Posts Tagged ‘Indexing’
Another Advocate for Indexing
Yesterday, I met with a Captain from Atlantic Southeast Airline (Delta Connection). As soon as he walked in the door, he handed me an article from USA Today about a new book by Justin Fox. Justin Fox was unknown to me but the title of his book, “The Myth of the Rational Market,” quickly caught my eye. After our meeting, I read the article in full. In the article, written by freelance writer Richard Eisenburg, we see that Mr. Fox has spent years tracing the evolution of the Efficient Market Hypothesis. This hypothesis says stock prices are random, can’t be predicted based on past movements or publicly available information, and are in some fundamental sense, right. His conclusion is that hiring a mutual fund manager to beat the market is a loosing game. Evidence of this is in 2008 when active managers in theory should have beat the market but instead most lost more than the S&P 500’s decline of 38%.John Bogle Endorses Wiser Wealth, Well…Sort of
Our friends at indexuniverse recently interviewed John Bogle. Mr. Bogle is the mutual fund indexing pioneer that started Vanguard. We listen very intently to Mr. Bogle because here at Wiser Wealth we are index investors and agree with many of his sought after opinions. The Wiser Wealth investing philosophy is to maintain a diversified portfolio, keep cost low and invest for the long term. Following Mr. Bogle’s presentation there was a question and answer section. He highlighted our core investing philosophies.
Index Universe asked the following questions to Mr. Bogle following his on-line presentation:
Diversification, Cost, and the Long Term: Part 1 Diversification
The title of this series is what we here at Wiser Wealth Management keep in mind when investing. I wanted to explain this and show how these simple words can lead to great investment results.
Diversification
Diversification when investing is spreading your investments out to eliminate business risk. Business risk is the risk one company, industry, or sector has. This does not include the risk of the economy but the risk of a particular business model and the risk from management making poor decisions. Proper diversification takes this risk away. The other risk that can not be taken away is market risk. Market risk is the risk of the overall economy on the stock market. ‘Cashing out’ of the stock market is a common method of trying to eliminate this risk but the difficulties of forecasting downturns often makes this method hard to act on. September 2008 showed how hard it is to avoid market risk. When the giant, Lehman Brothers filed bankruptcy many money market funds’ value dropped below $1. This means that what people thought of as cash lost value. A dollar invested in cash became at that time $.98. If you are following this, you know that a money market fund breaking a dollar is business risk gone badly. This is a small example, and those holding any insurance or banking stock will know, business risk has been abundant in 2008.
In the past, it was thought that proper diversification could be found in 15 stocks, than it was 30 stocks. Now, finance books report 50 stocks are needed to supply diversification. So what does that mean, 50 stocks are needed to gain diversification? It means that the there is no more additional benefit in adding one more stock. However, William Bernstein has written about the research done by Burton Malkiel, author of “A Random Walk Down Wall Street.” In Burton Malkiel’s research he shows that proper diversification requires a lot more than 15 stocks. Berstein goes further to add that 200 stocks are not enough and that the only way is to hold all the stocks in the stock market. This may be new to you but in affect, this is called indexing. He does not provide a recipe for the weightings of all the stocks in the stock market but he is clear that there is no point where adding another stock is not beneficial. It is clear by looking at all the research that there is the most addition benefit in adding stocks to a portfolio with less than 50 securities, however what this research says is that risk reduction can still be had by having highly diversified portfolio representing all the stocks available. In affect, this is free and easy risk reduction.
Diversifying Through ETFs
To obtain and build a highly diversified portfolio is very costly for most investors, since they must incur trading costs. Exchange Traded Funds (ETFs) can solve this problem. ETFs are like mutual funds, except they make no management decisions, are designed to track an index like the S&P 500 or Russell 1000. Investors can trade ETFs intraday like stocks. ETFs can be considered investable indexes. Investors wanting to use indexing or add an indexing component to their portfolios can utilize the benefits of constructing portfolios or different asset classes. Building efficient portfolios can be done easily with knowledge of modern portfolio theory and its techniques.
Wiser Wealth Management
Casey Smith, President of Wiser Wealth Management, and I were quoted in a recent article about municipal bond funds. Here’s a quote,
The Marietta, Ga.-based advisor notes that they’re still less expensive than ETFs. And Vanguard keeps its managers on a short leash in making moves differing from their respective benchmarks, says Smith, president of Wiser Wealth Management.
“Normally, when I hear the term ‘mutual fund,’ I cringe,” he said. “We’ve transitioned to all-ETF portfolios. But we’ve made an exception in munis, where we find that Vanguard’s quasi-active mutual funds are about half the price of the muni bond ETFs on the market right now.
“Vanguard’s muni funds hold up well on a performance basis to similar ETFs, says Kyle Waller, a research analyst at Wiser Wealth Management. He compared MUB to the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX).
Read full article here.
Stock Market Recoveries
One of my favorite pieces of stock market advice is by William Berstein,
Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of financial history to those who have one.
Keeping that in mind please look at these charts done by Morningstar about market recoveries and the effects of diversification among asset classes. Charts and all information by Morningstar, Inc
The Stock Market Fear Number
Since 1990, the CBOE has issued the volatility index, VIX. VIX is commonly called the ‘Fear Index’ because it tracks the amount of defensive options being bought at the CBOE. During times of uncertainy in the market and times when expectations are negative in the short term, many large investors use defensive options to protect their portfolios against these downturns, these act like insurance policies. I have linked a graph of the history of this index, which you can notice times of worry. As investors buy these defensive options the index increases. Notice over the last month this index has shot up higher than it ever has in history.
This represents fears mounting as the selling continues. The VIX index is thought the give a good representation of short term market expectations. This post adds to the information we gave in our last post, “Is this Panic Sensible.” It does answer whether or not it is sensible but only confirms that it is a panic. In 2006 investors could place bets on the index that measures fear.
To learn more about volatility indexes visit the CBOE site.
Some Market Wisdom
This video with Mr. Jack Bogle, founder of the Vanguard Group and former CEO, highlights some wisdom from a man with a lot of experience and who started Vanguard, a company that has a long history of being on the side of the individual investor.
The Last 52 Weeks in Review
As we are nearly one year from the peak of the S&P 500 this October, I want to take a look at how Exchange Traded Funds (ETFs) did compared to their mutual fund counterparts. To be clear I want to show how, in all market conditions, indexing will provide better long term results with less risk. As I will show, investing in the average mutual fund has not, as a strategy, beaten investing in low cost index funds of the same category. Most investors, investing their capital in diversified funds do not believe in dancing in and out of the stock market, trying to sell at market highs and buy in a market lows, so the question really is, what kind and which funds are best for me. Take a look at this report which compares category averages of Open End US mutual funds (small, medium, and large) to an ETF in the same category (fees are not included for Mutual fund category and are included for the ETFs). Click Here to see our chart open-end-funds-v-etfs
Market Panic Sell Off
Today’s panic sell off was based purely on emotions, not financial evaluations. Traders today are assuming that no one will eat out, buy a house, or travel ever again. The House’s decision to vote against the “bail out bill” was the cause of today’s sell off. Benjamin Graham’s quote that markets often perform more like a voting machine in the short term and a weighing machine in the long run applies here.
Let’s be clear that this bill was not a free bail out for the rich; it is a plan to provide liquidity to the US financial markets. The US Government is investing in the US Economy by loaning money to banks at relatively high interest rates. The other part of the package is to create an entity that buys up the securities that are causing the problems in this market. This buy up will basically replace the bad assets with cash. After the financial markets stabilize the government could issue the purchased securities back into the market place for a profit. If the Government does not get repaid from the loans, then they will get ownership of the company in question. In my opinion, either the US Government issues the loans or we will have more foreign investment into US Corporations.
What is Risk? Part 1
Risk of an investor’s portfolio can have several meanings. However, in highly diversified portfolios the only meaningful risk is the risk that an investor will have less money in their portfolios at the end of their planned time horizon. So, for our purposes now we will define risk as the amount of volatility and variability of the Capital Markets (the stock and bond markets).
All investments have fluctuations. Houses, property, oil, and of course stocks and bonds. We call the amount of variability standard deviation (variance is the square root of standard deviation), remember high school statistics class. So, we measure the fluctuations of our portfolios and the stock and bond market by standard deviation.
Since all assets have fluctuations, we define more risky assets as having higher fluctuations about the mean or higher standard deviation. Therefore in highly diversified portfolios, we can minimize the amount of risk of a portfolio by adding assets that have different fluctuations at different times or low statistical correlation. This is a very simple version of Modern Portfolio Theory (MPT), which Harry Markowitz won a Nobel Prize for and detailed in his book, “Portfolio Selection”. Using MPT one can ‘optimize’ a portfolio, minimizing risk and maximizing expected return.
This can give a portfolio made of many assets lower risk than each individual asset.
Wiser Wealth Management 
