time you get extra money like a bonus you may not have been counting on, try to save as much of it as possible. Continually doing this over the years could bring your retirement age closer.

Make a Tax-Deductible Charitable Gift

Schwabcharitable.org is a website that allows you to set up an account that has a strategic approach to philanthropy and donations.

Converting the IRA to a Roth IRA

In most cases, it doesn’t make a lot of sense to actually do the transfer. Intuitively, there is something amiss about the government asking us for more money now with the promise they will give us something later. I’d rather pay my taxes when I’m actually required to pay them. Now every case is different, so it’s up to you to figure out if you are a prime candidate. If you go to ifa.com and go to the Roth Calculator, you can fill out your situation and get the numbers to see if it makes sense for you. For most older people, it really does not make as much sense. Roth Conversions typically make more sense for younger investors because older investors would need to write a huge check that they may not be able to recover from in time to retire.

Harvest Tax Losses

At IFA, we have had a couple really good years the last two years which is to be expected since the market has done very well the last two years, and when you are invested in index funds, you own the market. But other clients who have come to us from other brokerage houses have needed help. Now there are a couple magic numbers to see if you are a good candidate for tax loss harvesting: 10% of your portfolio AND at least $10,000. When you sell out this position, you have to substitute it with a new position. After 31 days you can sell and go back to the old position. The reason those numbers are in place is you don’t want to expose yourself to the substitute position too much because if it does really well, you are looking at huge capital gains that would offset your capital losses, pretty much invalidating the entire process. If you want to see the advantages and disadvantages of this strategy, go to IFA.com and click on Page 2 of Step 12. Scroll down to section 12.2.5. One of the great things about tax loss harvesting under current tax law is, for example, if you were to declare $20,000 in losses, you can write off up to $3,000 a year on your capital gains until the $20,000 is depleted.

Set Up Your Financial Goals for Next Year

Most people spend more time planning for their next vacation (which will last maybe a couple weeks) than they do planning their retirement (which will last hopefully several years). You want to be able to live your golden years out and about, not stuck indoors bundled up in 12 blankets because you cannot afford to turn on the heater. At IFA, we have a Retirement Plan Calculator in Step 12 of our 12 Step program that allows you to layout your current situation, and what you need to do in order to have the type of retirement you dream of.

We hope you have enjoyed our first year of IFA Radio and we look forward to changing the way the world invests in 2011.

IFA Radio's Episode 51

IFA Radio — Fri, 17 Dec 2010 00:00:00 GMT

A Target-Date fund is a fund that is built with a specific date for your retirement in mind. If you were aiming for a retirement date of 2025, the target date would be formed to decrease in risk as you get closer and closer to 2025.

Recently, Chuck Jaffe wrote an article that touched on the Department of Labor’s proposal for new disclosures regarding Target-Date funds offered in 401(k) programs. The proposal, if enacted, would force plan sponsors to disclose a fund’s asset allocation and how that asset allocation will change in structure over the life of the participant. The proposal even asks for graphics. If you have been to IFA.com, you know we love graphics and charts.

It is hard to completely tear apart Target-Date funds. Having met with hundreds of small companies to discuss their investment options, we have learned there is a large percentage of the population who has not spent a lot of time studying investing. For those people, Target-Date funds do make some sense. It takes the thinking out of their investing, and they can take care of the other aspects of their life. The idea of decreasing risk as the person gets older is actually similar to IFA’s own glide path where we move you down our portfolio line the older you get.

But because these target date funds become an investment choice that basically involves the participant pointing to a year in the future and walking away, active managers who often run these funds are able to stuff fees into the portfolios. In doing so, they are able to make excessive profits, and because of the general lack of investment knowledge of the participant, they are able to achieve this in relative obscurity.

In addition to the problems with fees, Target-Date funds don’t always play by the same rules. There are Target-Date funds that target the date you give them as the end point. This means the fund reaches its most conservative point that year. But there are other funds that look at the target date of your retirement and do not put on the brakes until you are near your life expectancy. If you plan on retiring at age 65, and your life expectancy is 80, the fund isn’t at its most conservative until you are 80. I am sure you are already seeing the issues with this. Imagine you were ready to retire in 2003 at age 65. The portfolio would have still been carrying a decent amount of risk and would have been hit relatively hard in the crash of 2008. Now you are 70 years old, been out of the workforce for 5 years and have lost a significant portion of your retirement.

At IFA, your portfolio selection is different. Rather than simply letting the participant choose an arbitrary year for retirement, which at times can be 30 years into the future, IFA puts the user through a Risk Capacity Survey. This survey measures the five things needed to determine the best course for your investment future. We learn how long you will be invested, or your Time Horizon. We figure out your risk tolerance. How much market volatility can you handle? We use the survey to find how much you have to invest at this point in time, and we learn how much you plan on investing into your account as the years go by. And finally, we test your investment knowledge. Using these five criteria and an algorithm designed to measure these aspects, we are able to place you in the portfolio that gives you the best chance to fulfill your retirement goals. The result is a more accurate and more customized portfolio and glide path for you investing future.

While we should be a little encouraged the government is trying to hold investment companies somewhat accountable, we still should question why they only require these prospectuses be slightly more detailed, but still allow them to be ran by active managers. If you go toTSP.gov, you can see the government’s 401(k) plans and how they are invested. I’ll give you one guess as to what the U.S. government uses in its 401(k) plans… Yep … Index funds.

IFA Radio's Episode 50

IFA Radio — Mon, 13 Dec 2010 00:00:00 GMT

Best-selling author Dan Solin was a guest on IFA Radio this past week, and he talked about a number of issues. One particular issue that really gets him going is the whole concept of “The Lost Decade” that we are supposedly coming out of. Dan believes that the people like Jim Cramer and other stock pickers perpetrating this myth have an insidious agenda. They are trying to get people to buy and sell stocks at alarming rates in order to run up trading costs. It is true that it was a lost decade for the S&P 500. The most well known index in the world did not give investors much to celebrate as it was a little down over the 10 year period of 2000-2009. But there are very few, if any, competent financial advisors that would tell their clients to invest 100% of their money in the S&P 500.

The S&P 500 is not a shining example of a well diversified portfolio. It is merely a list of 500 large-cap stocks actively traded in the United States on either the Nasdaq or New York Stock Exchange. The index actually focuses primarily on U.S. companies with just a few companies in foreign markets. 500 large, predominantly U.S. companies do not offer the diversification you would need to minimize risk.

The S&P 500 is not the benchmark for the U.S. Stock Market, as some people actually believe. That would instead be the Wilshire 5000 which is a list of 5,000 stocks from many different asset classes. A truly diversified portfolio of index funds WOULD include all these different asset classes. So intelligent investors would never have put all their assets in the S&P 500 and walked away; garnering their portfolio negative returns resulting in a lost decade. They would have diversified their assets across stocks and bonds, and they would have invested in countries spanning the globe rather than the U.S. dominance exhibited in the S&P 500.

Concentrating your assets in the S&P 500 leaves you vulnerable to unsystematic risk, and that means company specific problems. But by investing in the above mentioned Wilshire 5000, you eliminate the unsystematic risk due to the fact you have the entire market. One company going bankrupt in the S&P 500 hurts the S&P a lot more than it would hurt the Wilshire 5000.

Systematic risk is the risk that nothing can protect you from. There is no escape other than being out of the market. In a financial crisis like that of 2008, everyone is vulnerable to the same systematic risk. If you were in the market, you were going down. But when you concentrate your assets in a sector, asset class, or a small, fairly specific index like the S&P 500 you leave yourself open to unsystematic risk. And the more risk you are taking, the worse the crash becomes.

So which investor did NOT have a lost decade? Was it the hotshot investor who picked stocks at all the right times and pulled out right before a stock market began its freefall in 2008? There may have been one or two that got lucky and succeeded in that endeavor. But the person who had a pretty standard makeup of 60% stocks and 40% bonds in a globally-diversified index portfolio, without all the stress of playing the market had very respectable gains. They got a 6% return per year. How many people in this country would take a 6% annual return on their investment over the last 10 years? Here is how IFA’s portfolios fared over the last decade. Because unlike stock pickers in a couple stocks, or someone who was tied to the S&P 500 like a man to the railroad tracks, every one of our portfolios would have left you in a better place than you were 10 years ago.

Sitting in 500 companies like the S&P, or even worse, sitting in a couple hundred stocks like some mutual funds left your portfolio open to far more unsystematic risk than necessary. And if there is anything you must learn in investing, it’s not about chasing the returns, it’s about limiting the risk as much as possible. If you do that, the returns follow. Build your portfolio on a solid foundation. It may take longer to build the finished product, but the risk your portfolio will crumble to the ground will dissipate.

IFA Radio's Episode 49

IFA Radio — Mon, 06 Dec 2010 00:00:00 GMT

The opening line of the Nova Special, “The Trillion Dollar Bet” is as follows: “Since the dawn of Capitalism, there has been one golden rule: If you want to make money, you have to take risks.”

Being passive is quite simple really. We rely on market forces to discover fair prices which result in fair returns that are just as likely to be above or below an appropriate return for the risk you take. The further your return ends up being from the appropriate return for the risk, the less likely it is to occur. We’ve moved away from the dark side, and towards the light side of market forces.

Another book is on the horizon that works to deconstruct the dark side, and push more people to the light. “The Investment Answer,” written by Daniel C. Goldie and Gordon S. Murray is an upcoming book that breaks down the five major decisions a person must make once they have decided to invest their money. Here at IFA, we agree that the answers to these five decisions will form your future investment experience, and how you answer these questions will determine if that experience is a positive one or a negative one.

The first is you need to decide if you are going to go it alone, or are you going to get help. Are you going to try to invest solo, or are you going to use an investment advisor. My experience from running IFA for 11 years has only solidified my initial belief: If you have over 100k to invest, a purely-passive, fee-only advisor is paramount in maximizing your returns.

The second important decision on your plate is asset allocation. Despite the many indexes available through IFA, and the 100 ways to create your allocations, it is pretty simple process. Our Risk Capacity Survey, which is either 5 or 25 questions, gives you a very accurate picture of where you should be investing.

The third crucial decision is how to diversify. At IFA, we study the data in an almost relentless matter, and through our analysis, we have found a GLOBALLY-diversified, small-value tilted portfolio is far and away the best diversification model available.

The fourth decision is one, if you listen to my show, you know may end up being the most important decision you make in your life. It may affect your ability to buy a home, retire at a reasonable age, send your kids to college…this decision is of course the decision to invest in a passive manner or an active one. It’s no secret IFA is in the passive camp…right alongside brilliant academics, Nobel Laureates, and the very history of the market itself.

The fifth decision is whether you are to rebalance or not. Rebalancing is an important function in maintaining the proper risk level you “signed up for.” Rebalancing is almost always recommended barring extenuating circumstances such as a huge capital gains tax hit, or something of that nature.

By making the right decisions to these five questions, you are making the decision to grind your teeth as your stomach churns at the volatility of the market, or you are making the decision to invest and relax.

IFA Radio's Episode 48

IFA Radio — Mon, 29 Nov 2010 00:00:00 GMT

Jason Zweig of Wall Street Journal Fame and the author of “The Little Book of Safe Money” recently wrote an article entitled “Are ETFs a Menace—or Just Misunderstood?” ETF is an acronym for exchange traded fund. They are essentially funds that hold all the securities in an index, but they themselves trade like a stock. During the flash crash a few months ago, they were some of the hardest hit investments. So are they a menace? John Bogle aptly labels ETFs as a “Trader to the Cause.” In his book, “The Little Book of Common Sense Investing” Bogle elaborates. “Simply put, the ETF is a fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund.” Zweig seems to echo these sentiments in his article based on a new study by the Ewing Marion Kauffman Foundation.

The report lists at least three worries that have arisen due to the rapid rise of ETFs.

The funds have over-concentrated the ownership of seldom traded stocks.
They have led to a rising number of trading failures.
They could lead to another huge swing in the market like the “flash crash” we had on May 6, 2010.

We want people to buy and hold. ETFs are made to be easily tradable. If I were Jason Zweig I would have changed the title from “Are ETFs a Menace—or Just Misunderstood?” to “ETFs are a Menace and Misunderstood.”

They are a menace because like a wolf in sheep’s clothing people think they are doing something good by indexing. And they are completely misunderstood because the individual who convinced you to buy these is usually misusing them completely. They are being used as an investment vehicle that the manager can move in and out of as opposed to something they can buy and hold. Now obviously these can be a decent form of investment if you have an advisor who can steer you away from trading them while buying and holding them indefinitely. But they are so easy to trade. At the time of this article, Fidelity and Schwab even allow you to trade them for free! It’s human nature to constantly want to avoid risk and try to grab at everything you think you can (even though the overwhelming evidence says you can’t). That nature coupled with the ease with which you can move them spells disaster.

At the end of the column, Jason Zweig recommends you may not want to use ETFs because no one really knows how they work. Some of the inner workings make you wonder how is money being made off of these? This brings us to Step 7 in the 12-Step program, Silent Partners. There are people that need to balance the shares when these things are created. This is done by people called creation units. They create these by buying all the stocks that make up each one of them. The hidden cost of turnover is dramatic as well. The Nasdaq QQQs are turned over (bought and sold) at about 6,000% per year. That’s a lot of turnover…and it’s not being done for free. And this turnover is STILL being based on the fact that these ETFs, like individual stocks, are being priced wrong.

Week after week we explain that markets are efficient because the hundreds of times a stock is bought and sold each day between a willing buyer and a willing seller sets the price at fair market value. Millions of traders are deciding the price of stocks, and we will include ETFs in this, so why does anyone think they can cheat the market? There are millions of goldfish in the pond that is the market. Why do so many traders insist they are sharks?

IFA Radio's Episode 47

IFA Radio — Fri, 19 Nov 2010 00:00:00 GMT

Lately, the market has been charging up and plummeting down, ramping back up and falling down. Some stock market pundits say this is proof positive that markets are NOT efficient. On the November 21^st show, we had a REAL investing expert, Eugene Fama Jr. on to discuss the apparent inefficiency of the market. If the name sounds familiar, it’s because he is the son of the famous University of Chicago Professor Eugene Fama, creator of the Efficient Market Hypothesis and co-creator of the Fama-French Five Factor Model.

Following in his father’s footsteps, Eugene Fama Jr. (click here for more with Fama Jr.) is adept at explaining his father’s complex formulas and equations in a way the investing novice can easily understand. He jokes that his father wrote the book on efficient markets, but he wrote the comic book version.

Eugene Fama Jr. asserts the fact that stocks are volatile and uncertain actually proves the markets are efficient. For markets to be efficient you would actually need to expect volatility and uncertainty making stock prices hard to predict. A volatile market is hard to out-predict. The crucial feature of the efficient market is it doesn’t allow more than the amount of people that would be able to beat the market by systematic chance alone, to exist. In other words, you wouldn’t have a casino where too many people were hitting jackpots on slot machines for the place to make money. Generally, the prices are set so quickly based on the almost instantaneous news and information that comes in about a company, that nobody could get a consistent read on them. If stocks were consistent and went up or down at a very steady pace, they’d be easy to predict, thereby making markets inefficient.

Fama Jr. is also not a fan of hiring active managers with a great track record. They won’t keep doing what they’re doing. A lot of managers slowly build up their mutual funds. Unfortunately, the return, by the time the average consumer hears about the fund, has already been realized. This means that shiny track record the mutual fund manager boasts has already come and gone and you bought high. You are in the fund just in time for the grind that is stock market investing. The fund will likely continue to grow and grow to the point where it become a generic fund that resembles the S&P 500, but unlike a straight S&P 500 index fund, there will be loads of fees and transaction costs.

Fama Jr. explains investing as this: Taking part in capital ventures wherever they exist and taking part in the effort of human commerce in every corner of the world where you can get reasonable diversification and reasonable risk exposure.

Here at IFA, we call that Capitalism Inc. When you diversify in 43 countries and 12,000 companies, you basically own capitalism.

IFA Radio's Episode 46

IFA Radio — Fri, 12 Nov 2010 00:00:00 GMT

Proper Benchmarking: The Missing Link in Investing

Style drift refers to the tendency of active managers and actively managed mutual funds to deviate from the expected investment style they stated in their prospectus. This drift can occur gradually over time, like when a "small-cap" manager starts buying larger and larger companies as their fund asset base grows. Of course it can happen quickly as well, like when an active manager has a gut feeling large cap is going to take a dive, so he sells off the stock and buys gold.

I sometimes refer to what I call the “missing link” in investing. That missing link is bad benchmarking. In order to test how well a fund is doing, you have to use a benchmark to compare it. And all too often, people use the wrong benchmarks to analyze potential funds. The benchmark they choose has far greater or far less risk than the fund they are comparing it to, making it an apples to oranges comparison.

One great way to analyze style drift is to measure the fund’s exposure to different indexes at sequential times. Below is a chart that illustrates the drifting styles of the Fidelity Magellan Fund from June 1988 to December 2004. Note that the dark blue zone is a large value index and the light blue is a large growth index. If you look at June 1995, it would have probably qualified as a large value fund. Fast forward to February 2000 and you’ll see it has morphed into a large growth fund.

How is a person supposed to properly assess the risk level of that fund with its wide swings in asset allocation? When the fund started back in 1983, it was mostly a small value fund. Over the last 82 years, small value has provided the best long-term returns. So this fund started off performing quite well and people started flowing into it, expecting more of the same. Well, by 1988 the fund was constituted of mostly large growth, and it had hardly ANY small value. It wasn’t remotely close to the fund it was a mere 5 years earlier. Compare the erratic asset allocation of the Fidelity Magellan Fund to that of IFA’s Large Company Index.

Notice how little the fund moves back and forth between large value and large growth. At no point can you definitively say it is a large growth or large value fund because the asset allocation remains consistent. This allows an investor the opportunity to accurately deduce the risk level of the fund. Remember to pay attention to the “missing link” of investing. The evolution of your portfolio depends on it.

IFA Radio's Episode 45

IFA Radio — Mon, 08 Nov 2010 00:00:00 GMT

Mutual Funds are a Fee Circus

A recent study by Morningstar simply stated that by studying the expense ratio of mutual funds, you will get a better indication of their future performance than by using their vaunted star rating system. The study lays out the cold hard truth for fund managers, that their 1 year, 2-year, 5-year averages…none of them are as important in determining a funds future performance as looking at their expense ratios.

Just how high can these fees get? Let’s take sales loads for an example, which can be 4% or 5%. Cleverly stated, the fund manager will quote you a return percentage based off your original deposit AFTER the money has been taken out. In other words, if you put in $100,000 and they take a 5% sales load, you really only put in $95,000. Then, your broker comes back to you relishing in the 5% he just made you. In reality, that 5% just brings you back to where you started from because the entire 5% they made you only paid for that sales load. Fees are a silent killer of your portfolio returns.

Maybe you think these small percentages a reasonable price to pay. After all, nothing in life is free, right? Well, over the last 82 years, the market has given a return of about 9.5-10% on average per year. If you take 4.75% off the top in a sales load, and another 1% off in expense ratios, you’ve lost half your earnings! You don’t even want to ponder what the compound interest of all that lost money would end up being when it’s all said and done. Rest assured, it’s compounding somewhere. Just not in your account where it should be.

Not only are some of these fund managers charging you a sales load along with the expense ratio of the fund, they are also buying and selling, they are short, long and neutral, they are as active as a 3-year old five minutes after he devoured a one pound bag of Skittles washed down with Mountain Dew. But like the sugar powered three-year old, the active fund manager eventually crashes…HARD. You can’t cheat risk which is what active managers try to do when they short stocks or buy and sell on gut instincts. Why would someone sell you a security that has no risk or volatility with huge returns? The only way that would come about is if they charged you an arm and a leg for that security because no one in their right mind is going to give you a security like that at a discount. Stock trading, like everything else, requires the sense that isn’t so common. If you want high returns, you better be prepared to deal with high risk and high volatility.

And that’s why I wrote this 12-Step program. People need to be broken of habits, and cured of their addictions as it pertains to active management. Even indexing stalwart Burton Malkiel admits to getting an itch to buy a specific stock once in a while. But you must resist the urge and remain passive and diversified. Whenever you think you have found a steal of a stock, use that common sense thinking I talked about earlier: If this stock is such a good deal and is going to take off to the moon with no risk whatsoever, why is it so cheap?

IFA Radio's Episode 44

IFA RADIO — Fri, 29 Oct 2010 00:00:00 GMT

This Hedge Needs Clippers

In a 2009 New York Times article by Mark Hurlbert, Professor Wermers said he believed that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone. By definition, therefore, such a fund could not have been identified in advance.” The investment implication is clear, according to Mark Kritzman who conducted a study to measure the long-term impact of all the expenses involved in investing in mutual funds and hedge funds. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”

So my question to the active manager is, “How’s that working out for you?” I attended a seminar the other day where there was a big hedge fund manager. He went on and on about how you should buy good stocks and sell bad stocks…as if that’s all there is to it. The SEC should lock this guy’s front doors and never let him do business again.

When we were finally able to nail him down and get some actual returns from him, it was shocking. After all the crazy fees someone would have to pay, like around 2% to Merrill Lynch, 2% to the fund, and over 2% plus 20% of the profits to the manager himself, they made a surprising 6.58% per year for 7 years; surprising only because with all those fees, 6.58% is a miracle. Our portfolio 32, which is a very low-risk portfolio we would recommend to those who are getting real close to retirement or maybe are even retired already, earned 6.57% over the same period.

So how much risk are you actually taking with a hedge fund? Well, it’s tough to even talk about the standard deviation in a hedge fund because of the leverage involved. If you lose 20% in a fund you are leveraged in 5 to 1, you lose 100% of your money. That 20% lost in the fund was your money because when it drops, the bank calls and gives the liquidation order so they do not lose money. They want to make sure it eats up your share, and not the share they loaned to you. Imagine putting $100,000 down on a house while borrowing $400,000…then the property values in the area drop 20% and the bank asks you to sell your home thereby eating the loss before the crashing real estate market eats into their equity. In order to properly assess the risk in a hedge fund, you need to take the standard deviation of the underlying 20% and multiply the risk by the leverage. So if you were leveraged 5 to 1 in a hedge fund, and the standard deviation was 15, it would actually be 75.

Despite the horrible nature of the investments, he had intelligent people at the seminar - CEOs, Presidents, Vice – Presidents - lining up to get into his fund. These individuals are obviously smart people. But when you do not know the data, you cannot make informed decisions. Whether it be buying the right car, or the right TV; setting up an aquarium or taking care of a horse; you need to know everything possible before investing your money.

I am reminded of a quote from Fred Schwed Jr., "Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and brokers’ yachts.’ ‘Where are the customers’ yachts?’ asked the naive visitor."

IFA Radio's Episode 43

IFA RADIO — Fri, 22 Oct 2010 00:00:00 GMT

A Time to Hold, A Time to Trade...or not

There was a recent article in the Wall Street Journal by E.S. Browning called, “Pension Funds Flee Stocks in Search of Less-Risky Bets.” The reason being is stocks are being viewed as far riskier than the perceived safety of bonds. For example, Boeing’s pension was 60% stocks in 2004, but now sits at about 34% stocks. Exxon Mobile has moved down to 60% stocks from its previous level of 75%.

This is a blatant disregard of one of the warnings in Index Funds: The 12-Step Program for Active Investors. In Step 4, the practice of Market Timers or Time Pickers is broken down, and the results are not good for this destructive practice.

Below is a chart from the National Association of College and University Business Officers (NACUBO), which is an organization with memberships totaling more than 2,500 U.S. colleges and universities. In part, NACUBO provides comprehensive annual data that reports on the financial status of university endowments, and is the industry standard for such information.

The chart below shows the one-year comparison for various levels of asset pools versus comparable IFA Index Portfolios. The specific IFA Index Portfolios were selected based on the average asset allocations of equities and fixed income/cash equivalents, as provided by NACUBO. As you can see, the passively managed IFA Index Portfolio outperformed the endowments at every asset pool tested.

In 10-year periods, these results stay consistent. The IFA Index Portfolios win.

We also had John P. Scordo on the program, author and gatekeeper of research-finance.com. Scordo had this to say about the abundance of research done on the market:

“I’ve been interested in investing and the workings of the market for a while now, and ya know, when the internet came out, there was a lot of material on there, obviously. There’s a lot of marketing material on there. And there’s a lot of interesting articles that are sort of the Money Magazine type articles that will allude to some of the data and allude to some of the studies that have been done. But if you dig deeper, which is what I had an interest in doing, I was surprised to find out there was this large group of literally rocket-scientists who had been studying the market in-depth for ages who have these massive databases of stock market and market data; they analyze it every conceivable way it can be done, and as [Mark Hebner] pointed out, it’s a peer reviewed article and its free, and best of all, its objective. They don’t have any real agenda coming out one way or the other. So I was really, to be honest with you, in the beginning, pretty surprised to find there was these resources on the internet and they hadn’t been cited too often and really there was no easy way to find them all, so I started collecting a series of links I would go to just to read the latest in the research and that led me to want to research the original papers.”

Fortunately for you, you can see a lot of these articles and the highlights of the articles by logging on to ifa.com and clicking on the Articles or Papers buttons in the menu bar to let your education begin.

IFA Radio's Episode 42

IFA RADIO — Thu, 14 Oct 2010 00:00:00 GMT

IFA Radio's Episode 41

IFA RADIO — Thu, 07 Oct 2010 00:00:00 GMT

“Market Timing is a wicked idea! Don’t try it--EVER.”

-Charles D. Ellis

This week’s episode deals with the perilous practice of Market Timing. Before you think you or a manager you hire can see the writing on the wall, it’s best to review the research on the people who are trying to move in and out of investments. A Dalbar study found that, over a 20 year period, the average bond-fund investor only earned 1% a year. But if you looked at a bond index, it went up 7% a year over the same ten years. So by moving in and out of these bond funds at inopportune times, they only captured 15% of the potential return of these bond funds.

No matter how you cut it, people who think they know more than the market usually fail because markets are priced fairly. If the amount of risk you take warrants a 5% return, then you are just as likely to get a 7% return as you are a 3% return. Case in point, in August there was no shortage of “experts” screaming on the television and radio, “It is time to get out of stocks. Stocks are going to crash. Get out before the double-dip recession starts! September is a horrible month to be in the market.” How did the market do in September? It was only the strongest September for the market since 1939. Most of us weren’t even born the last time the market excelled like that in September.

To put the danger of market timing in context with one an IFA Index Portfolio, one of our full equity portfolios is up 7% year-to-date. That’s not bad amidst all the doom and gloom being shoved down our throats on CNBC and Fox Business. But let’s just say you pulled out of the market before September when a lot of the “experts” were telling you to get out. That same portfolio would be DOWN 3%. That’s around a 10% swing in your portfolio’s value because you missed just one month in the market!

We can break down the destructive effect on your portfolio even further. There is ample, tangible damage done by simply missing a few days over a long 10-year periods, not just an entire month over a relatively short nine month period.

Market timers have proven time and time again they are just gambling with your money. The S&P 500, while not a great example of a diversified index, beat all 25 market timing newsletters over a 10 year period from 1988-1997 in a study conducted by Mark Hulbert. Some of the newsletters it absolutely killed.

In the end, time pickers have two critical decisions to make: when to get in the market and when to get out. The data is now conclusive that there is no reliable timing method to help with either decision. It is time, not timing, that determines an investor's return.

IFA Radio's Episode 40

IFA RADIO — Thu, 30 Sep 2010 00:00:00 GMT

In a recent article in the Wall Street Journal, it was revealed that the percentage of active managers failing to meet their benchmarks is growing. It’s higher now than it was in the period of 1995-2007. What are these active managers blaming their new found (well, not necessarily new found, just further exasperated) incompetence? The title of the article says it all: “'Macro' Forces in Market Confound Stock Pickers.” What does that mean specifically? As Tom Lauricella writes, “More and more investors aren't bothering to pore through corporate reports searching for gems and duds, but are trading big buckets of stocks, bonds and commodities based mainly on macro concerns. As a result, all kinds of stocks—good as well as bad—are moving more in lock step.”

On IFA.com there is an article/audio debate in the “What’s New” section that pits Rex Sinquefield against Donald Yacktman. The debate was from 1995, but it is extremely topical and I like to refer to it as an Oldie but Goodie.

In this debate, Rex Sinquefield said, "It is my contention that active management does not make sense theoretically and isn't justified empirically. Other than that, it's O.K.” So not only does active management not work on the theoretical level, it is also folly on the active level. The reason it doesn’t work theoretically because free markets set prices in a fair way, and when prices are set fairly the price has as much chance of going up as it does of going down. Empirically, we can go back and look at the data and see the performance of investment managers. All the information is out there if people want to take the time to read it. And all the studies are quite clear: Over the long-haul, active managers rarely reach their benchmark.

In that same debate, Rex Sinquefield also half-joked, “So who’s left to say that markets don't work? It looks like it’s only the North Koreans, the Cubans and the active managers.” This is because, like socialism, active managers try to choose the prices based on speculation. Speculation, as defined by the dictionary, is a conjectural consideration of a matter; conjecture or surmise. Gordon Gekko defined it slightly differently in the new movie “Wall Street: Money Never Sleeps” when he said, “The mother of all evil is speculation.” Since stock prices are priced fairly and have an almost equal likelihood of going up or down, you are betting on red or black at the roulette tables.

Remember the study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” Using data which prevents survivorship biases and excludes funds with less than five years of performance history, and taking into account the large effects of active management fees, the study concludes that 99.4% of all fund managers failed to demonstrate true stock-picking ability. That’s 12 out of 2,076. And those 12? The guy who headed up the study, Prof. Russ Wermers, said “The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives.” In layman’s terms, they were lucky.

IFA Radio's Episode 39

IFA RADIO — Fri, 24 Sep 2010 00:00:00 GMT

What exactly are prognosticators saying when they predict next year will be a stock picker’s year? Well, in all honesty, they are saying they need to continue to work and their job would disappear if people stopped reading/listening to them. Therefore, they say exactly what they know people want to hear…and people want to hear they can get rich quick by making “smart” investments they can brag to their friends about. It’s really no different than bragging about huge winnings at a casino.

$50 on GE please.

Most of this industry is in the business of making money because people TRADE! They trade stocks, then they trade some more. Unfortunately for the clients of these firms, the more you trade, the more you lose. And the more you trade the less likely you are to capture the market rate of returns.

The main reason that stock pickers fail is that stock prices are moved by news, and news is unpredictable and random in nature. Therefore, the movements of stock prices are unpredictable and random. This simple logic makes it impossible for any human being to consistently pick stocks that outperform the averages of a market.

But what about those who think there are tons of stocks priced incorrectly? Well, there are millions of people who all have access to the same information (unless they are taking part in insider trading). So the price that the stock is selling for is the best estimate for that particular stocks worth with all the information we have. Someone may have a gut feeling that stock will skyrocket, but it’s a gut feeling…those are also often referred to as personal opinions. And despite it being election season where everyone presents opinions as facts, opinions are not facts until they are borne out to be true and provable. So these “gut feelings” or “gut instincts” people brag about having are nothing more than their best guess.

For many mutual fund managers, analysts, traders, stockbrokers and various other individuals associated with the financial industry, the idea of index funds strikes fear in their hearts. This is because stock pickers and analysts charge very high fees on mutual funds, and these fees pay for a lot of the jobs in the industry. It is in the interest of these stock, time, manager, and style pickers to imply that a market can be beat by listening to their strategist or by risking money with their manager. Who will pay for their cars, houses and yachts? Thousands of jobs in the industry are redundant and completely useless to an investor. As one book from the 1940s asks, “Where are the Customers’ Yachts?”

IFA Radio's Episode 38

IFA RADIO — Sun, 19 Sep 2010 00:00:00 GMT

Not all professors are created equal. Recently, there was a Wall Street Journal article entitled, “Beware of Professors Bearing ETFs” by Ian Salisbury. In Step 2 we take the common theme of finding a higher power to help with your addiction. In investing, those higher powers are the academics and Nobel Laureates. When I was writing “Index Funds: The 12 Step Program for Active Investors” I tried to take the readers through a story as told by the researchers and the discoveries they made. The more I read the more I realized how much research and work had been done. So much evidence had been compiled and built into the story of our stock market. The main plot points of this tale being the randomness of the market, its efficiency and the underlying truth that the greater reward you desire, the more risk you have to take.

One of my favorite stories is Alfred Cowles. He caught tuberculosis right after the crash in 1929. In those days, one way tuberculosis was treated was to go to Colorado where the high altitude was used as a treatment method. While he was at the hospital he met the administrator of the hospital who also happened to be a statistician. They got to talking and started to wonder how nobody was able to predict this crash. So they decided to collect some data. In 1932, Alfred Cowles established the Cowles Commission for Research in Economics with the motto, "Science is Measurement."

He also funded the Econometric Society's journal, Econometrica. (see these great papers) The Commission moved to the University of Chicago in 1939 and later to Yale University in 1955, where it was renamed the Cowles Foundation. Almost every U.S. winner of the Nobel Prize in Economics has spent time with the Cowles Commission.

Cowles created a market index in 1938, which became the basis for today’s Standard & Poor's 500 Index. The goal was to establish a stock market index to represent the average experience of stock market investors. Cowles reviewed approximately 12,000 recommendations and four years of transactions by twenty leading fire insurance companies and published his results in a July, 1933 article titled, Can Stock Market Forecasters Forecast? His conclusion was, "It is doubtful." His extensive study of stock market data provided an early demonstration of the "random walk" in stock price movements and the beginning of the Efficient Market Hypothesis.

It’s amazing when one thinks about the beginnings of the S&P 500 and the use of statistics in figuring stock market returns. If Alfred Cowles had not caught tuberculosis, how different would the investment landscape look? How far behind would we be in the science of investing?

IFA Radio's Episode 37

IFA RADIO — Fri, 10 Sep 2010 00:00:00 GMT

Morningstar had a study that stated the amount you pay others in fees is a better indicator of how well your portfolio is going to do than the Morningstar Star Ranking System itself. This brings up the issue of trust. Who are you going to trust when it comes to your investment path? Morningstar is basically saying their well known Star Ranking System isn’t the best way to determine where your portfolio will go. Fees are the best way. So, who are these fees going to? Well, most of the time, a good chunk of these fees are going to the individuals giving you advice, or the companies they are promoting. Well, that sounds like a conflict of interest. Upton Sinclair once said, "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

Paul Samuelson, Nobel Prize winner in Economics in 1970, put it bluntly, "This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead."

In Step 2 of the 12 Step Program, whether it be for drugs, alcohol or gambling, it usually involves looking to your higher power. In the world of investing that higher power consists of Nobel Laureates and brilliant academic minds. These minds are not motivated by the greed. They aren’t going to receive fees for publishing their studies. They are simply providing them for the betterment of public knowledge.

The foremost experts in their fields should be the most trustworthy, and this is no different in the world of investing. So what do the Nobel Laureates, high level academics and most successful investors say?

Well, to put it bluntly:

"Most of my investments are in equity index funds."

-William Sharpe

"Most of the mutual fund investments I have are index funds, approximately 75%."

-Charles Schwab

"...the best way to own common stocks is through an index fund..."

-Warren Buffett

"[Most investors would] be better off in an index fund."

-Peter Lynch

“If the data do not prove that indexing wins, well, the data are wrong."

-John Bogle

There is a distinct pattern emerging from all these brilliant minds: Index funds are the wise choice. So why do they all support index funds? William Sharpe, Nobel Laureate in Economics in 1990, had this to say about research in the market, "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." Basically, he’s saying to come to any other conclusion other than passive beating active one is either manipulating the data, of they have no idea how to measure it. Those are strong words coning from one of the most brilliant financial minds in history. They are not words to be swept under the rug by your local stock broker who stands to make more money the more you trade.

IFA Radio's Episode 36

IFA RADIO — Fri, 03 Sep 2010 00:00:00 GMT

Proper Benchmarking and Alpha

Sept 09, 2010 By: Mary Brunson

When you look at your own personal investments, or those of an foundation, 401(k) or defined benefit pension plan, proper benchmarking is the most critical factor in determining whether active managers possess the skill necessary to consistently deliver returns in excess of the risk-appropriate benchmarks.

A Little Background

In 1952, Nobel Prize winner and consultant to Index Funds Advisors, Harry Markowitz set forth his Nobel Prize winning notion that risk must be considered as well as return. Through his risk-reward scatter plot (LINK), you can estimate whether or not your investments have been optimized so that your expected returns are maximized for your current level of risk.

In 1964, Sharpe’s Capital Asset Pricing Model set forth the idea that the returns of investments are explained by how closely those investments have matched or correlated to the market portfolio. The market portfolio is considered a “beta” of one and investments with betas greater than one (more volatile) should have higher expected returns and visa versa. This single risk factor model is a common measure obtained from Morningstar or Lipper data, however, it only explains about 70% of the returns of diversified portfolios. This leaves room for benchmarking errors by active managers when they compare their returns to a single market portfolio and claim that they have beaten the market.

From Sharpe’s single risk factor model, assertions arose from active managers that the various active strategies, such as stock selection, manager selection, market timing, and sector rotation could produce returns in excess of the market, which is referred to as “alpha.”

This line of reasoning asserts there are mispriced securities and by avoiding the over-priced securities and acquiring the under-priced securities, active managers can beat the market. But passive investors have a very different perspective. They realize there are millions of willing buyers and sellers in the world, all of whom have easily obtainable and low cost access to publicly available information. In total, those market participants are trading about 10 billion shares per day based on this information. It is not plausible that the securities would be mispriced. To the contrary, publicly traded securities may be the most accurately and fairly priced item in the world. Stock and bond prices determined in a free market are instantly and continuously being updated based on new and randomly occurring information. The news describing the progress of global capitalism is on average positive. Therefore, the market increases in value over time as the result of the profits from capitalism.

The notion that active managers can skillfully and repeatedly beat markets is enticing, but academics have not been able to confirm “manager skill” in empirical research. Instead, they commonly label the very few managers who have beaten a multi-risk factor model as being just lucky. Unfortunately and by definition, luck does not persist.

Numerous studies have concluded that “alpha” is a myth and it essentially disappears when exposure to two other risk factors are properly measured. Therefore, the common assumption that the market portfolio, often measured by the S&P 500, is a sufficient benchmark for diversified portfolios has been shown to be incorrect.

In 2005, a study titled False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, by Laurent Barras, Olivier Scaillet, and Russ Wermers investigated the presence of true alpha in 2,072 domestic equity mutual funds for the 32 years from January 1975 to December 2006. It concluded that when properly benchmarked (through a multi-factor regression, as opposed to the single factor regression), 99.4% of active managers failed to demonstrate genuine stock picking skill.

The Real Test of Above-Market Returns

Eugene F. Fama of the University of Chicago and Kenneth R. French of Yale University examined each of the post-1927 returns of every stock in the domestic markets, as well as the volatility of those returns, in search of commonalities that might explain why certain stocks deliver higher returns than others. Their ground-breaking Multi-Factor Model showed that Sharpe’s CAPM, although quite elegant, is incomplete. In addition to a portfolio’s exposure to the market as a whole, two other factors explained stock market returns over time: These are the degree to which the market portfolio carries increased or decreased exposure to small company stocks and stocks with high book-to-market ratios, also known as value stocks.

Since 1927, the portfolio that carried higher exposures to these markets also carried higher returns. But through diversification, the volatility was dampened to about the same as the market portfolio. This is why the Index Funds Advisors’ full equity Index Portfolio 90 is tilted toward small and value companies and invests in 12,000 companies, as opposed to 500.

The findings of Fama and French show that their three factors (market, size and value) explain more than 96% of stock market returns.

Over the last 82 years, the size premium (for greater exposure to small companies) has been 3.17%, and the value premium (for greater exposure to high book-to-market companies) has been an additional 5.04%. The market premium for broad market exposure above the return of 30 day T-bills has been 7.50%. Fama and French’s subsequent 5-Factor Model shows the risk premiums for fixed income, as well. These are term risk and default risk, where the premiums are 2.03% and 0.31%, respectively.

Fama and French further concluded that not all risk factors are worth taking. For stocks, 82 years of data have shown that growth stocks are not efficient uses of risk, with relatively high risk and low returns. For fixed income, long-term instruments carry higher term risk, but have not provided higher returns to adequately compensate for these risks. For investment committees who select active fund managers, these findings are critical, summarizing that true alpha can only be identified once investors have properly benchmarked against indexes that incorporate the multiple factors identified by Fama and French. And when this occurs, alpha becomes just a matter of luck. This leads investors to the unavoidable conclusion that they should cut their costs in half and simply buy a portfolio of indexes in the form of a small value tilted, globally diversified portfolio of index funds. The key issue remaining is what risk level is appropriate for each investor or group of investors and which blend of indexes is most likely to maximize returns at that level of risk. Then hold on, rebalance and let the earnings of capitalism justify the increased values over time.

These concepts are substantive and have endured much scrutiny under the watchful eye of peer reviews, Nobel Prize committees, and the institutional investing world largely governed by the Prudent Investor Rule and its five principles of prudence. They are also the guiding principles for the Index Funds Advisors approach.

IFA Radio's Episode 35

IFA RADIO — Thu, 02 Sep 2010 00:00:00 GMT

With the fall season fast approaching, we are entering a time of the year where the market gets really volatile. It is in these times that being tied to the mast so you do not succumb to the siren songs of active investing becomes so important. Because with volatility comes downs AND ups. Pulling out of the market because the market is dropping and getting back in while it’s rising takes a crystal ball…well, a crystal ball that actually DOES tell the future.

There are no future tense verbs in the market. Prices have a way of washing out all known and projected market changes, thereby resetting the price so it has an equal chance of going up or going down based on a positive expected return. Every price comes with an expected positive return commensurate with the risk they take. This is the basic fundamental principle guiding the market each and every day. The market has to clear everyday, which means contrary to the notion that no one wants to buy any equities, people are constantly buying them.

As advisors, we like to let send out a little article that we call The Resilience of Capitalism.

Warren Buffett gives us his opinion on our capitalistic market.

"The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway... It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market."

-Warren Buffett

Capitalism will rebirth itself. Companies on average make a profit. Even in turbulent, down economies, stock prices will correct themselves to a point where people are interested in buying them. On average over a long period of time, capitalism works.

So how does a person’s portfolio become a representation of the capitalism system? Diversification. If you diversify your portfolio over thousands of stocks, you stand to capture the ups and downs in the different sections of the economy. If it helps, you can view the economy as a cube. This over time this cube is slowly moving upward. Inside this cube all hell is breaking loose with things bouncing around up and down. Screaming voices, things appearing, things disappearing. Nothing is standing still. There are times the cube will stall; sometimes it will drift down. But by owning a well diversified portfolio, you own that cube and therefore capitalism, which over extended periods of time has been moving upward since it came into being. If you have a select group of stocks that are not diversified, you own parts of the chaos that takes place inside the cube.

Below is a chart comparing the average equity investor with a Global Equity Index Portfolio. By owning capitalism (essentially the Global Equity Index Portfolio) you capture capitalism where the average investor, who likely owns select portions of capitalism, falls well short.

Nobel Prize winning economists and academics have revealed that broad-based diversification among low-cost indexes has shown to be the most prudent investing strategy over time. Harry Markowitz, the 1990 Nobel Prize in Economics winner and Academic Consultant to Index Funds Advisors, recently stated, “In choosing a portfolio, investors should seek broad diversification. They should understand that equities and corporate bonds involve risk and that markets inevitably fluctuate. Their portfolio should be such that they are willing to ride out the bad as well as the good times. “

IFA Radio's Episode 34

IFA Radio — Thu, 19 Aug 2010 00:00:00 GMT

Forbes had a recent article entitled “Retirement Roulette.” In it, they discuss the baffling choice a lot of people are making with their retirement dollars. In these tough economic times, a large percentage of the population is investing in the company they know best: The One They Work For. If Enron taught us anything, it’s this: You don’t put yourself in a Double Jeopardy situation. If your company goes under, you lose both your job AND your retirement. Diversification is one of, if not the most important aspect to having a successful investing experience.

"Buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either."

-Warren Buffett

By buying your company’s stock in mass quantities and filling up your 401k with it WHILE you are working there, you are essentially doing exactly what Buffett is talking about. You are trying to pick a little beauty, that beauty being the company you work for. Nobody can pick these beauties. Studies show stock picking skill is statistically indistinguishable from zero.

As of the writing of this article, stock picker Jim Cramer currently likesR.R. Donnelley & Sons and KBR. If he were to buy loads of stock in these two companies, he would still be better off than the person who invests heavily in the company they work for. Even if those companies tanked, he would still be receiving regular income (as dubious as his method of making that income might be) from CNBC.

The article in Forbes goes on to say that 51% of Coca-Colas 401k assets are in the company’s stock. McDonalds has 45% of their 401ks in their stock! Granted these two companies have little chance of going completely under. But if they did, people would lose their stream of income and half their portfolio in once crushing blow.

If you have an option to buy company stock for your 401k, the percentage of your portfolio it should make up should probably fall between 0-0%. You should have NONE of your company’s stock in your portfolio. Sure, it sounds noble to have your company in your portfolio so you can see your hard work raise the company’s stock price. But at the end of the day, as many people in this downturn learned, it does not matter how good of an employee you were or are. The economy can swallow up even the biggest fish. If you get laid off because your company is crashing and burning, the last thing you want is your retirement portfolio to turn into a grease fire as well. It’s entirely possible that your retirement portfolio will become even more important because your career path did not go anywhere close to where you had it charted.

When you build a properly diversified portfolio, you want a vast array of stocks that span across different sectors and countries. But before you start buying these well-diversified mutual funds it is of the utmost importance that you determine just what kind of investor you are in terms of risk. Are you high risk, moderate risk, or low risk? Most people think they can just classify themselves based on a feeling they have about themselves, or based on an idea they like. You may view yourself as a conservative person so you automatically assume you should be in a very low risk portfolio. Some people think of themselves as a live fast, die hard type of person so they think they belong in high risk. The truth is you need to take a Risk Capacity Survey that will ask you specific questions that can cut through the presuppositions you may have about yourself.

If you take the survey and follow the recommended allocation of stocks and bonds, you will be way ahead of the average person who spends most of their time chasing after the next big thing or the “hot” fund from last year or last quarter.

IFA Radio's Episode 33

IFA Radio — Fri, 13 Aug 2010 00:00:00 GMT

Diversification has always been one of the major topics of this show. Diversification is what lower the risk in your portfolio. So how important is it? Well, I have some year to date numbers (as of Tuesday, August 10, 2010) to share with you across some various asset classes. These numbers will illustrate why it is important to be spread across all the asset classes across thousands of companies and stocks.

International Value: Up 0.2%

Emerging Markets Small Companies: Up 10%

Real Estate: Up 10.8%

Large Company (like the S&P 500): Up 1.7%

So why am I giving you these numbers? They obviously cannot tell you anything about where the market is going. But what they can tell you is returns in various asset classes are all over the board. 6 months from now International Value could skyrocket while Real Estate plummets. But by owning all of them, they can cover each other when one goes up and the other goes down. Jack Bogle talks about people who are searching for that needle in a haystack. He recommends buying the whole haystack. That way you know you got the winner.

Obviously a full equity portfolio is not for everyone. You really need to take a risk capacity survey in order to find what mix of equities and bonds is right for you. Someone in their 70s should not be invested 100% in equities since they are retired or close to retiring.

But regardless of how much of your money is in equities, it is important to make sure it is in passively managed index funds. Here is a table that contrasts the basic aspects of investing and how Active and Passive differ.

At the end of the day, Active investors believe they are in control. They delude themselves into thinking they have a special understanding of the market, a superior edge over less knowledgeable investors, making them immune to disaster. The truth is all investors can access the same information as professional money managers through the Internet and many other sources. Still, many investors believe they are smarter and more sophisticated than the average investor. Those under this illusion fail to realize how much investment performance depends on luck. Most of them eventually pay dearly for this mistake.

IFA Radio's Episode 32

IFA Radio — Sun, 08 Aug 2010 00:00:00 GMT

Study after study after study…they all say the same thing: Active Management does not work. It absolutely baffles me as to how anyone would actually choose to put their money in actively managed funds. I know why they do. They typically won’t read the books and literature that tell them how wasteful they are being. I suppose it’s more fun to dream. When the lottery gets up to $100 million and you buy a ticket, you know you have a better chance of being struck by lightning on a clear day than winning, but the dream of what could be…lightning striking in almost impossible conditions…is worth the risk of one dollar. Unfortunately, people put a lot more on the line than one dollar with active managers and their hope they can get 20%+ returns.

So what about the happy medium of buying indexes in the form of ETFs and trading those? People can get index funds and still try to find elusive deals. Well, if you have been listening to this show for very long you know that in the investing world it is almost impossible to have your cake and eat it too.

Now, ETF’s are certainly better than going and picking individual stocks.

I like to give a little background on why picking one stock is so dangerous.

Individual stocks and bonds contain both systematic and nonsystematic risk. If investors hold the market portfolio of stocks like the Wilshire 5000, they have eliminated nonsystematic risk and they have not concentrated their portfolio on fewer stocks than the market. Concentration risk occurs when investors try to pick stocks and bonds that they think will outperform the market. Concentration of investments is akin to speculation and adds risk, but provides no additional expected return.

Concentration risk comes from all active management strategies such as trying to pick stocks, timers, managers or styles. Look at the chart below.

So yes, ETFs are not completely evil, but they are not the ideal answer.

The ETFs come in at an average of around 15 basis points. That means they cost 0.15% per year. Index mutual funds cost a bit more and come in around 25 basis points (0.25% per year) if you count some of the small value and international funds. So index mutual funds are a little bit more costly.

But…

In his Little Book of Common Sense Investing, Vanguard founder Jack Bogle weighs in mightily on the subject of ETF trading, He states:

"If long-term investing was the original paradigm for the classic index fund designed 31 (now 34) years ago, surely using index funds as trading vehicles can only be described as short-term speculation."
"If the broadest possible diversification was the original paradigm, surely holding discrete — even widely diversified — sectors of the market offers less diversification and commensurately more risk."
"If the original paradigm was minimal cost, then holding market-sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them, nor the tax burdens incurred if one has the good fortune to do so successfully."
"Typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market."

...and Bogle's parting shot on trading ETFs provides an ominous warning:

"I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting."

ETFs can be a tempting siren song. They are an easy way to jump in and out of index funds. Jack Bogle estimates only 20% of these ETFs are bought and held. That means they are being traded about as much as normal stocks which brings in the trading fees, the taxes and all the other silent partners that drain your portfolio.

If buy and hold is the best strategy as all the academic research indicates, you stand a greater risk to lose the hold portion of it when you buy ETFs.

IFA Radio's Episode 31

IFA Radio — Mon, 02 Aug 2010 00:00:00 GMT

When I first heard about indexing and the concept of simply putting your money away in an index fund and not touching it, I did what anyone trying to learn more about any subject would do: I bought several books that dealt with indexing. I purchased Burton Malkiel’s classic, A Random Walk Down Wall Street. I got John Bogle’s Common Sense on Mutual Funds, and as I was wading through them, I couldn’t help but notice it was a lot more interesting to read a magazine like Businessweek because of all the colorful graphs and charts and even artwork. So I thought a compromise was in order. The dense, rich language of these brilliant books could maybe use some colorful graphs and art like you would see in Businessweek or Money magazine. So that was the genesis of the idea of Index Funds: The 12 Step Program for Active Investors.

But as I continued reading all these books, I realized that it wasn’t just the colorful charts and beautiful art that was missing. The books seemed to jump around to different subjects. Whether it was Stock Picking, or Market Timing, it seemed like these books couldn’t nail down the subjects. It made sense to me to have all the information that debunked a particular active strategy all in one place, so when it came time to explain the folly of an active investor’s ways, I could easily thumb through a book and get to it.

And finally, as I continued my reading, more and more evidence piled up against active investing, I started to wonder how anyone could take part in it. Academic research was drowning out any “proof” that someone could speculate and make more money than someone who actually invests. This led me to the correlation of those who are addicted to gambling. A gambler knows deep down that the numbers and statistics are heavily in the house’s favor (else there wouldn’t be a “house”). So when I did an internet search for help programs for stockoholics, Alcoholics Anonymous popped up with a special section that dealt exclusively with Stock Market Gamblers. The light bulb went on! It occurred to me that there was no real 12-Step program for stock or tradeaholics. And what better way to organize all these different problems with active management than going through each one step by step by step. So I took the fragments of my earlier ideas and combined them with that and came up with the framework for Index Funds: The 12 Step Program for Active Investors.

IFA Radio's Episode 30

IFA Radio — Mon, 26 Jul 2010 00:00:00 GMT

Mission Responsible

Among individual investors and institutions, the question often arises: How can we invest in a manner that is consistent with our faith? And a further basic consideration quickly falls on the heels of that question: How much return must we sacrifice to invest in a socially responsible manner?

Mary Brunson, Vice President of Investing for Catholics (IFC) a division of Index Funds Advisors, Inc. (IFA), is the driving force behind a movement that the United States Conference for Catholic Bishops has encouraged and asked to share with Catholic individuals and institutions throughout the country. Essentially, IFC has two goals:

1. To educate the Catholic community on the benefits or passive investing.

2. To dispel the myth that social filters mar the returns of portfolios, when in fact the portfolios with social filters have the ability to capture similar returns to traditional index funds.

The foundation of IFC is built from IFA’s passive investment strategy and principles. The process of socially responsible investing begins with the traditional index portfolios. A third- party corporation then applies the outlined social values as a filter to the index funds, creating socially responsible index funds. In this way, IFC remains an advisor for passive investment strategies to ensure that optimal returns are accomplished. Often, tying the investor to the mast is the strategy that benefits the investor in the long run. The process of screening thousands of securities and companies is not complicated, yet aggressive enough to extensively and properly evaluate the stocks before placing any investments. In the end, investors enjoy peace of mind when invested with socially responsible funds because they can achieve optimal market returns without unneeded expenses or excuses.

Harry Markowitz, Nobel Laureate and IFA consultant, also weighed in on the issue of social filters disbanding the diversification accomplished by worldwide index funds. Teaming with IFC Vice President, Mary Brunson, Markowitz and Brunson produced an academic paper theoretically and empirically reinforcing the notion that investors can in fact invest in a socially responsible manner while expecting little or no sacrifice to returns. Using 82 years of back-tested performance data, both were able to confirm the similarities of returns from both strategies. In truth, socially responsible investors are afforded the ability to invest in a manner adhering to their values.

IFC’s questions to you: Are you a socially responsible investor? Do you like achieving the expected market rates of return? Do you want to adhere to your values when investing? Now you can take the first steps and discover the world of passive investing geared towards social responsibility.

IFA Radio's Episode 29

IFA Radio — Thu, 15 Jul 2010 00:00:00 GMT

Click here to see a checklist for your Plan Sponsor.

Is Your Company Vulnerable to a 401(k) Lawsuit?

Plan Sponsor Questionnaire Can Save You Litigation

More and more corporations face litigations brought on by their employees concerning the management and responsibility for 401(k) and 403(b) plans. Picking up the list of recent lawsuits, you’d be hard-pressed to miss the number of occasions where the liabilities have fallen back to the plan sponsors after expensive litigations to prove the responsibility delegated to the plan providers was insufficient.

Financial service providers, especially brokers and insurance companies have successfully evaded responsibility by claiming that they merely recommended securities, rather than accepting responsibility for selecting the investments that make up the options for a corporation’s 401(k) plan. What’s the difference between recommending and selecting? The two seem semantically identical, don’t they? Not so, and not understanding the difference creates enormous personal liability for plan trustees—including human resources administrators. Watch your step because you may be paying for advice without reaping the rewards of return—all while you retain liability you thought you had offloaded to your service provider.

The reason why plan sponsors are unaware of the liabilities still falling under their umbrella could be as simple as being misled by providers. Placed into the tight situation of offering 401(k) plans to their employees, plan sponsors place much unwarranted trust in the corporations providing the plans.

This is how plan sponsors save themselves. First, the questions in the checklist provided as a link on this page give plan sponsors the arsenal required to strip down the convoluted wall constructed by plan providers and delve into the nit-gritty stuff of the services and fees rendered to the sponsors and participants. And if you’re unsure of whether or not you’re a plan sponsor, a simple question will fix the dilemma, “Did you sign something?”

The point of a 401(k) plan is that the plan sponsors and, ultimately, plan providers are required to act in the best interest of their clients. Does this happen? Yes, and no. When you ensure that your plan provider is an ERISA 3(38) Fiduciary, the provider will aid in establishing a healthy retirement fund for all clients or be held liable. However, if this seemingly minor detail falls under the radar, the plan sponsor can be held fully liable for the health of the employee’s plans. The truly shocking part of the 401(k) discussion, as mentioned earlier, can be witnessed by the number and sheer size of companies —especially, the giants of Wal-mart and Caterpillar to name two—brought to court pertaining to abysmal 401(k) plans and the exceedingly large amount of money litigated from these lawsuits. As pension plans fast become a concept of the past, 401(k) plans will be relied on to fund the future.

The future of 401(k) s is bright, yet few plan sponsors are conscious of the improper practices that befall current plan fiduciaries. The following examples list significant examples of how plan providers fail their clients:

declining to account for revenue sharing—fees paid for recommending specific funds, commonly 12b-1 fees
providing investment options in actively managed mutual funds rather than passively managed index funds – actively managed funds carry expense ratios as much as 5 TIMES those of passively managed funds (index funds), but fail to offer higher expected returns and frequently carry more risk than index funds
failing to monitor similar 401(k) plans for competitive expense ratio structures
requiring the plan to pay retail investment management and administrative fees without compensating for increased prices with better retail services. Altogether, plan sponsors are continually scammed due to the ignorance of the corporations offering 401(k) plans to their employees.

To fix this problem, questions must be asked, providers must be prodded, and reasonable compensation for fees rendered must persist. As a new rock is turned over in the 401(k) division, the plan participants have the initiative to ensure their retirement funds are properly managed and plan sponsors have a responsibility to hold their providers accountable. The key to 401(k) plans is to simply establish the fees and agreements of the plans in writing. In spite of everything, plan sponsors and participants can save the sweat and bubble bursts by turning the power off at the source: requiring the provider to be in writing an ERISA 3(38) Fiduciary.

Surely your company doesn’t have $16 million lying around waiting to settle that 401(k) litigation…or maybe you do. Nowadays, a large sum of cash seems to settle all matters.

Click here to see A Letter for Your Plan Sponsor.

IFA Radio's Episode 28

IFA Radio — Fri, 09 Jul 2010 00:00:00 GMT

Click here to see A Letter for Your Plan Sponsor.

Are you saving for retirement? If you are working for a corporation, you will most likely have a 401(k) plan in place. Furthermore, you’re probably fairly prudent at depositing a portion of your earnings into the plan on a regular basis. After all, saving for retirement is a process right?

Now let’s delve a bit deeper: do you know where your hard-earned earnings are in the market? Sure, your equity allocation is spread across a certain percentage of stocks and the fixed income bonds; but, do you know what the costs are of the plan? Surprise! Did you know that if your retirement is currently actively managed, three to four percent of your fund is going to the managers moving your money in an out of the market? Just a thought: shouldn’t saving for retirement require some form of relaxed investing—when did active investing enter this “relaxed” long-term picture? Finally, why subject your hard-earned retirement to luck?

In this episode, Mark Hebner discusses whether or not your retirement is being taken care of correctly. Joining him in the discussion for an inside look at 401(k) plans is IFA’s COO and a qualified investment advisor, Ben Brinkerhoff. Ben brings a unique insight to the subject of 401(k)s as he discusses his experience with plan participants, sponsors, trustees, and the all-to-deceptive provider.

As a plan participant, employees should be unequivocally concerned with the asset allocation of their retirement plan. As an employee, if your retirement plan is unknown to you or poorly performing, a visit to your HR department is in order. You should seek passively managed options through index funds with a low cost structure. Expense ratios can easily distinguish the active funds from the passive ones. Without these options available in your 401(k) plan, some good old fashioned grass-rooted complaining is certainly the subsequent step.

As a plan sponsor, the concern for the health of the employees’ plans also falls on the corporation’s, or plan trustees, part. If you are a plan sponsor, are you familiar with the details of the plan offered by your provider? Further, are they an ERISA 3(38) fiduciary? This is important. An ERISA 3(38) fiduciary assumes the responsibility for the decisions made to invest the plan participants in certain funds. ERISA 3(38) fiduciaries cannot have a vested interest in the funds they advise for clients separating the managers performing with luck from the managers acting in the best interest of their client’s assets. Furthermore, this agreement allows prudent sponsors who do not have the expert investment skills and abilities to delegate the responsibility to an expert entity. Without a 3(38) agreement, the consequences or litigations fall under the plan sponsor. Scary, but that is reality. If you are unaware of the explicit expenses of your plan provider, you are not alone. In other words, don’t be this guy: “I was told the services and plans were free.” We live in a world of deceptive practice and convolution. To ensure the 401(k) plans are properly managed, the provider must be confirmed as an ERISA 3(38) fiduciary on paper. Sure, the provider may be assumed to be the expert on investing in the business relationship, but the hard truth is that the firm will be able to escape any responsibility for the advice given simply by slipping the right words into the small print of the disclosures. If the plan sponsor is to act in the best interest of its employees, these concerns must be addressed.

In the end, know what you’re investing in, where your money is, whose hands it’s in, and how much you’re paying for the 401(k) plan. In the long run, the safest option is to invest in index funds with low cost expense ratios. After all, your retirement should be comfortable and not be funding the active manager’s annual vacation to the Cayman Islands.

IFA Radio's Episode 27

IFA Radio — Fri, 02 Jul 2010 00:00:00 GMT

In honor of the United States’ Independence Day, the radio program this week highlights the passive investor’s life, which is free from excessive fees, active managers, and market timers. By building a passive portfolio based on Markowitz’s “Modern Portfolio Theory”, investors are able to sleep better at night—invest and relax. But, how can an investor expect their portfolios to be safe with the constant, random fluctuations of the stock market? This program discussion centers on the inner workings of the market and how it works.

In essence, the entire market scheme is simply about the price of securities at the end of the day. To realize this statement, we need to take into account the “Hebner Model.” This model plainly elucidates how prices are set on the free market.

The Hebner Model attempts to simplify free market forces into 3 simple variables: Price, Expected Return and Economic Uncertainty (News). In short, prices move in the opposite direction of economic uncertainty so that expected returns at a specified level of risk can remain essentially constant. The only way to alter the expected return is to alter the risk of a diversified portfolio held and rebalanced to maintain the risk of the whole portfolio over time.

At the foundation of the model is Eugene Fama's Efficient Market Hypothesis, which says that market prices are fair. This implies the price fully reflects all available information or news, including economic uncertainty at the moment of the trade, new information concerning the investment, and the predictions on the probabilities of future information.

Hebner discusses the underlying determinant of price by saying, “The job of free market participants is to set prices so that investors will be compensated for the risk they bear.” The truth of this statement is the foundation for capitalism. The spontaneous order of the market is essentially why capitalism works and continues to thrive as a system. By allowing the buyers or investors to assist in setting the price of the products sold, a price is discovered at which the investor will be compensated for the risk they take in buying the product. In this light, the price is found through a spontaneous order of news inflow. The only determinant able to affect the level of price is new information.

At the core of the Hebner Model, investors can rest assured with proven evidence illustrating that the markets are only inefficient in the short term. In the long term, markets do reflect all available information or economic uncertainty. Nevertheless, investors will be compensated for bad news by the resetting of prices. As discussed, an IFA client is quoted for saying that on March 9 (the lowest point in the stock market decline) he “saw nothing but darkness on the horizon.” For the investors who rode this period of downturn through, markets responded with a sharp increase the very next day, and would go on to recover with 3 to 4% daily increases over the following weeks.

As Hebner reaffirms this week with the efficiency of the market, the key to investing is manifested in a passive investment approach through the use of index funds. Over a risk appropriate holding of the value of an investment, a positive expected return is produced from a level price where investors will be compensated for the overall risk they bear.

IFA Radio's Episode 26

IFA Radio — Fri, 25 Jun 2010 00:00:00 GMT

Mark Hebner with his guides in Bhutan

Mark Hebner visiting Druk Holding and Investments Ltd.

IFA Radio's Episode 25

IFA Radio — Fri, 18 Jun 2010 00:00:00 GMT

Investors, today, are at a disadvantage. The disadvantage begins with the investors’ lack of historical evidence. Frankly, the ability to expend money and time to learn how to correctly invest in the market escapes today’s average investor. Therefore, investors fall victim to the large investment banks that charge excessive fees and commissions with the promise of producing high returns and a bright future.

How do we discern what is reality from what is myth?

Is there a way I can achieve great return without risk?

What about the ‘great manager’? Do I need to spend the money to hire the right manager?

Myth; myth; and more myths! In this exclusive insight, Mark “Money-Mythbuster” Hebner answers recent questions posted to ifa.com concerning the market and the scam of modern investing firms.

The truth of the matter is that one can avoid the stress and excessive fees related to active investing by placing his/ her assets into a low cost portfolio designed to commensurate return with risk. Yet again, we are reminded of Warren Buffett’s timeless wisdom when he stated in his 1996 Berkshire Hathaway shareholder letter, “The best way to own common stocks is through an index fund.” Moreover, in his 2003 shareholder letter, Buffett added, “those index funds that are very low cost are investor friendly by definition and are the best selection for most of those wishing to own equity.”

Of course, his timeless values pose the question, “Why not hire a great money manager, like Buffett?” Expending the extra resources to allow a money manager to jump in and out of the market, become swayed by the commissions of other mutual funds, and believe that “he” alone can time the market and beat the benchmarks is a complete waste of the investor’s hard-earned wealth.

If your manager is thinking…“Which one of our funds would be the best for our client?” You might want to think about Hebner’s advice, “A 32 year time period determined that stock picking skill was statistically indistinguishable from zero. Also, 99.4% of those active managers were without genuine stock picking skill. [The bottom line is:] do not pay loads, do not invest with somebody who is not your fiduciary, or somebody who is biased to a particular product that is paying them to recommend their product to you.”

IFA Radio's Episode 24

IFA Radio — Fri, 11 Jun 2010 00:00:00 GMT

When you compare IFA funds and Vanguard funds, why do IFA funds have a higher return when they are all index funds? (Vanguard vs. IFA PDF)

We do not have any IFA funds or investment products. We provide investment advice. Because we are an independent investment advisor, we accept no fees from an investment product we would recommend for our clients. That takes all bias out of the equation.

Few investors understand the difference between index funds. The primary difference is there are different indexes. DFA does an enormous amount of research, and they have found companies that are smaller and value tilted have had higher returns when going back as far as 80 years. There are many advantages in tilting your portfolio towards small value.

In this environment, should I buy Toyota?

You have to completely discount the beginning of that question. “In this environment” is wrong because all investing environments are the same. When you invest, you are investing in capitalism. Capitalism stays generally the same. It may fluctuate based on the purity of the current capitalistic market, but it generally stays the same. The danger is the line of thinking that, “This time things will be different.” When it comes to investing, “This time things will be different.” is a complete myth. There is no difference. The reason for this is at any given time you have thousands of people looking at the same information and determining the price of the investment based on many factors INCLUDING the “uncertainty” of the time. It’s factored into a stock price like any other uncertainty pertaining to that company.

It’s always the right time to invest the right way. The right way is to diversify. It is certainly not to buy stock in a single company. Companies can go out of business. Indexes don’t. The expected return of a stock is the same as the expected return of the index it is in. By spreading your wealth out across the entire index, you protect yourself from the Enron’s of the world. The index has half the risk the individual stock. So you have half the risk, with the same reward.

IFA Radio's Episode 23

IFA Radio — Fri, 04 Jun 2010 00:00:00 GMT

[INCLUDE]Nobel_Laureate_Harry_Markowitz[/INCLUDE]

IFA Radio's Episode 22

IFA Radio — Thu, 27 May 2010 00:00:00 GMT

Have you ever taken a two week vacation? You know: grab the kids, fly to an exotic location, and enjoy yourself for two weeks without the impeding interruption of the developed world. Not a care in the world; no cell phone; no internet…..you’re laughing right? What’s going on in the market while you are away? You mean you were online for those two weeks reading the latest fluctuations and speculations in a market halfway around the world? What kind of vacation did you take?

This week, Mark Hebner gives his closing thoughts on Step 11 of the Index Funds: 12-Step Program for Active Investors and makes the transition to the final step: “Step 12: Invest & Relax.” Once you understand how to manage your risk exposure, you can start the passive journey of making money.

Hebner finishes Step 11 with a brief discussion on standard deviation and the all-important bell curve. His question to you, “Do you know the shape of your bell curve?”

Everyone remembers the statistics class they couldn’t escape in high school and/or college. Possibly the only concept one remembers from this course is the bell curve which lays out the distribution from any kind of measurement. In the curve, the center is the median or average for the number of times you can expect something to occur. The middle of the bell-curve or 2/3 of the middle contains +/-1 standard deviation. The edges of the curve include the infrequent or rare occurrences of the event. In our case, the bell-curve represents the return one can expect from a month to month basis. Every portfolio has a bell shaped curve representing the future anticipated returns for investors. In Hebner’s words, “Every investor should understand the shape of their bell.” The actual return for a respective month is all a question of probability.

The final step of Hebner’s 12-Step Program is: “Step 12: Invest & Relax.” The great investors of our time, including Warren Buffett, Charles Schwab, and Peter Lynch, are known to support investments made in index funds because the beautiful reality is the ability to leave the speculations of the market behind. When “Tradeless Nirvana” is reached, investing becomes a simple matter of rebalancing your portfolio to maintain a consistent level of risk. However, the act of rebalancing can be fairly difficult, especially when you are forced to sell off the securities rocketing up and to buy the ones with seemingly average performance.

In the light of rebalancing, Hebner discusses the concept termed the “glide path.” The option to glide path is not new to the 401(k) industry, but may be to those still on the outside looking in. The concept is relatively simple. As you mature in age, your portfolio is automatically adjusted annually to a reduced level of risk. The amount of exposure in the market—fundamentally, less volatile portfolio—brings comfort to the individual approaching retirement. After all, you save for retirement with the intention of keeping your contributions, and possibly increasing the fund with gains on your holdings.

The final part of the program discusses a unique practice largely unknown to the average investor. Tax loss harvesting is a way to shelter the losses incurred in a bear market without having to pay taxes at a later stage with the gains made on the rebalancing of the portfolio. This technique is normally left unutilized because of the potential errors which may occur with trading in and out of the market in a set time period.

Smart investing leads to efficient investing. Efficient investing allows you to grow your wealth. So is the life of the intelligent passive investor.

IFA Radio's Episode 21

IFA Radio — Mon, 24 May 2010 00:00:00 GMT

Diversification, diversification, diversification.

Everyone’s saying it, but who’s doing it? Maybe the question on everyone’s mind is: How do you do it? Selecting the right type of mutual funds can be a difficult process, one made even more difficult when the correct type of risk exposure must be considered.

Along the Journey to Tradeless Nirvana, we’ve picked up and proven the fact that active management doesn’t work. Stock picking is a pointless endeavor when the expenses and lack of diversification are considered. By switching your investment strategy to passively managed index funds, you find yourself in a position of mimicking the returns in the overall market. Sheltered from the short-term affects of the bull and bear markets, index funds find their way to the light over longer periods of time. One can almost hear the birds sing, witness the flowers bloom. One thing is certain, life becomes simpler. Moving away from speculation, we’re able to intellectually begin looking at investment options.

Euripides once stated, “There is safety in numbers.” Diversification is the key to risk exposure because one is then able to spread their risk over a broad spectrum of stocks and bonds. Attempting to manage the proper amount of risk exposure can cause the average investor a great deal of unnecessary headaches.

I suppose a resounding question is still unanswered: How in the world do you pick the right mutual funds? To cover all of the “prudent” and efficient investor attributes, one must seek the qualified advice with recommendations that consider the different levels of risk exposure appropriate for the respective client. Of course, many firms exist in the world offering their services; however, few implement academic research aimed at solely benefitting the client.

In this episode, Mark Hebner explains the decision to follow the funds compiled by an advisory firm called Dimensional Funds Advisors (DFA). DFA conducts and implements extensive academic research and is purely a passive mutual fund company. Comparatively, Hebner discusses the DFA outlook in that “none of their products are based on a forecast.” Furthermore, DFA is unique in creating their indexes. The founders of DFA, Rex Sinquefieldand David Booth, were involved in the creation of the first institutional index fund; therefore, DFA’s vast experience and knowledge base significantly aids in their formulation of funds offered to their clients.

Near the close of the program, we are reminded of the rules of buying and selling. These rules are fundamentally counter intuitive of the general trend of the market; yet, with the proper guidance and knowledge, these rules rear the formula for success. Buy when you have the money (Anytime! Can you believe it?!) and sell only when the money is critically needed or your portfolio requires rebalancing. Allow the years to roll by as you fast-forward to your success.

IFA Radio's Episode 20

IFA Radio — Thu, 13 May 2010 00:00:00 GMT

[INCLUDE]Matching_People_with_Portfolios[/INCLUDE]

IFA Radio's Episode 19

IFA Radio — Thu, 06 May 2010 00:00:00 GMT

[INCLUDE]5_Factors_Determining_Your_Investment_Future[/INCLUDE]

IFA Radio's Episode 18

IFA Radio — Fri, 30 Apr 2010 00:00:00 GMT

[INCLUDE]the_past_supports_the_passive[/INCLUDE]

IFA Radio's Episode 17

IFA Radio — Thu, 22 Apr 2010 00:00:00 GMT

[INCLUDE]how_strong_is_your_stomach[/INCLUDE]

IFA Radio's Episode 16

IFA Radio — Thu, 15 Apr 2010 00:00:00 GMT

[INCLUDE]Improving_Your_Odds_of_Investment_Success[/INCLUDE]

IFA Radio's Episode 15

IFA Radio — Sun, 11 Apr 2010 00:00:00 GMT

[INCLUDE]Improving_Your_Odds_of_Investment_Success[/INCLUDE]

IFA Radio's Episode 14

IFA Radio — Sun, 04 Apr 2010 00:00:00 GMT

[INCLUDE]a_little_off_the_top[/INCLUDE]

IFA Radio's Episode 13

IFA Radio — Sun, 28 Mar 2010 00:00:00 GMT

[INCLUDE]Active_Managers_are_Dust_in_the_Wind[/INCLUDE]

IFA Radio's Episode 12

IFA Radio — Sun, 21 Mar 2010 00:00:00 GMT

[INCLUDE]The_Madness_Doesnt_End_in_March_with_Active_Managers[/INCLUDE]

IFA Radio's Episode 11

IFA Radio — Sun, 14 Mar 2010 00:00:00 GMT

[INCLUDE]After_the_Fall[/INCLUDE]

IFA Radio's Episode 10

IFA Radio — Sun, 07 Mar 2010 00:00:00 GMT

[INCLUDE]the_price_is_right[/INCLUDE]

IFA Radio's Episode 9

IFA Radio — Sun, 28 Feb 2010 00:00:00 GMT

[INCLUDE]look_to_a_higher_power[/INCLUDE]

IFA Radio's Episode 8

IFA Radio — Sun, 21 Feb 2010 00:00:00 GMT

[INCLUDE]the_addicts_denial[/INCLUDE]

IFA Radio's Episode 7

IFA Radio — Sun, 14 Feb 2010 00:00:00 GMT

[INCLUDE]market_timing_is_indeed_perilous[/INCLUDE]

IFA Radio's Episode 6

IFA Radio — Sun, 07 Feb 2010 00:00:00 GMT

[INCLUDE]no_more_active_funds[/INCLUDE]

IFA Radio's Episode 5

IFA Radio — Sun, 31 Jan 2010 00:00:00 GMT

[INCLUDE]pundits_pathetic_prophecies[/INCLUDE]

IFA Radio's Episode 4

IFA Radio — Sun, 24 Jan 2010 00:00:00 GMT

[INCLUDE]an_advisement_about_advisors[/INCLUDE]

IFA Radio's Episode 3

IFA Radio — Sun, 17 Jan 2010 00:00:00 GMT

[INCLUDE]wheres_the_trust[/INCLUDE]

IFA Radio's Show Notes - Episode 2

IFA Radio — Sun, 10 Jan 2010 00:00:00 GMT

People wanted to quit last March, but if you stuck with it, the DJI ended up 18% higher, the S&P 500 ended up 23.5% higher and the NASDAQ ended up over 40% higher. The IFA Portfolio 85 ended up 35.35%.

If you owned an S&P 500 fund, you would have lost on average about 1% per year over the entire decade. If you were in a globally diversified index portfolio (like the Portfolio 65 accessible through Index Funds Advisors) you could have made an average of 5.83% per year over the last 10 years.

The volatile market shows how difficult it is to engage in market timing. Sam Stovall says it seems people are a little smarter when it comes to pulling out of the market, but not as smart when it comes to knowing when to jump back in.

IFA President, Mark Hebner talks about manager picking and the likelihood of shoot out the lights performance.

Anywhere from 40%-70% of the new money in the market flows into the funds of the previous year’s successful managers. People are taking their cash and investing it with someone who is more likely to miss their benchmark than not. A study showed the managers that were fired and replaced by these new managers did better than their replacements over the same 3 year periods. So despite being hand selected by people who are paid to hire money managers, the managers they fired beat the managers that were hired.

A study looked at 8,577 hiring decisions regarding manager pickers and they discovered the newly hired managers had excess returns over their benchmarks of about 2.9% over the 3 years prior to their hiring. But in the 3 years after their hiring they finished below their benchmarks by about .5%.

Investors have paid $140 billion in 12b-1 fees--money taken out of the investors’ pockets and placed into the money manager’s bank account. 12b-1 fees are an annual marketing or distribution fee on a mutual fund. Make sure to buy truly no-load funds where the money you invest is the money that goes into the fund.

Mark Hebner is fed up with gold commercials working overtime to convince investors to buy gold when they do not look at the long-term data clearly showing gold is for fools.

Over a 48-year period ending in 1992, gold had an annual return of 4.9%, but its risk was 26%. US Treasury Bills over the same period would have given you an annual return of 4.8% (almost identical) with a standard deviation of about 3%.

Over the last 35 years, gold delivered a return of 5.34% with the risk sitting at 17.6%. But you could have purchased a treasury bill that would have given a 5.68% return with a risk of just 0.89%.

If you subject your portfolio to enormous amounts of risk with very little expected return, you entered into a sucker’s bet. Index funds are an investment in capitalism. Capitalism goes up over time because companies make a profit.

Holy Cow! There were more than 2,000 funds liquidated out of existence last year alone.

Investing is a long-term process that is about building wealth. When trying to find a different word for the word “investment” in a thesaurus, the word speculation was listed. This should not be the case. Investment should be disciplined, scientific, well-thought-out, and destined to succeed over the long term. Risk must be known, quantifiable and controllable. Investing is different than speculation.

Q & A Section:

What are your thoughts on distribution rates and retirement?

Something that works well is variable withdraws. You need to adjust your withdraws based on how the market is doing. It is actually the way people live from year to year before they retire. The variable withdraw method takes the guesswork out, and there is no way you can outlive your assets.

It is not enough to simply diversify by putting international stocks in a portfolio. You also need to get some smaller and value type stocks as well across all of the international markets.

It used to be that index investing was investing across the S&P 500. If an investor would have done that during the last 10 years, they would have lost about 6%. If you used one of Index Funds Advisors’ portfolios with the same risk level, you would have had a return of 77% over ten years after the highest advisory fee IFA charges any client of 0.9%. As you can see in this chart, every one of Index Funds Advisors’ portfolios significantly outperformed the S&P 500.

At Mark Hebner’s upcoming workshop, they will discuss the two things that make up an investment: the return and the expected risk. You will see investments that have low risk and high return and investments with high risk and low return. This will allow a better understanding of what mix of investments are the best mix.

Index Funds Advisors likes to go off of 50 year investment periods as opposed to the short 2-3 year window most investors use to show results.

At the IFA Workshop they will discuss the strategies that do and do not work in investing. The mistakes that are made are trying to pick stocks, times, managers, and styles, and paying high fees. What does work is selecting the right amount of risk for each investor and matching it up with an asset allocation of risk.

IFA Radio's Show Notes - Episode 1

IFA Radio — Sun, 03 Jan 2010 00:00:00 GMT

USA Today had their Investor Roundtable for 2010 where there was a wide range of forecasts for the coming year.

The Wall Street Journal recently had a piece on how poorly stock pickers did when selecting the 2009 hot stocks back in 2008. The consensus picks were horrible, and the best stocks were ones that nobody even imagined would be the best.

You are not going to get in front of the market, so your best bet is to move with the market because you are more likely to be in the market when you should be out, and out of the market when you should be in.

Special guest Eugene Fama Jr. explains the reason for investor’s insistence on staying with actively managed funds is due to a general lack of understanding of how the market works.

Securities at any given moment are being affected by two different types of people: bears and bulls. The combination of the two pulling on the stock will create the “perfect description” of what the company is worth based on the information available at that moment.

Mark Hebner explains how the media tells people to trade because that’s the main source of revenue for the majority of the financial services industry.

Index Funds Advisors had a $5 million client who cracked at the bottom of the recent recession and sold out their portfolio. IFA recently calculated that the client’s portfolio would now be about $700k higher than it was when they cashed out. It illustrates why it is so difficult for investors to capture the returns of the funds they are in.

Dimensional Fund Advisors does not advertise much in order to keep the prices down for their investors. Their funds are professionally created and should not be mimicked by the “at home” investor.

Small cap and value companies have a better chance of increasing exponentially in value because large, strong companies tend to be priced high and do not necessarily provide the opportunity for high returns. There is more risk in small cap and value companies so the market demands a higher return on them.

DFA funds differs from Vanguard funds by having flexibility when reallocating their funds so they can look for the best deals they can get on stocks as opposed to strictly following the reallocation of funds across a set index.

The recent market crash was not unheard of in stock market history. It was a hard and severe downturn, but it merely illustrates the self correction efficiency of the market.

Mark Hebner talks about recent proclamations by the “experts” who are saying large growth is where you should be, but if you look at all the 12 month periods over the last 81 years, the large growth sector was a better place to be only about 41% of the time. If you stretch it out to 10 years, it’s 23%, and if you stretch it to 20 years, it’s 8%.

The NYSE on average lost .5%. It’s the worst decade since the 1930’s. The 1990’s were up 17.6%, and the 1980’s were up 16.6%. This does not include international stocks.

Q & A Section:

Q: Since interest rates will probably rise soon, does it make sense to have bonds in a portfolio right now, or should I go with money market accounts, etc?

A: Tom and Don have never suggested long term bond investing because the risk vs. reward ratio is not particularly good.

Q: Where would you place Ginnie Mae funds as it pertains to bonds?

A: They tend to be at the longer term of intermediates as they tend to get paid on average at 12 years.

Principal Financial group did a well being index of their employees and retirees:

Nearly half said they would be scaling back on who they got gifts for and how much they spent on the people they did buy for.

About one quarter of retirees said they would be scaling back on who they got gifts for and how much they spent on the people they did buy for.

70% of retirees and 60% of employees said they would spend less than $500 this holiday season.

The top two New Year’s resolutions by employees were pay off credit card debt (33%) and put savings away on a monthly basis (32%).

The top two New Year’s resolutions by retirees were pay off credit card debt (19%) and put savings away on a monthly basis (19%).

74% of Employees and 79% of retirees said they would make more of an effort to keep their resolutions as a result of this year’s market.

For all those people who are serious about making strides in their investing, the last thing you want to do is turn on your television because all you will see is talking heads trying to talk you into buying a certain stock. By doing this you will get emotional and become less like an investor and more like a gambler.

IFA is an independent firm which is important because they are not associated with any product and they are paid for their advice, not a particular product.

Mark got interested in the fact that professionals were packaging their luck as skill. His MBA program, coupled with other books brought him to realize there was something to passive investing and a new type of investing company was needed. So in 1999 he utilized his investing knowledge and the rising power of the internet to create ifa.com.