Losers are Winners and Winners are Losers

Why do individual investors typically under perform institutional investors? The answer lies in the chart below. Many individual investors chase returns - buying last years’ winners and selling off losers. After being burned in the stock market in 2008, these investors moved to bonds, cash and gold, last year’s top asset classes. I call this the Money Magazine strategy. Pick up Money Magazine in December and buy what they recommend. Then watch last years winners become this year’s losers as institutional investors reallocate assets. Next year’s Money will have a whole new set of losers to chase.

The top 3 asset classes on the Chart below have now moved to the bottom of the chart in the first 6 months of 2009. Last years losers are this year’s top performers as Emerging Markets and Growth oriented stocks out performed all other classes.
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Asset Allocation: Going Green

In case you haven’t noticed, just about everyone, even the Nation’s capital, is going “green”. In December of 2006, Washington DC became the first city in the nation to pass legislation requiring not only government-owned office buildings larger than 50,000 square feet to adhere to green building standards, but privately owned buildings as well.

How can you make a positive impact on the environment and capitalize on the “green” phenomenon?

Take Steps Towards Becoming Carbon Neutral

The concept of becoming carbon neutral can be debated by many as is global warming in general. However, for the purpose of this article, I will assume we all want to make a positive impact on our environment. You can start by taking steps to move your household towards carbon neutrality. I took the test at http://www.carboncounter.com/ and learned that I generated 4 times the carbon of the average US citizen! Thus, according to the calculations on the web site, I need to donate $576 to “offset” my carbon emissions and become “carbon neutral”. The donation goes to the Climate Trust, a 501 (c) (3) working towards a more stable climate.

According to the website, offsets are used to:

• Increase energy efficiency in buildings, factories, or transportation,


• Generate electricity from renewables such as wind or solar,


• Modify a power plant or factory to use fuels,


• Put wasted energy to work via cogeneration,


• Capture carbon dioxide in forests and agricultural soils.

Practice Energy Efficiency
Next time you buy a new appliance, remodel your home or buy a new one, factor energy efficiency into your decision-making process. According to the US Green Building Council, http://www.usgbc.org/, 10% of all carbon dioxide emissions in the country come from our homes. Typical American homes lack energy-efficient appliances, windows and insulation, thus consume extra energy to compensate for loss of heat and air conditioning. The up front costs of improvements will be recouped in the long run.

Recycle and Buy Recycled Products
Most people today recycle bottles, plastic and newspapers in their homes. However, few of us use recycled products. Using recycled materials, especially if they are locally made, can have a huge impact on the environment. Many of today’s building materials come from recycled waste. If you are in the Washington area, check out Eco-Green Living. Eco-Green Living, is the premier green, organic, and fair trade store in the Washington, D.C. metro region for lifestyle, home remodeling, and personal care products. You can find out more at http://www.eco-greenliving.com/

Invest in “Green” technology
The following is a list of funds that invest in various forms of “Green” technologies:

PowerShares Water Resources Fund (PHO) is based on the Palisades Water Index™. This Index seeks to identify a group of companies that focus on the provision of potable water, the treatment of water, and the technology and services that are directly related to water consumption.

PowerShares Global Water Fund (PIO) is based on the Palisades Global Water Index™. This Index seeks to identify a group of global companies that focus on the provision of potable water, the treatment of water and the technology and services that are directly related to global water consumption.

PowerShares Global Clean Energy Fund (PBD) is based on the WilderHill New Energy Global Innovation Index. The Index seeks to deliver capital appreciation and is composed of companies that focus on greener and generally renewable sources of energy and technologies facilitating cleaner energy.

PowerShares WilderHill Clean Energy Portfolio (PBW) seeks to replicate, before fees and expenses, the WilderHill Clean Energy Index, which is designed to deliver capital appreciation through the selection of companies that focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy.

PowerShares WilderHill Progressive Energy Portfolio Fund (PUW) is based on the WilderHill Progressive Energy Index. The Index is comprised of U.S.-listed companies that are significantly involved in transitional energy bridge technologies, with an emphasis on improving the use of fossil fuels.

The Spectra Green Fund (SPEGX) is a mutual fund that seeks long-term capital appreciation by investing at least 80% of its net assets in equity securities of companies of any size that, in the opinion of the Fund's management, conduct their business in an environmentally sustainable manner, while demonstrating promising growth potential.

By doing your part in the “Green” movement, you can feel good about the choices you make for a better world for you and your children.

Warren Buffet on International Investing

Each year I look forward to reading Warren Buffet’s annual report to the shareholders of Berkshire Hathaway. The 76 year old Buffet is the Chairman of Berkshire Hathaway, a holding company that owns a diverse group of subsidiaries.

With an estimated net worth of $28 billion, Buffet is one of the ten richest men in the world and considered by many to be the best investment analyst ever. In the past, he has stuck primarily with US investments, but as he says in his report to shareholders, things are changing.

In reference to the $2.2 billion dollars he made on currency exchanges and the nearly $3 billion earned on his investment in PetroChina, Buffet said, “As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. . . the U.S. had $.76 trillion of pseudo-trade last year - imports for which we exchanged no goods or services (only money).” By doing this, Buffet said, “the US necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy, but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.”

Buffet continued, ”The ‘investment income’ account of our country – positive in every year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card.

And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay for ever-increasing amounts of interest on interest.” In addition to our trade imbalance, non-U.S. companies are gaining ground in areas traditionally considered U.S. based businesses. As an example, the world’s largest producer of steel and the largest supplier of beer are US Steel and Anheuser Bush, right? Wrong. Mittal Steel, owned by an Indian and headquartered in the Netherlands, is the world’s largest steel producer. U. S. Steel is the 7th largest producer of steel behind six other non-U.S. companies. InBev, the result of a merger of a Brazilian company AmBev and a Belgium company, Interbrew, is the largest producer of beer in the world. Anheuser Bush is the third largest, behind InBev and SAB/Miller, a South African company.

The world’s best companies continue to make huge investments outside the U.S. We must follow their example and do the same. Over the past 5 years, the EAFE Index, has had an annualized compounded return of 16% compared to a return of just 7% for the S & P 500. A balanced investment portfolio must include a heavy dose of non-U.S. investments.

Buffet summarized his thoughts on this issue by stating, “It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future, U.S. workers and voters will find this annual “tribute” so onerous that their will be a severe political backlash. How that will play out in the markets is impossible to predict – but to expect a “soft landing” is wishful thinking.”

Asset Allocation: Avoid Picking Individual Stocks

I recently attended an economic presentation by Dr. Gene Fama of the University of Chicago, the leading champion of the efficient market theory and a favorite to win the Nobel Peace prize one day. Dr. Fama stated, “I’d compare stock pickers to astrologists, but I do not want to bad-mouth astrologists.”

One of the biggest mistakes individual investors make is following the advice of the media, a stock broker or money manager on individual stock picking. Why is it that every year Money Magazine selects its top stocks to beat the market and never reports on how they performed the next? Why does Fortune Magazine list different “top money managers” each year and forgets to tell you about their selections of previous years. Why does CNBC run experts with differing opinions 14 hours per day and never tracks their recommendations? The reason is that it sells magazines and ad space!

Let’s look at some of Fortune Magazine’s “All Star” stock picks in their July 2000 edition:

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In the January 2000 issue of Time Magazine, Amazon founder Jeff Bezos was declared man of the year. If you purchased Amazon in January of 2000, your stock lost 75% of its value within a year. This year’s person of the year is “you”! The ramifications of this prediction are a little scary. This phenomenon is not limited to just stock picking either. Money Magazine’s “timely” June 2005 issue touted the virtues of buying residential real estate and denied the existence of any housing bubble. According to the magazine, “These days, everybody knows someone who has made money in real estate, and rising prices have become a national preoccupation. We are a wealthier country than we have ever been, so it makes sense that we would spend more on real estate, pushing prices to new highs. After a l l , F e d e r a l R e s e r ve Chief Alan Greenspan complained of "irrational exuberance" in 1996, more than three years before the stock boom ended in tears.”

I feel truly sorry for those that followed that advice. Once a financial trend hits the main stream, it’s generally time to get out. Over the past 20 years, money managers failed to beat their market bench marks over 80% of the time. This leaves just 20% of money managers or stock pickers beating the market on an annual basis. The problem is that different managers beat the market each year.

There is very little consistency with these managers beating the market from year to year. On the occasion that one of these star managers floats to the top, so much money flows into their portfolio that it creates a drag on future investment performance. Maybe if we can locate these emerging managers, we can beat the market more consistently. So how do we find these guys? When Peter Lynch, arguably one of the best stock pickers ever, retired from his job as manager of Fidelity Magellan, he and the executives at Fidelity spent an enormous amount of time and money scouring the investment world for the best money manager. Three money managers later, Fidelity Magellan has underperformed its bench mark index by exactly the management
fee it charges. What makes us think we can pick a good portfolio manager when Peter Lynch and Fidelity cannot?

What about the great stock picker Warren Buffet? According to Buffet, he may find 2 or 3 good stock ideas every couple of years. Mutual fund companies typically hold 150 to 250 stocks. How does a mutual fund manager find 200 good ideas? I guess they simply select 2 good ideas and 198 average ideas. Buffet also inserts himself into the management of the good ideas he selects, a likely boon to his returns. This does not happen in the traditional portfolio managementindustry. So, if we can’t pick stocks that consistently beat the market and we can’t pick managers that consistently beat the market, what should investors do? Stop trying to beat the markets! Put your savings to work and earn a market rate of return. As investors, we are entitled to the market return. Anything less is our own mistake. How do we get this?

In order to answer this, we need to understand some basic facts about what the “market” is and risk. Here is a table showing the typical market asset classes and their performance over the previous ten years.

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As you can see, different asset classes perform differently from year to year. Many times one year’s winner is the next year’s loser. By diversifying among these asset classes in such a way that meets your individual risk tolerance, you can obtain market returns with an appropriate amount of risk. This can be done by purchasing index funds and exchange funds that mirror the asset classes. Now, if we simply select the asset mix that meets risk and return profiles, we can earn the market return and go play golf!

If you need help, don’t hesitate to call. This is our specialty!!!

Asset Allocation

Buy Low, Sell High – Not As Easy As It Sounds

Small investors seem to continuously chase the market trend and use a strategy I call “recency”: What ever the most recent phenomenon of making money is, follow it. We have seen recency with dot bomb stocks, real estate, emerging markets, gold, etc. These investors are applying reverse market timing. Wait until something gets run up really high, then buy it only to watch it free fall. Then sell it! In other words, “buy high, sell low”.

Why does this happen? Most institutional investors apply an asset management strategy in their portfolios. This means that when one asset class of the portfolio grows beyond the tolerance set by the manager, they sell. It also means when an asset class falls below the tolerance level they buy. Here’s the rub: institutional investors have more money than retail investors. So when a retail investor is following a trend, and the institutional investors are selling what is high, the retail investor becomes the bug and the institutional investor becomes the windshield. So why play this game?

Fasten your seatbelts, do not panic, have patience and follow a long term plan. In its simplest form, asset allocation is a strategy with fixed percentages in cash; bonds both domestic and international, US Equities both large and small, and international stocks both large and small. The portfolio is then rebalanced periodically. This rebalancing process creates the “buy low sell high” discipline! It also removes guessing which generally creates havoc on the portfolio.

The Value of Asset Allocation: A Case for Indexing

Large cap stocks or mutual funds are core to any portfolio. Allocations to this asset class range from 15% to 35% depending on risk tolerance. (If you have more than this, you may want to evaluate your portfolio!) Most of us have seen the articles featured in the Wall Street Journal where a chimpanzee throwing darts at a stock page tends to outperform Wall Street’s brightest managers. Over the past 20 years there have been numerous studies on the value of selecting managed mutual funds vs. simply buying an index fund.

An index fund is mutual fund designed to mimic the returns of a given stock market index such as the S& P 500. For example, the Schwab Institutional S & P 500 Index fund simply utilizes a computer model to purchase all of the US’s largest 500 stocks in a weighting equal to their market cap.

According to a recent article in the Journal of Financial Planning by Thomas P. McGuigan, CFP, the large cap fund index (S& P 500) outperformed managed mutual funds 72% to 84% of the time over rolling 5,10, 15 and 20 year periods since 1993. The study concluded that the longer the period of time, the more likely the index beat the managed funds. The percentage of mutual funds that outpaced the index fund was only 10.59%. Thus, only 18 of 171 mutual funds outperformed the index fund over 20 years. The majority of out performers, 12 out of 18, only outperformed by 1% or less. This study did not take into account all the funds that are no longer in existence. If this figure was included, the percentage of funds that beat the index would be even lower. The study also found that the cost of selecting the wrong fund was very high.

The majority of the underperformers (113 funds), missed the mark by 1 percent or more. In my opinion, these odds are just not worth the risk.

Why is it that a chimp can outperform a manager in large cap stock selection? The answer lies in market efficiency, managed fund expenses and taxes. The US stock market and particularly the large cap stocks are nearly perfectly efficient. This means that the markets impound information into prices so well that the analysis of publicly available information will not produce excess returns. Thus manager out performance is simply luck rather than skill.

In addition to market efficiency, fund costs have a huge impact on performance. Fund costs include expense ratios, commissions, bid ask spreads and impact costs. Expense ratios are the cost of staff and overhead. Commissions and bid ask spreads are the actual costs of trading stocks. Impact costs relate to the expense associated with liquidating a large position in a particular stock. These expenses range form 1 to 2 percent per year for all funds.

On the other hand, an index fund has considerable lower expenses. For example, the Schwab Institutional S &P 500 Index fund mentioned above has a total expense ratio of just .22%. This gives the index fund a considerable advantage over its peers. Not only do managed funds have to beat the index, they must also cover their expenses. If the case above for indexing is not powerful enough, consider the impact of taxes. Managed portfolios generate nearly twice as much tax liability as index funds.

If all of the hold true for large cap stocks, what about smaller cap funds and international funds? While fund costs for these asset classes are actually higher, markets are less efficient giving some managers the edge. I generally used index funds for large cap portfolios and best in class institutional money managers for other asset classes.