Tag Archives: novel-investor

Happy Hour: Build Your Own Smart Beta

I don’t own smart beta funds because I don’t believe they fit my strategy. Instead, I stick with a simple approach, four funds – a U.S., developed international, emerging markets, and treasury bonds – adjusting the allocation based on valuation. Basically, I move from expensive to cheap and if all equities are expensive then move from expensive to bonds. That’s the simplified version. I don’t believe smart beta would add enough “extra return” due to the adjustments. It’s very possible – I haven’t tested it – that I’d get a lower return from smart beta funds due to poor timing and higher costs, so I just stick with the lowest cost approach. Why pay more for something that I might not get? That’s the way I see it. It’s not perfect but it fits my mentality and it’s easy to manage. But if I could design the ideal smart beta fund around my strategy, it’d be based off a global index weighted by quality and price. The highest weighting would go to the highest quality, lowest priced stocks and move down from there. And I really see no reason to own every stock in said index. I’d eliminate all the highest priced, lowest quality stocks or expensive junk. And it would maintain a “cash position” if too many stocks exceeded a specific low quality and/or expensive limit. And it would do it all at a low cost. Pipe dreams, I know. Maybe someday it will be possible to build personally customized funds at a low cost. If it happens, I’m certain someone will screw it up. Anyways, the point of this was because of a slew of smart beta articles I saw this week. Smart betas “market-beating returns” are nice to look it. That’s the draw and the downfall. Too often people pick funds based on performance – not what best fits their strategy – because they don’t have a strategy or their strategy is to chase performance. So most investors will never see those returns. They’re not willing to accept periods of less than market returns to get the excess return over time. Most investors will get better returns simply by being more robotic. Less mistakes lead to higher returns over time. Doing nothing more often with a basket of basic index funds will get you a better return than chasing the best performing smart beta funds. All their doing is spending more money (via higher fees) to make the same costly mistakes. Once you’ve got doing nothing down pat, then look into smart beta and factor tilts. If it fits your strategy, then use it. And if not, then don’t. Last Call

Raskob’s Folly: When Optimism Fails

Optimism has a funny way of feeding off itself sometimes, bleeding into enthusiasm and excess. You’ve seen this story before with the internet boom and the housing bubble. But before that, it led to the rise of the 1920s, where people like John J. Raskob fueled the easy money market that “Everybody Ought to be Rich”. Raskob’s bold claim in the August 1929 issue of Ladies’ Home Journal was typical for the time: Suppose a man marries at the age of twenty-three and begins a regular saving of fifteen dollars a month – and almost anyone who is employed can do that if he tries. If he invests in good common stocks and allows the dividends and rights to accumulate, he will at the end of twenty years have at least eighty thousand dollars and an income from investments of around four hundred dollars a month. He will be rich. And because anyone can do that I am firm in my belief that anyone not only can be rich but ought to be rich. – John J. Raskob The Roaring ’20s ushered in a new economic prosperity that would last. Or so people thought. Raskob’s idea was simple. Systematically invest $15/month into stocks of good companies. At the end of 20 years, you could live off the $80,000 nest egg that he promised. (Let’s put these dollar amounts into perspective. The average person spent about 18 cents per meal in the 1930s, with an average income around $1,100. By 1950, the average income was about $3,200. So, $15/month – $180 per year – was possible, and interest on $80,000 would easily cover the average person’s income 20 years later.) Raskob’s idea wasn’t too far-fetched… except for his expectations. A month after his interview, on September 3rd, the market peaked at Dow 381, and on October 29th, the market crashed. The Dow wouldn’t see 381 again until 1954. Raskob’s timing was terrible. Or was it? I ran the numbers to see what would happen if someone jumped on the bandwagon and invested $15 on the first of every month starting in August 1929 until the end of 1949. Instead of finding “good companies”, I settled for investing in the Dow (but also ran the numbers for the S&P 500, along with a 60/40 split with 10-year Treasuries). Totals for 15/month Investment from Aug. ’29 to Dec. ’49 Total Investment Dow S&P 500 60/40 Dow/US 10-year 60/40 S&P/US 10-year $3,675 $9,951.70 $9,744.93 $7,924.93 $7,943.37 The S&P 500 and the Dow produced fairly similar results. The $15/month fell far short of Raskob’s expectations, but it shows he wasn’t entirely wrong. Putting money away every month was probably the best idea for the time, since it performed better thanks to the market crash . So, a savvy investor with a secure job, disposable income, trust in the financial system, and an iron stomach could have done just fine. Of course, for the average person, this was literally impossible. If the aftermath of the ’29 crash didn’t scare investors away, the Great Depression did. If they weren’t unemployed, their pay was being cut. Few people trusted their local bank. Why would they trust Wall Street? The average person wasn’t saving or investing. They were trying to survive. (The assumption of frictionless investing – no cost or taxes – covers the rest). But since we’re dealing in hypotheticals, I thought I’d reach a bit further to see if any other investment or strategy got closer to Raskob’s $80,000 target. Other Investment Totals for 15/month from Aug. ’29 to Dec. ’49 Savings Account Gold Small Cap Stocks Large Cap Mom. Small Cap Mom. Large Cap Value Small Cap Value $3,858.48 $2,043.07 $5,108.12 $14,157.04 $37,333.19 $15,730.23 $25,541.50 Everything fell short by more than half (I actually ran the scenario for more options, but left out the middling performers). The benefit of hindsight makes this a fun exercise, but that’s it. Costs, taxes, and the law (you couldn’t own gold after 1933) make it impossible or would severely drag down real results further (accuracy of the data from that far back is another issue to consider). Besides, it’s unlikely the average person suffered through the crash of ’29, the volatility of the 1930s, and the Great Depression and came out unscathed. It’s more likely they never got started. Even though stocks were the best-performing asset over that time, they were also the most hated, which explains a lot. Still, the lessons remain. Excessive optimism causes people to ignore the risk of being wrong. Raskob’s folly was an extremely enthusiastic view of the future, but his call to average into the market was solid advice, because averaging into a depressed market can actually help performance. Hated assets eventually perform well enough to become loved again. And as tough as it might be, saving more money and staying the course probably offers the best protection in case optimism fails you.

Jeremy Siegel’s Case For Equities

Jeremy Siegel has done more work on historical stock returns than pretty much anyone. He literally wrote the book on it, pulling stock data going back to 1802 for Stocks for the Long Run . In a recent Master in Business podcast interview he summed up his case for equities simply: What I showed was when you stretch out your holding period, up to 15, 20, 30 years, stocks actually were safer than bonds – had a lower variance and lower volatility than bonds. The long term, of course, gets overlooked with stocks. Everything – returns, variance, volatility – smooths out once you start to stack years together. I’ve broken down the S&P 500 returns over longer periods before. Since 1926, one-year returns range from a 54% gain to a 43% loss. If you put five years together, the annual returns range from a 29% gain to a 12% loss. Ten-year annual returns range from a 20% gain to a 1% loss. Fifteen-year annual returns range from a 19% gain to a 1% gain. Notice a trend? The range of possible returns shrinks as you extend the holding period. This is why stocks are Siegel’s asset of choice: If we know that return over that longer period of time is going to beat bonds by 3-4-5% per year, wow, that becomes the asset of choice for the long run. So why not only own stocks? Because people still fixate on one-year returns. It’s not much of a reach to suggest that fixation does more harm than good. It drives action. People look at one year’s return and expect it to continue. So money flows into stocks after a great year, and out after a terrible year. This need to act is why diversification is so important. Bonds become a psychological buffer for the short term craziness in the markets. And then there’s valuation. There are times when stocks become so expensive in the short term that it negates much of that long-term potential. The difficulty is in trying to time these periods because a high valuation doesn’t guarantee immediate poor returns – high priced stocks can always go higher in the short term – and valuation tools, like the CAPE ratio , don’t help the cause. Prior to the dot-com bubble, Siegel was a devout index fund fan: I was wedded to cap-weighted at the same time I said tech was crazy. And I didn’t know how to reconcile those two. Your typical index fund is market-cap weighted , which makes it extremely efficient. There’s just one big flaw. If a few stocks become wildly inefficiently priced (like internet stocks during the dot-com bubble) there’s no way to sell those stocks in a cap-weighted index. Rather, the cap-weighted index fund continues to buy more as the market cap rises. So Siegel’s solution was to change the weighting – essentially creating fundamentally-weighted index funds based on objective earnings data and opening the door for the rise of smart beta. Now, the fundamental weighting method isn’t perfect either. It won’t magically prevent a losing year. But if you’re only focused on one-year returns, it won’t matter anyway, you’ll be too busy acting before you ever see the benefits.