Holy Cow! They're finally catching on!

Recently Registered Rep Magazine posted an article 'Forget Stock Market Gains , It's Best to Avoid Losses' Well, it's about time!

The article features a mutual fund company that is just now figuring out what we have known all along, the math of investment losses makes preserving capital the most important task facing individual investors. Maybe soon they will realize that folks don't buy stock because they enjoy getting proxy notices, we buy stock in hopes of actually making money, and if the market stinks we want to take our marbles somewhere else to play.

If you lose 10% it takes just over 11% to be back to even. That kind of gain is quite common for the S&P. If you suffer a 20% loss you need a 25% gain just to be even, years where the S&P rise 25% are rare. If you suffer a 50% loss it takes a 100% gain just to get back to even, the S&P will take years to achieve the double you need for that. It is easy to see that avoiding really big losses is the key to investor heaven.

But rather than put together a mutual fund that is fighting the last war, investors would do better to learn to recognize the warning signals that the markets exhibit and be prepared or even expect that you'll need to sell any investment from time to time.

Minimizing Loss

With the recent turmoil in the stock, bond, and real estate markets it is a good time to review one of the most important tenets of successful investing; minimizing your losses.

The math of losses works in a funny way. If you lose 10% on your investment, a 10% gain does not make you even. It takes a little over 11% to be even. If you lose 20% it takes a 25% gain just to be even, and if you lose 50% it takes a 100% gain just to get back to even.

That's why you should have a strategy to protect yourself when things inevitably go wrong. 10%-15% gains in the stock market come along fairly frequently, but 25% plus gains are very rare. If you can implement a disciplined strategy to protect yourself from large losses you can be ahead while everyone else is still working to make it back to even.

Rebalancing Act

My previous entry on reversion to the mean may have seemed a little academic, but it has a very practical application in managing your portfolio. Over time investments, like closets, tend to become disorganized. You may have spent considerable time and effort in setting up an asset allocation for your 401k, but if you stop there you will eventually have a portfolio that no longer meets your needs, and could potentially expose you to much more risk than you originally intended.

Rebalancing your portfolio can insure that your risk remains tolerable, and can actually improve your investment returns over time. There is always disagreement over when you should rebalance, some prefer quarterly, some monthly, some have complicated formula's that trigger rebalancing. You can put me in the annual camp. When I have looked at hypothetical portfolios and compared annual to quarterly rebalancing I usually find that annual rebalancing provides more return, while quarterly rebalancing does a better job of reducing risk. No matter what choice you make, the process of rebalancing can benefit you.

The reason rebalancing works is that "reversion to the mean" shows that different asset classes and subsets within those classes go through periods of under performance and out performance. By rebalancing your portfolio you force yourself to take some profits in areas that are outperforming, and purchase securities that have become relatively cheaper. This goes against human nature because we all tend to want all our money in whatever is providing the best return right now. Just remember that all things in life have cycles. You may not be able to predict when a cycle will begin or end, but you do know that it will. Rebalancing provides discipline to your investment process and can keep you from making the big mistake of being late to the party and late to leave, like the dot com investors of the last bull market.

/p>

technorati tags:re-balance, Finance, financial planning,

Reversion to the Mean

One of the most important concepts in investing is reversion to the mean. This is a fancy way of saying things tend to return to normal.

You have probably noticed that like a pendulum the stock market is subject to wide swings up and down, and like a pendulum spends little time in the middle. This is true of the market as a whole and in the groups and individual securities that make up the market. Everything seems to go too high or too low.

Look at the chart above of the S&P 500 rolling monthly returns from 1975 to 2006. The mean (average) return for this period was about 13% but the rolling annual returns varied from up almost 50% to down nearly 30%. While there is no rhyme or reason to the swings of this pendulum you should be able to see that when things look the best you should be taking some profit, and when things look the worst you should be buying bargains. Trouble is this goes against what comes naturally.

This process of reversion to the mean takes place in all subsets of the market too. Remember tech stocks in late 99 and early 00? Or telecom? Or oil? For the last few years small caps have been outperforming and many on Wall Street have predicted a resurgence in large company growth that has yet to materialize, but has shown recent strength relative to small and mid size companies. Maybe it is finally time for their reversion to the mean.

The first step to profiting from this phenomenon is to recognize its existence. The next step is to have the discipline and courage to act. Remember, things are never as good or as bad as they seem.

technorati tags:Finance, investing, Stocks

SEC Podcasts

The Securities and Exchange Commission has begun a series of short (five minute) podcasts. The series titled "Your Money" is designed for beginning investors but has information that is appropriate for all investors. My favorites are "Choosing a Financial Professional" and "No-Load Funds". You can access the series here.

Technorati Tag SEC Podcast financial planning

Playing With A Stacked Deck - Equity Index Annuities

Bob Clark, a columnist for Investment Advisor magazine, recently said, "...the role of advisors is to protect their clients from the financial services industry". Many times the products pushed by the large financial service firms do more harm to investors than good. The "hot" product de jour is currently the Equity Index Annuity.

While the equity index Annuity itself is not an evil thing, the way they are presented to investors is many times misleading, and they are often pushed to be a much larger part of a portfolio than prudence would justify. Regulators have become so concerned that the SEC has issued an explanation of equity index annuities, and the National Association of Securities Dealers has issued an "investor alert".

In brief, an equity index annuity, provides returns that a related to some stock market index. As such they can be viewed as an equity derivative (remember those?). Investors typically receive a return that is some portion of the return of an index like the S&P 500 (for example 90% of the point to point return of the price increase of the index, not including dividends), the average monthly return of the index over a predetermined period (again not including dividends), or the monthly gain of the index with a predetermined cap (often 2-3% per month cap). The big draw is that you receive a guarantee that your account will not have a negative return over some period of time. Often touted as "heads you win, tails you don't loose". On the face that sounds enticing. It is only if you kick the tires that problems become apparent.

First, like most annuities there is a long period of time where you a charged a surrender charge if you want or need to withdraw more funds than allowed in the contract (I have even seen instances where the surrender charge is applied to any withdrawal except in the case of annuitization).

Second, any gain from annuities is considered to be distributed first, and taxed as ordinary income (you do not get favorable dividend of capital gain rate when you file your taxes), and any distribution before age 59 1/2 could be subject to a 10% premature distribution tax penalty.

Worst of all the returns investors receive will likely not measure up to expectations. A good place to find information on how different equity index annuities would have performed is available at Personalyze.org. The pitfalls of monthly caps and averaging returns is also available here. This site is great for comparing equity index annuities to each other but for the investor to make a true comparison the returns need to be compared to the benchmark. To give you a means to compare check the growth of a $100,000 investment in a equity index annuity given by Personalyze.org to the following values derived from the sites own data for an investment in the index (of course this does not include dividends). For the period 1970 through 1979 (considered a bear market era by personalyze) $100,000 invested in the index grew to $117,250. For the period 1990 through 1999 (considered a bull market era by personalyze) $100,000 grew to $415,762, and for the past 10 years an investment in the index grew to $202,657.

Technorati Tag Equity Index Annuity

Investor Behavior - Common Mistakes

Harvard's Daniel Gilbert explains the psychology of errors in estimating. If you listen with an ear toward the investment applications it helps explain many of the common errors investors make over and over again. It is a long piece ( about an hour) you can listen here or download mp3 to listen when you have the time or take with you on the road. If you choose to down load look for the file SXSW06.INT.20060311.DanielGilbert.mp3

Technorati Tag behavioral investing