Months ago I did a review of Prosper, a website which allows you to earn interest by lending money directly to others (Prosper takes a small cut). After looking at the mechanics of their system as well as their own historical loan data, the main conclusions from my initial review were:

1. You should avoid loans from those with poor credit rated E and HR like the plague, as they have negative annual returns ranging from -10% to -30% annually. Prosper lenders as a whole priced this subprime market very poorly.
2. If you stick exclusively to the borrowers with the best credit score (rated AA and A), manage your cash carefully, and the default rates don?t keep rising, you may achieve average net returns of about 8% annually.

A key part of that last sentence is if the default rates don?t keep rising. Sure the initial interest rate may be a snazzy 10-12%, but these loans are all three years in length, and my theory was that as time goes on more and more people will default on these loans. Or maybe some will vary between being late and becoming current again, so that the return stays pretty constant. Now that there is more history in their database, I decided to run some number to test this theory out.

As in my original review, I took all the loans that originated in the first half of 2006. Then, I looked at the ROI (average annual return after taking into account defaults and Prosper fees) as observed on different dates ranging from October 2006 to June 2007. Here are the results:

Summary
It would appear that there is indeed a gradual “decay” of annual returns, with the rate of decay increasing as you drop into the lower credit grades. Although this is not conclusive evidence, it is something to consider if you are expecting a certain level of performance. If I were to lend on Prosper, I would stick exclusively to the AA-rated loans.

Even with AA-rated loans, right now we are less than halfway done with these loans. If these trends continue, by the end of the 3-year term, I expect the average net return to be about 7.6-7.8% annually. Again, this is an average value, and one would still need enough money spread across a number of loans to protect from individual loan risk. 7.7% actually isn’t bad, and is almost enough to make me commit some money to this if the spread above FDIC-insured equivalents remains high enough. I’m currently remaining on the sidelines until I see how the marketplace responds to any federal interest rate hikes.

I’ve been toying again recently with the core and explore idea of putting a few thousand dollars into my Zecco account and testing out some active trading theories like options, swing-trading, technical analysis, fundamental analysis, whatever. I finally feel like I have a large enough portfolio that a thousand dollars is only a few percent of the total.

The money is already there, I just haven’t pulled the trigger yet. Now, I don’t have better than a 50/50 chance of beating the market, but I do think it would be fun to try and I could learn some things along the way. Does anyone else have a similar account?

In addition, I’ll be openly sharing all of my trades, and keeping track of my performance very carefully. That’s what I’ve always wanted – to actually see people who actively trade reveal their true performance. (And mock them – like you’ll be able to do to me! 😀 )

John (Jack) Bogle is both the founder of the low-cost mutual fund company Vanguard and the creator of the first index fund available to the public. These days he spends his time speaking about corporate ethics and how index funds are great investments for the vast majority of people. But what does he invest in?

According to this Morningstar article An Inside Look at Jack Bogle’s Portfolio, the answers may surprise you.

Overall Asset Allocation?

“My current asset allocation overall is about 60% bonds and 40% stocks. There’s a fair amount of money involved here, and I feel no need whatsoever to overdo equities. After all, if stocks (surprisingly) soar–I’ll do just fine, not in percentage terms but in dollar terms.”

Stocks – Active or Passive? Value or Growth?
The article is a bit cryptic, but by how I interpret it he seems to be split down the middle:

50% Passive – Total Market Index Funds
50% Active – Vanguard Explorer, Wellington, Wellesley Income, and Windsor Funds

So Jack tilts his portfolio to the value side of the style box. That style tends to be more conservative and puts more emphasis on stocks paying dividends.

Bonds
The bonds portion seems to be conservatively invested in 50% Short-Term Bonds and 50% Intermediate-Term Bonds.

Last time we talked to Jack, he had shifted away from long-term bonds and GNMAs. This time, we see that Jack is moving into TIPS (Treasury Inflation Protected Securities). “In fact, the only investment change I’ve made in the past few years is a move of about 6% of combined assets from Vanguard Intermediate-Term Bond Index VBILX to Vanguard Inflation-Protected Securities VAIPX . The latter is essentially a similar index fund, but with a possible advantage if inflation heats up more than the present discount suggests. I probably should have added to my holdings in the inflation-protected fund earlier.”

Even though this article isn’t the reason, I am starting to rethink my bond allocation to add exposure to inflation-indexed bonds. This would provide an additional hedge against some unexpected inflation.

Before anyone uses his portfolio as a model, consider the following:

1. He’s 78 years old (76 at the time of this article), and even though he had a heart transplant, is still working. This guy likes his job.
2. He has enough money that he doesn’t even need to withdraw anything to maintain his lifestyle. I would imagine he’s probably just trying preserve wealth as much as achieve growth.
3. Since he’s the founder of Vanguard, he may have some sentimental or loyalty reasons to hold certain funds, and states as much.

I doubt many people reading this are in a similar situation 😉 Really, the only thing that I can take away from this is that there really is no “perfect” portfolio for everyone. But it certainly satisfied my curiosity; I wish more investment personalities would share their actual portfolios. You can see my imperfect portfolio here. I’m going to attempt to simplify it a bit sometime in the coming months as well.

While reading The Little Book of Common Sense Investing by Vanguard founder Jack Bogle, I found one of the chapters on predicting future stock returns especially interesting. Here’s my attempt at summarizing it.

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).

As an example, let’s take a fictional company and call it Bob’s Taco Shack. The taco stand has earnings of $20,000 a year. It has 1,000 shares, so it’s earning $20 per share (EPS). Bob gives out $10 of that $20 as a dividend to shareholders, and reinvests the remaining $10 back into the company. Currently, the share price is $200, which gives us a price/earnings ratio of 10 and a dividend yield of 5%. Now, let me pose some statements, which I hope make sense.

1. If earnings stay constant, then one would expect the share price to stay constant as well. The stream of money coming is the same, so the price should be the same.
2. If earnings stay constant, and dividends are 5% year, then your return should be just that 5% a year. From the example, you just get that $10 in dividends (5% of $200).
3. If earnings grow by 5% a year, and there are no dividends, then your return would again be 5% a year. You are paying 10 times earnings. If the earnings go up by 5% to $21 per share, then the share price should go up to $210. You earned the same amount as the earnings grew.

This leads to the formula for what Bogle terms the “fundamental” return:

Now, if Bob announces that he plans to expand into fancy shrimp tacos and fish tacos, then maybe people will expect higher future profits and be willing to pay more per share, raising the P/E ratio. But this is based on speculation. Bob hasn’t actually done anything yet. So now we have speculative return:

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)

What about the future?
Great, right? As long as corporate earnings growth keeps chugging along and we keep getting some dividends, we should be good to go. Over the past 25 years, the U.S. stock market has had earnings growth of 6.4% and an overall dividend yield of 3.4%. Nice! But wait – there was also a speculative return of 2.7% due to the overall P/E ratio expanding from about 9 to 18!

As you can see below, that gave us really strong annual returns of 12.5% since ~1980. The problem is, this isn’t likely to continue. For one, dividend yields continue to drop, and are now about 2%. As Bogle states, even if you assume a continued corporate earnings growth rate of 6%, now you have a total of 2 + 6 = 8%. But the P/E ratio is not likely to get any bigger. If anything, history says it should shrink back a bit. If it goes back to 16, that alone will subtract 1% from expected returns.

Data taken from Little Book of Common Sense Investing, Exhibit 7.1

(If you don’t agree with the 7% number, make up your own based on your expected dividend rate, earnings growth, and future P/E expansions or shrinkage.)

As you can see, this shows that it is unlikely that in the next 25 years we will earn much more than 8% annually from stocks alone, and chances are it will be more in the range of 7%. Add in those bonds as you get older, and that return decreases even further. Food for thought…

My comment was – Will earnings growth rates increase, as companies are presumably re-investing money not paid as dividends in themselves? I sure hope so, but it seems like a lot to ask.

Even though the expense ratio for an ETF may be slightly lower than a mutual fund, that doesn’t necessarily completely explain the cost differential between them. In addition to any commission costs, there are also the issues of bid/ask spreads and deviation from NAV. These are explained briefly below along with some useful tools to evaluate their impact.

Historical Bid/Ask Spread Values
Since ETFs are by definition traded on an open exchange, there can be differences between what people are currently willing to pay (the “bid” price), and what people are willing to sell at (the “ask” price). Even if you assume the ETF is priced correctly at it’s inherent value, this bid/ask spread means you will be overpaying a bit when you buy, and losing a bit when you sell. It can be thought of as slight purchase fee and redemption fee. (This also holds true when you trade individual stocks!) Mutual funds, on the other and, always trade at net asset value.

Some people try to avoid getting a “bad fill” for their trade by doing a limit order between the bid and ask instead of a market order, but limit orders carry the risk of non-execution. If the share price goes up, you’ve missed out and must submit another order anyways.

Many of the low-cost ETFs I am interested in are from Vanguard, and thankfully they have compiled a list of the average bid/ask spreads over the last 30 days for their entire ETF line-up. Here’s a sampling:

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