Don’t Assume Beating the Market Is Easy

Posted on August 22, 2014 | Investor Update

Investor-Update
The majority of investors use active strategies for a single reason: to beat the market. There are other reasons, of course, to handpick securities (or pay a fund manager to do so), such as realizing a higher stream of portfolio income or reducing volatility. Today, though, I want to focus on what you should consider when trying to beat the market.

The financial industry has done a great job making beating the market seem easy. Go to just about any financial media outlet (traditional or social) and you’ll find plenty of chatter claiming index funds are for suckers. What you often won’t find is a frank discussion about the long-term results actually realized by a large group of investors or fund managers.

There is a good reason for this: The numbers aren’t good. Consider the performance data published in our 2014 Guide to the Top Mutual Funds. Just 35% of funds with 10-year track records beat the S&P 500 index on a 10-year annualized basis. In other words, you had nearly a two-thirds chance of trailing the S&P 500 over the past 10 years if you bought an actively managed fund. The actual odds are worse because funds that folded over the last 10 years are excluded (“survivorship bias”) from the current guide and taxes are excluded from the return calculations.

The performance hurdle is not just limited to mutual funds. Barry Ritholtz, who writes The Big Picture Blog, says an active trader has to beat the S&P 500 by 25% annually to come out ahead. The large margin primarily reflects the impact of taxes. The active trader pays short-term taxes, and these costs add up. The long-term passive investor, conversely, pays little in taxes until he or she retires and makes withdrawals at a potentially lower tax rate.

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Are Smart Beta ETFs Smart Investments?

Posted on August 15, 2014 | Investor Update

Investor-Update
The concept of smart beta funds has intrigued me. Smart beta funds use quantitative rankings to determine what stocks to hold and how to weight them. I agree with the general concept, but I wondered if smart beta exchange-traded funds (ETFs) actually delivered better performance. So I used the data in our ETF Guide to conduct an analysis.

This would seem to be an easy task: just line up the funds and compare the returns. After all, most funds, be they mutual funds or ETFs, can be quickly categorized as passive or active, small cap or large cap, domestic or international, etc. With smart beta ETFs, things weren’t so simple. In fact, I quickly found myself facing a quandary: What actually counts as a smart beta fund?

Morningstar does not designate funds as being smart beta in the data it supplies. (We use Morningstar’s data for our mutual fund guide, our ETF guide and our Quarterly Mutual Fund Update.) A search on Google for a list of smart beta ETFs didn’t turn up much either. This meant my first step was to create a list of smart beta ETFs.

The first few choices were easy. I knew there are ETFs based on Research Affiliates smart beta indexes, such as the PowerShares FTSE RAFI US 1000 (PRF). I included ETFs based on equal-weight market capitalization indexes, such as Guggenheim S&P 500 Equal Weight (RSP), even though equal-weight indexes were in existence before the term “smart beta” became popular.

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August Is More Grumpy Cat than Ferocious Lion

Posted on August 8, 2014 | Investor Update

Investor-Update
Judging by the 70-degree weather we’ve been having in here in Chicago, it’s hard to believe that August is starting tomorrow. But the calendar does not lie. For summer enthusiasts living in northern climates, the month represents the last chance to enjoy long hours of daylight and wear shorts outside. For investors, August has a different connotation.

August was the best month of the year for stocks during the first half of the 20th century. Mark Hulbert published a column on MarketWatch saying the month remains one of the better ones when the entire history of the Dow is considered. Using data from 1896 through 2013, Hulbert calculates an average August return of 1.13% for the Dow. This is the fourth-highest return of any month. Jeff Hirsch at the Stock Trader’s Almanac says that August’s performance is a tale of two long periods. While August was a great month between 1901 and 1951, it hasn’t been since. The Dow has experienced an average decline of -0.1% since 1950. The negative return makes August the fourth-worst-performing month.

Note the size of the decline: -0.1%. It’s not anywhere close to being big enough to justify the transaction and tax costs you could incur from pulling out of the market. In fact, most daily fluctuations in the Dow are larger. The danger, of course, is incurring a decline of greater than 0.1%. Big drops have occurred in August before. A combination of events, including the Long-Term Capital Management implosion, led to a 15.1% drop in 1998. Saddam Hussein triggered a 10% slide in 1990 when he invaded Kuwait. More recently, the sovereign debt crisis in Europe led to a 4.4% slide in 2011.

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New Money Market Fund Rules Mostly Spare Individuals

Posted on July 24, 2014 | Investor Update

Investor-Update
New rules for money market funds were approved by the Securities and Exchange Commission (SEC) yesterday after a few years of contentious debate. Some money market funds will have floating net asset values (NAVs) instead of having their NAVs strictly pegged to $1 per share. Redemption restrictions will also be allowed on certain money funds during times of stress. Finally, the SEC will also issue a re-proposal on how it will gauge a fund’s credit-worthiness, using methods other than credit ratings.

The majority of money market funds available to individual investors will not be affected by the new floating NAV rules. This appears to be a compromise the SEC accepted as part of its fight with the fund industry to get the reforms pushed through. The floating NAV rules will apply to institutional prime money market funds and (according to Mike Krasner at iMoneyNet) tax-free institutional funds. This said, “retail” money market funds will continue to be able to peg their NAVs to the $1 per share mark.

Non-government money market funds will “have the ability to impose to fees and (redemption) gates during times of stress.” In other words, the SEC will allow non-government money market funds to restrict the size of withdrawals and/or place redemption fees during periods of stress. This rule is intended to prevent large institutional investors from engaging in what is the equivalent of a bank run and harming individual investors in the process.

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More Experience Won’t Necessarily Improve Returns

Posted on July 17, 2014 | Investor Update

Investor-Update
If you listen to Malcolm Gladwell, you might believe spending 10,000 hours on investing will help you make better portfolio decisions. In his bestselling book, “Outliers” (Little, Brown and Company, 2008), Gladwell cites data from a study linking hours practiced to expertise. Gladwell’s assertion of the number of hours required to gain mastery of a skill is based on a 1993 study of violinists by K. Anders Ericsson and colleagues at Florida State University. The best violinists practiced 10,000 hours, 2,500 more hours than other violinists, according to the Ericsson group.

The Ericsson et al. study is widely cited. If one were to extrapolate its results, a link between the amount of time spent investing and portfolio returns could be drawn. Similar links could be drawn between practice and other activities as well. This is not the case, however. A study recently highlighted by Business Insider argues the amount of practice actually only plays a small role in the mastery of a skill.

In “Deliberate Practice: Is That All It Takes to Become an Expert?,” six researchers analyzed the data from many studies on chess and music. The researchers describe these activities as the “the two most widely studied domains in expertise research.” They found deliberate practice only accounts for 34% of variance in chess performance and 29.9% of variance in music performance.

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Social Security’s Lump-Sum Payment Option

Posted on July 3, 2014 | Investor Update

Investor-Update
The Social Security Administration offers the chance to receive a lump-sum payment of up to six months’ worth of benefits. It’s not a well-known option, but it is available to anyone meeting the basic requirements. There are also caveats to consider.

Retroactive benefits can be claimed by a person who has reached full retirement age (FRA) and is not currently collecting benefits. FRA is currently 66 for those born between 1943 and 1954. It increases in two-month increments for those born between 1955 and 1959. Those born in 1960 or later will not reach full retirement age until they turn 67.

Full retirement age is the year at which a person first becomes eligible for the primary insurance amount. Social Security benefits can be claimed prior to the FRA, but they will be below the primary insurance amount. Conversely, if claiming is postponed, delayed retirement credits increase the benefits until age 70. The increase in benefits is why conventional wisdom calls for delaying the claiming decision until as close as possible to age 70 for those in good health.

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Social Security’s Lump-Sum Payment Option

Posted on July 3, 2014 | Investor Update

Investor-Update
The Social Security Administration offers the chance to receive a lump-sum payment of up to six months’ worth of benefits. It’s not a well-known option, but it is available to anyone meeting the basic requirements. There are also caveats to consider.

Retroactive benefits can be claimed by a person who has reached full retirement age (FRA) and is not currently collecting benefits. FRA is currently 66 for those born between 1943 and 1954. It increases in two-month increments for those born between 1955 and 1959. Those born in 1960 or later will not reach full retirement age until they turn 67.

Full retirement age is the year at which a person first becomes eligible for the primary insurance amount. Social Security benefits can be claimed prior to the FRA, but they will be below the primary insurance amount. Conversely, if claiming is postponed, delayed retirement credits increase the benefits until age 70. The increase in benefits is why conventional wisdom calls for delaying the claiming decision until as close as possible to age 70 for those in good health.

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10 Ways to Ensure Your Retirement Savings Last

Posted on June 26, 2014 | Investor Update

Investor-Update
A big financial challenge retirees face is ensuring their savings last the rest of their lives. It’s a daunting task for those making the transition into retirement as well as for those already in retirement. While saving as much as possible during your working years is important, the decisions you make in retirement are also very important. Fortunately, there are steps you can take to improve your odds of financial success. Here are 10 of them.

1. Withdraw a Safe Amount—Limiting the size of withdrawals from your retirement savings is critical for ensuring your portfolio lasts throughout your lifetime. William Bengen calculated a 4% withdrawal rate, adjusted upward annually to account for inflation, as having a very high probability of ensuring a retiree will not run out of money. You may be able to sustain a higher withdrawal rate, but the risks of running out of money will increase as well. Even bumping the withdrawal rate to 5% comes with some increased risks, though going above this level significantly increases the risk of a shortfall.

2. Allow for Variability in Your Spending—The 4% withdrawal rate is a good benchmark for determining how much to withdraw, but it’s just a benchmark. During good years for the market, you may be able to withdraw much more from your retirement savings; during bad years, much less. You will also have years when your spending is elevated (vacations, home repairs, medical bills, etc.) and years when your spending is lower. By allowing for variability in your spending, you can help to offset the blow taken from the years with bad market conditions or high spending.

3. Be Cognizant of Longevity Risk—Longevity risk is the probability of outliving your savings. The Social Security Administration estimates a 25% chance of a person turning 65 today living past age 90 and a 10% chance of living past age 95. (The average life expectancy is 84 for a man and 86 for a woman.) These numbers mean a person retiring today could potentially be looking at living off of his or her retirement savings for at least 25 or 30 years.

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Guidance for Following Portfolio Alerts

Posted on June 19, 2014 | Investor Update

Investor-Update
How fast should you act in reaction to a portfolio addition or deletion alert?

A good general rule for following any portfolio, whether it is one of ours or one run by another organization (e.g., a newsletter service), is to buy when an addition alert is issued and sell when a deletion alert is issued. If you want to mimic the performance of the portfolio, it only makes sense to follow the changes. Acting quickly is prudent.

There is a difference between ‘quickly’ and ‘immediately,’ however. In the Model Shadow Stock Portfolio stock order guidance rules, we advise members to be patient. In the user’s guides for our Stock Superstars Report and AAII Dividend Investing portfolios, we suggest generally “acting on portfolio addition and deletion alerts within the week.” We follow up this statement by saying “don’t be afraid to wait longer if you feel the stock price is moving in your favor (falling if you are a buyer or rising if you are a seller).” In other words, don’t dawdle, but don’t feel rushed either.

The amount of patience you should use depends on the stock itself. A large-cap, widely held stock likely won’t be affected by a newsletter alert. We didn’t notice any unusual trading activity in Apple (AAPL) when we added it to our dividend investing portfolio this past April, for instance. Conversely, a smaller, less-followed stock may well be affected. Before the financial crisis, I once saw Movado (MOV) move upward by more than 10% in just a few days because Jim Cramer talked favorably about it on Mad Money. Lower volume will cause a stock to move in reaction to favorable or unfavorable comments or actions, especially if the portfolio or the commentator has a sizeable following.

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Retirement Is Evolving, But Not Completely Changing

Posted on June 12, 2014 | Investor Update

Investor-Update
Two new, but separate, studies by Vanguard and Merrill Lynch revealed evolving trends among retirees. Neither study shatters commonly held beliefs, but both do show that some differences between perception and reality exist.

The Vanguard study, “Retirement Income Among Wealthier Retirees,” looked to see how sources of retirement income have changed. The firm surveyed more than 2,600 households ages 60 to 79 with financial assets of at least $100,000. The researchers requested a complete inventory of income sources and wealth holdings and then asked about the amount and movement of withdrawals.

Lending support to current perceptions, 85% of survey participants received Social Security and 71% received pension income. These public and private income sources accounted for nearly half of aggregate non-housing wealth. Ownership of retirement accounts (e.g., 401(k) plans, IRAs, etc.) was also high, with 84% of respondents holding at least once such type of account.

Where things get interesting is the composition of non-housing wealth. Among the six groups that Vanguard segmented respondents into, Social Security recipients and pensioners received about 70% of their non-housing wealth from the two traditional retirement income sources. Among the other six groups, however, the proportion of total wealth from Social Security and pensions ranged between 18% (for business Investors, who were the most reliant on business income) and 32% for annuity investors (who were the most dependent on annuity income). Even those who are the most dependent on income from stocks, bonds, funds and similar investments—retirement investors and taxable investors—still depended on Social Security and pensions for about a quarter of their total non-housing wealth. In other words, while many retirees are not solely living off of Social Security and pension payments, the two sources still account for a significant portion of wealth and income for most retirees.

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