Daniel Kahneman, behavioral economics guru and Nobel Prize winner, has a new book out called Thinking, Fast and Slow. This one is definitely on my to-read list. You may remember him from his TED Talk about Happiness = Earning $60,000 A Year?

He wrote an article for the NY Times called Don’t Blink! The Hazards of Confidence (a little jab at Gladwell?), which covers one of the cognitive fallacies discussed in the book caused by overconfidence amongst professional stock-pickers and money managers. First, he covers what some of you may already know about the performance of actively-managed mutual funds:

Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

More important, the year-to-year correlation among the outcomes of mutual funds is very small, barely different from zero. The funds that were successful in any given year were mostly lucky; they had a good roll of the dice. There is general agreement among researchers that this is true for nearly all stock pickers, whether they know it or not — and most do not. The subjective experience of traders is that they are making sensible, educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are not more accurate than blind guesses.

The second story was more personal, and had to do with a small group of financial advisors.

I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarizing the investment outcomes of some 25 anonymous wealth advisers, for eight consecutive years. The advisers’ scores for each year were the main determinant of their year-end bonuses. It was a simple matter to rank the advisers by their performance and to answer a question: Did the same advisers consistently achieve better returns for their clients year after year? Did some advisers consistently display more skill than others?

To find the answer, I computed the correlations between the rankings of advisers in different years, comparing Year 1 with Year 2, Year 1 with Year 3 and so on up through Year 7 with Year 8. That yielded 28 correlations, one for each pair of years. While I was prepared to find little year-to-year consistency, I was still surprised to find that the average of the 28 correlations was .01. In other words, zero. The stability that would indicate differences in skill was not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill.

My, that must have been an uncomfortable presentation! Investing is an area where it is very hard to discern skill from luck, so be careful when asked to pay a nice chunk of money for it, be it through mutual fund expense ratios or portfolio management fees.

Vanguard’s research division published a new report [pdf] that found that a portfolio split 50/50 between stocks and bonds had very similar inflation-adjusted returns regardless of whether the U.S. economy was growing or in recession. Here are the numbers from 1926-2009 taken from the report summary:

Given that timing recessions and expansions has been shown to be very difficult, this would suggest that making big asset allocation moves (bets, really) to 100% stocks or 100% bonds in anticipation is not worth the effort.

It also reminds me that as a portfolio asset allocation gets closer to 50/50, the swings in return each year are less wild. After 2008 and 2009, I think many people have a new appreciation for lower volatility. Maybe it would be better for many investors that don’t have full “faith” in the stock market to move their asset allocation to 60% stocks/40% bonds or similar, instead of the 80 or 90% stocks that some calculators or target-date retirement funds would suggest.

Along those same lines, Morningstar has found that most “tactical asset allocation” funds have had a hard time beating the simple-and-cheap Vanguard Balanced Index Fund (VBINX), which is basically just two index funds in a fixed 60% stock/40% bond ratio. The 10-year returns are in the top quartile of similar funds, with a below-average standard deviation.

Vanguard recently decided to kill off it’s own market timing fund, the Vanguard Asset Allocation Fund, formerly actively managed by Mellon Capital. Even a low expense ratio of 0.27% couldn’t save this one.

I’m currently reading the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks. Inside, he talks a lot about risk. Most people seems to grasp the idea that riskier investments offer the prospect of higher returns. Stocks are expected to offer higher returns than cash or bonds. Bonds are considered less risky, and thus return less. However, Marks states that too many people have a simplistic risk/return relationship in their heads:

Source: Table 5.1, The Most Important Thing

However, there is no requirement that riskier investments will actually provide those higher returns. It’s only the average expected returns that are higher, but since the uncertainty is also higher. Put another way, the distribution of potential returns is wider. To be more precise, he shares this risk/expected return chart instead:

Source: Table 5.2, The Most Important Thing

When I started investing several years ago, I remember reading several personal finance articles that responded to questions from older investors that had some catching up to do with their nest eggs. The solution was simple – own more stocks! You’ll need the extra return, they reasoned. That’s exactly the wrong way to think. There is no easy shortcut to saving more.

If you have an account with Vanguard, you may have noticed them rolling out improvements to their online interface this month. If not, try logging in and see if you notice anything different. Today, I received an e-mail that they are also improving their funds availability rules when buying mutual funds with online bank transfers:

Same-day trades with electronic bank transfers
Now you can get today’s trade date if you use our electronic bank transfer service to buy a Vanguard mutual fund. Just submit your request on business days before the close of regular trading on the NYSE (generally 4 p.m., Eastern time) and you’ll receive that day’s closing price.

Finally! I placed at trade and it appears to have worked. The previous rule was that if the purchase was before 10pm Eastern of Day 1, then you will get the purchase price as of closing on Day 2. So even if I wake up at 6 am in the morning on Thursday and place a trade, I would get the price as of market close at 4pm Eastern Friday. Your bank account is debited on Day 3.

Others have reported receiving this notice weeks ago, and while I’m happy to see it in my account, I also think it was long overdue. You can already get the same-day closing price if you exchange from another mutual fund already in the account, like a money market fund. So basically what they were saying is that they don’t trust that your bank funds would clear. However, it takes 3 business days (T+3) for things to clear anyway, so it’s not like you could run off with the money. I have been able to initiate a money transfer into my Scottrade account and start buying stocks seconds later for years. This way, I don’t have to keep money sitting around in a money market fund earning zero interest.

You could argue that if I’m not timing the market then I shouldn’t really care when the trade clears. But the way I see it, I am rebalancing my account and buying what has been dropping. I would be highly annoyed if the stock market bounced up 5% the next day, meaning I shouldn’t have rebalanced at all.

I don’t usually post market forecasts, but I just wanted to jot this one down for posterity. Jack Bogle, founder of Vanguard, is interviewed in a WSJ article Why a Legendary Market Skeptic Is Upbeat About Stocks where he makes a prediction of 7% annual returns for stocks for the upcoming decade. He correctly predicted 10%+ gains for the 1990s, and also low single-digit returns for the 2000s. Let’s see if he’s correct for the 2010s.

Over the next decade, Mr. Bogle said stocks are likely to generate an average annual return, including dividends, of around 7%. “Your money will double in 10 years,” he said. “How bad is that? People ought to get over the illusion [of higher expectations] and realize that they may have to invest for longer time periods, start earlier and save more.”

There other good observations in the article, although they won’t surprise any Bogle followers. I previously wrote about Bogle’s future return prediction methodology where total stock returns are the sum of earnings growth (aligns with GDP growth), dividend yield, and P/E ratio changes. The diagram below is reproduced from his 2007 book Little Book of Common Sense Investing, which also shows us a 7% forward prediction at the time. Well, we’ve got some catching up to do…

In a discussion about risk on the Bogleheads forum, member John Norstad brought up an intriguing question. Let’s say you won $1 million (net after taxes) in the lottery tomorrow. This money will get added to your existing investment portfolio, and may or may not be enough to allow you to fully “retire” as you would like to. As a result, how would you change your investment style?

Make it more aggressive. Sample reasoning: Now that I have a head start and a cushion, why not gamble a little and see what happens? I should buy more stocks, and perhaps I can retire even earlier or with a bigger nest egg. This is given the term Decreasing Relative Risk Aversion (DRRA).

Make it more conservative. Sample reasoning: I’ve just gotten much closer to my goal, and I don’t want to mess it up. I can now invest more in safer things like bonds and be more confident in reaching my goal eventually. Known as Increasing Relative Risk Aversion (IRRA).

Keep it the same. Sample reasoning: I have a set allocation set up, and I see no reason to change it. Anything I don’t spend, I will leave to my heirs. Known as Constant Relative Risk Aversion (CRRA).

If you won the lottery, how would you adjust your investment style?

• I would invest more aggressively and take more risks.
• I would invest more conservatively and take less risk.
• I would keep my same portfolio asset allocation.

View Results

 Loading ...