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.

Average Is Not Normal

Here is a great slideshow from Slideshare, that was posted by planner Carl Richards on Behavior Gap. Take a few minutes for a really great lesson in investing.

Average Is Not Normal

View more presentations from Carl Richards. (tags: behavior gap)

Under The Matress Is Good

Zero Yield: The flight to safety achieved a new benchmark as Treasury sold four-week bills at a 0% yield yesterday, and the yield on three-month bills briefly turned negative.

This is certainly a sign of fear gone wild. There is no trust left if institutions are willing to pay the government to hold their cash for them.

Remember, the capital markets are predictive mechanisms. They do not reflect what is happening today but rather the combined forecasts of all the participants.


For contrarians this has to be a good sign.

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.

Investment Wisdom

With the stock market in a late summer swoon, I thought some pearls of wisdom on the art of investing might take your mind off the non stop "the sky is falling" gibberish on CNBC. I hope you enjoy these.

• If you see a bandwagon its too late. - James Goldsmith
• You only see who's swimming naked when the tide goes out. - Warren Buffet
• Individuals who cannot master their emotions are ill-suited to the investment process. - Benjamin Graham
• The long run is a misleading guide to current affairs. In the long run we are all dead. - John Maynard Keynes
• If investing is entertaining, if your having fun, your probably not making any money. Good investing is boring. - George Soros
• It's not the bulls and bears your need to avoid - it's the bum steers. - Chuck Hillis
• Sometimes your best investments are the ones you don't make. - Donald Trump
• I made my money by selling too soon. - Bernard Baruch
• We are all wrong so often that it amazes me that we can have any conviction at all over the direction of things to come. but we must. - Jim Cramer
• Don't bottom fish - Peter Lynch
• I measure what is going on and I adapt to it. I try to get my ego out of the way. The market is smarter than I am so I bend. - Martin Zweig
  

Russian Roulette

Nick Murray is a well known figure inside the investment advisor community. He could be called an advisor's advisor. A prolific writer with a dry style and laser sharp insight his monthly columns in Financial Advisor magazine are greatly anticipated.

This past month Nick chose to discuss concentrated stock positions. He weaves an interesting story about one of the bluest of blue chips, Merk. Noting that over the years Merk has been an excellent investment creating great wealth for shareholders. But then on September 30, 2004 Merk announced that it was withdrawing the blockbuster drug Vioxx from the market. You can remember the story from there. Fear of class action lawsuits and memories of how asbestos decimated the building industry in the 1980s and how silicone implants crippled Dow Corning came flooding to the public consciousness.

Merk opened down 27% the next day and eventually bottomed about 70% off its highs. Nick then coins one of the phrases he is famous for: "You can get rich by under diversifying. But you cannot stay rich by under diversifying."

Wow! what a great way to sum up in a nutshell a lesson that could have saved millions of dollars for the employees of Enron, Cisco, Sears, Xerox, and a host of past Wall Street darlings that eventually fell on hard times. In fact, Nick likens overly concentrated stock holdings to playing Russian roulette with your financial future. You may be okay today, "but tomorrow may be the day when the sun comes up on your Vioxx."

Nick's advise? "Sell every share you have to until that stock is no more than 20% of your net worth...and do it by nightfall."

The Shrinking Stock Market

Many are puzzled buy the recent strength of the US stock markets. Once again it looks like a simple case of supply and demand. In this case, less supply. USA Today reports that the supply of stocks has been shrinking due to the buyout activity of private equity ( read LBO) firms. Astoundingly, the Wilshire 5000 is no longer made up of 5,000 companies it has shrunk to only 4,910! Read the full story here.

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.

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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

The Security Of Your Securities

On more than one occasion a client has come to me with securities they have found or received from an inheritance that they cannot find a value for. Sometimes it is a company that is now defunct, or it could be that there was a buyout or merger in the past where the original company is no longer in existence. But they have a certificate and no idea of the value.

Sometimes when a client has a relative die they know the deceased had shares of a company but they can't locate the certificate, or they receive a dividend check from a company they knew nothing about.

Having physical possession of stock and bond certificates can make things hard for your heirs and yourself. If a certificate is lost or stolen the owner must complete an affidavit with the facts surrounding the loss or theft, obtain a indemnity bond to protect the corporation and the transfer agent against the possibility that the certificate may be presented later by an innocent purchaser, and the request must be made before must be received before the company receives notice that the missing certificate has been acquired by another bona fide purchaser. Indemnity bonds generally cost about 2% of the value of the lost certificates.

In the event of a corporate merger or acquisition you may overlook the instructions for having certificates of the new company issued and your heirs may not know what happened to the company you originally invested in. If the certificates become part of your estate an affidavit of domicile and copy of your death certificated must be sent to each company to have the shares reissued to your heirs.

Finally, if you wish to sell your shares they must be presented and deposited with a broker dealer before they can be sold. This could cause an inopportune delay in executing your sale.

Having your certificates held in an investment account can make things much easier. You will be informed of any corporate actions requiring your attention, any changes in corporate name, merger, or acquisition will be handled by your custodian, your shares will be in a safe place, will be available for sale on any day the market is open, and if you die your heirs only have one entity (your brokerage firm) to provide with affidavit of domicile and death certificate.

technorati tags:Finance, stock certificates, financial planning

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