Thursday, September 29, 2011

Avoid Hell's Kitchen and Beat 90% of All Investors

There ought to be a new entry in Wikipedia’s definition of “mean reversion” – See Bill Miller. 

I hate to kick a guy while he is down, but the Bill Miller example is just too good an opportunity for a teaching moment.  Princeton professor Burton Malkiel is famous for his book, “A Random Walk Down WallStreet.”  One of my favorite Malkiel quotes:

“if picking stocks is a random walk down Wall Street, picking funds is an obstacle course through Hell’s Kitchen.”

There is no better example of how difficult it is to not only pick stocks, but also to pick mutual funds than the Legg Mason CapitalManagement Value Fund (Ticker: LMVTX)  managed by famed investment manager Bill Miller.  Bill Miller’s face once graced the cover of virtually every investment magazine after producing one of the greatest streaks in investment history.  Miller became famous after managing to beat the S&P 500 Index 10 years in a row with his LMVTX mutual fund.

Unfortunately, as is usually the case, terrific investment returns are typically followed by dreadful investment performance.  This phenomenon has been seen time and time again, and makes picking mutual funds at least as difficult as picking winning stocks – maybe harder.  Bill Miller’s Legg Mason Capital Management Value Fund is unfortunately the poster child for this phenomenon.  After beating the S&P 500 Index 10 years in a row, the LMVTX has failed to beat the S&P 500 Index in 4 of the last 5 years, and is on pace to lose again in 2011.  What’s worse is the margin of failure. Consider the following performance figures in percentages:

2006    2007    2008    2009    2010    2011 YTD
LMVTX             5.9       -6.7     -55.1    40.6      6.7      -7.6
S&P 500         15.8       5.5     -37.0    26.5     15.1     -1.8
Difference       -9.9     -12.2    -18.1    14.2     -8.4      -5.8

Despite its name, the Legg Mason Capital Management Value Fund competes in the Large Cap Blend Morningstar category where its 5-year and 10-year performance track record is now so poor it is ranked in the bottom 1% of all mutual funds competing in that category. Don't get me wrong, Bill Miller is a very smart guy. He has done nothing "wrong."  He's just a guy who was very lucky for 10 years and he has been very unlucky more recently.  The fact is, most mutual funds fail to beat simple broad market index funds.  In that case, Bill Miller is in good company.

If this one example of how difficult it is to identify mutual funds that will outperform broad market indexes, consider the following information I gathered while perusing the Morningstar database of mutual fund returns.  Morningstar shows 1,890 mutual funds in the Domestic Large Cap Blend category (the same category in which the fund above competes).  Of these 1,890 funds only 823 have been in existence for 10 years.  Of those 823 funds with 10-year track records, only 209 or 25% have produced a 10-year return higher than their benchmark index.  So, there you go. It’s easy to find mutual funds that have beaten their index IN THE PAST.  I just found 209 of them.  But, the Bill Miller example shows you that while it is easy to find PAST WINNERS, it is impossible to predict future performance.

If that isn’t enough, consider the Morningstar database of 426 Mid Cap Blend mutual funds. 193 of these funds have a 10-year track record, but only 25 of these beat the relevant mid cap index over the 10-year period.  That’s right, only 13% of all mid cap blend mutual funds beat their benchmark index. Another way to look at it is 87% of the mid cap blend mutual funds failed to beat their benchmark index. 

And, the data on the funds above OVERSTATE the performance of mutual fund managers due to something called survivorship bias.  The Morningstar database only shows the funds in existence right now, and does not include the hundreds of funds that went out of business over the past 10 years due to poor performance. Thus, your odds of picking a fund that will outperform index mutual funds IN THE FUTURE is likely less than 10%.  (This will be the topic of another post, soon).


The lesson here is that it is extremely tough to pick winning mutual funds since their historical track records provide no guide for the future whatsoever.  The funds with great track records rarely give a repeat performance.  So, how is an investor supposed to pick mutual funds that will beat stock market indexes IN THE FUTURE? You can’t, so just buy index funds and you will likely beat 90% of all investors. 

So, when your over-paid investment advisor shows you a list of 8-10 mutual funds with fantastic performance records that he/she recommends you buy, don’t be impressed.  Turn and walk away.  There are many good index funds out there, but I have always recommended Vanguard mutual funds to my friends, family, and in my books.

Saturday, September 17, 2011

Jack Bogle one of the founding fathers of indexing

Here is a great video interview with Jack Bogle, the founder of the Vanguard Group of mutual funds and the inventor of the first index fund. Bogle has also written several books, the best of which is, "The Little Book of Common Sense Investing" (I highly recommend reading).  Many followers of Bogle call themselves Bogleheads and they have a website designed to help individual investors.

I agree with 99.9% of what Jack (John) Bogle says in the video. The one thing I don't quite agree with is his stance on foreign stock funds.  I've run the numbers several times utilizing statistical optimization software and I am convinced that a small position in a foreign stock index fund both REDUCES THE RISK of a diversified portfolio and INCREASES RETURNS over sufficiently long-run results.  The impact is somewhat small, but every bit helps.  Luckily, despite Bogle's views, Vanguard has the best foreign stock index fund in the business called the Vanguard Total International Stock Index Fund.

I have never worked for Vanguard, but I've always been a big fan.  I have the vast majority of my own money invested in Vanguard Mutual Funds and Exchange Traded Funds (ETFs).  I use only Vanguard Mutual Funds in my book "The Rollover IRA Cookbook" and use many Vanguard ETFs in "The ETF Cookbook."

As always, you can see all my books at

Thursday, September 15, 2011

Increase Your Investment Earnings +180%

The Editor’s Note in The Wall Street Journal Sunday was somewhat interesting.  The editor speaks about the returns an investor with a 401(k) would have earned over the past 12 years.  There is a chart that shows the growth of a 401(k) account where $250 is invested every two weeks and the hypothetical employee also received a company match of 50% or $125 per pay period.  In 12 years the employee would have an account worth approximately $137,000 if all money went into an S&P 500 Index Fund.  He then points out that the lesson to be learned is to “always get the company match.”  This of course is an important lesson.

However, I believe the author missed an opportunity to point out another very important lesson that I firmly believe is vastly understated in its importance with most investors.  I’ve said it before, and I will say it again, BUY MONTHLY AND REBALANCE ANNUALLY.  I took The Wall Street Journal’s hypothetical 401(k) above and made a few tweaks to show everyone just how important diversification and rebalancing truly are.

First, I take issue with the editor’s assumption that a 401(k) retirement account be invested in only one S&P 500 Index Fund.  First, that is not a properly diversified account.  Second, the owner of the account would also miss out on the benefits of yearly rebalancing that can enhance returns by systematically trimming your winners and adding to your losers year after year after year.  So here are the figures that I wish the editor ran, but I have calculated for you.

The article shows the investor would amass $137,000 by consistently investing in the S&P 500 Index fund.  However, if the investor instead invested just 60% of their account in the S&P 500 Index fund and the remaining 40% in a bond index fund AND rebalanced once per year, the investor would have amassed an account value of over $151,000 or $14,000 more than investing in the S&P 500 Index fund alone.

What if we took this a step further?  What if this investor bought one of my books (and actually read it) and discovered that there are several asset classes an investor should utilize in order to be properly diversified.  Let’s take the typical 50-year-old which would again have a 60/40 stock/bond mix as the last example, but with a few tweaks. 

Of the 60% of the account invested in stocks only 30% would be invested in the (large cap) S&P 500 Index, 10% would be invested in a mid cap stock index fund, 10% in a small cap index fund, and 10% in an international stock index fund.  Further assume that the 40% invested in bonds would be allocated 20% to TIPS bonds (treasury inflation protected securities), 10% in long-term bonds, and 10% in intermediate term bonds.  Oh, and don’t forget the annual rebalancing.  This account would accumulate $173,000!

That is a difference of $36,000 or 26% more just by adding diversification and rebalancing.  I should also point out that if you add up all the monthly contributions, you would see that the original investor (in all cases) would have invested about $117,000.  Thus, the original portfolio would have earnings of just $20,000 ($137,000 - $117,000).  By adding the principles of diversification and rebalancing, the account would have earnings of $56,000 ($173,000 - $117,000).  We are talking about earning $56,000 instead of just $20,000, or an increase in earnings of 180% just by diversifying and rebalancing once per year!


$250 bi-weekly contribution with $125 matching funds (1999-2011)

Total dollars invested: $117,000
                                                                        Ending                                     % Increase
Portfolio                                                           Value               Earnings          in Earnings
S&P 500 Index only                                        $137,000         $20,000           --
Add bonds and annual rebalancing                $151,000         $34,000           +70%
Proper diversification and rebalancing           $173,000         $56,000           +180%
Moral of the story:       Investing in an S&P 500 Index fund is not an investment strategy.

Lesson:                       Diversify and rebalance. 

See my books on Amazon by clicking here.

Thursday, September 8, 2011

You can have a “do-over” on that Roth Conversion

Golfers love a mulligan after a bad shot, but so do investors. You have a chance at a do-over courtesy the IRS. Here is a great article from SmartMoney magazine for those folks that converted a Traditional IRA to a Roth IRA.  With the fall in the stock market, you may be able to save some taxes by reversing that conversion if your account is smaller now than when you converted.  The process is called “recharacterization” and is explained well in the article.  The deadline for this is October 17 so you need to hurry.

Keep in mind, if you converted to Roth in 2010, the IRS gave you an option to declare the income from the conversion over two years - ½ in 2011 and ½ in 2012.  If you undo the 2010 Roth Conversion, you will lose this option.  If you later reconvert into a Roth you will not be able to spread the income over two years and will have to declare all the income in the year of conversion.

The article says you need to wait 30 days after recharacterization before you reconvert to a Roth IRA.  Keep in mind you can’t convert and reconvert in the same tax year.  Someone made a comment on the article that is incorrect about this.  Neither the article nor the comment is exactly correct. I urge you to read the IRS language for yourself on page 30 of IRS Publication 590 and consult a local tax CPA if you want to do this.

Friday, September 2, 2011


Richard Warr is a finance professor at NC State, and a great friend.  He runs a terrifically interesting finance blog called Finance Clippings.  I highly recommend subscribing to it.

Professor Warr recently pointed out a fascinating PBS video called “Mind Over Money.” It highlights research done by psychologists and economists in their attempts to understand why we all sometimes do stupid things when it comes to money, a field now called "behavioral economics" or "behavioral finance."

See the video by clicking here.

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