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Trevor Stone's Journal
Those who can, do. The rest hyperlink.
A Random Walk in Fancy Stockings 
31st-Jan-2015 08:10 pm
currency symbols
I remember thinking, in 2010, that the stock market was likely to rise for a while after falling precipitously in 2008 and 2009. I also had a significant chunk of cash (earning really low interest) from five years of living below my means. "I should do some research, figure out how to actually buy stocks, and invest a bunch of that cash."

With the exception of maximizing 401(k) contributions, I didn't do that research and didn't invest anything. Partly this was because I had a continual sense of "I might decide to buy a house in the next two years," so the chance of losing a bunch of money due to market fluctuations was unattractive. But mostly it was because I like to do a lot of research to understand significant decisions and financial research is both endless, in the sense that there are thousands of securities one might invest in and their prospects change frequently, and boring, in the sense that finance takes everything that's interesting and unique about companies and governments and human decision making and reduces them to a whole bunch of numbers about the past and present accompanied by verbose disclaimers that past performance is no guarantee of future results.

It turns out that not investing in the broad U.S. stock market in 2010 came with a significant opportunity cost: the S&P 500 has roughly doubled in value in the last 5 years. International stocks haven't done as well, with non-U.S. developed markets growing around 4% per year and emerging markets growing by less than 1%. Had I invested $50k in 2010 in half-U.S./half foreign indexed funs I would today have about $30k more I could spend on a house (which I'm still not ready to buy). [It's not totally clear that not investing was a terrible decision, though. I spent much of the energy I could have devoted to poring over financial data becoming a better software engineer and making friends and having fun. The total future outcome of these activities in terms of future salary and well-being may well be worth tens of thousands.]

In December I happened to be looking at charts of the S&P 500 over the last few decades and noticed that the shape of the graph has a recent slope comparable to the slopes leading to 2000 and 2008, but with a present value significantly higher than when the market crashed in those two years. I spend a lot of time at work looking at graphs of web traffic and server performance, so a graph shape that matched historic trouble zones looked worrying to me.

After a checkup on and a rebalancing of my 401(k), I set out to the book store in search of a sensible volume educating readers how to invest in the market. My selection criteria mandated a copyright date after 2009, figuring that a book without the lessons of the worst financial crisis in nearly 80 years would be an incomplete read. Fortunately, there's a new edition of A Random Walk Down Wall Street by Burton G. Malkiel. This book argues that investors (particularly average folks) can achieve no better return, over the long term, than to put their money in a low-cost fund tracking a broad stock market index. When the book was initially published in the early 1970s, one couldn't actually invest in the market as a whole (short of buying a few hundred stocks, which a person with modest means can't do). Malkiel's advocacy of this strategy led to the creation of mutual funds based on indexes like the S&P 500 and the Russell 3000.

The reasons for the primacy of an indexing approach to investing are several. Perhaps most fundamentally, the demand for securities which outperform the market exceeds the supply of such securities. With demand exceeding supply, prices will rise until the securities are priced so high that they no longer outperform the market.

More concretely, in order to outperform an indexed fund, the total returns of the security must exceed the index by more than the cost of maintaining the fund. This cost is expressed as "expense ratio" in mutual fund documents and represents both payments to the people responsible for selecting the components of the fund and the transaction cost of buying and selling the underlying stocks when they become attractive or no longer attractive. Index funds of U.S. stocks often have an expense ratio below 0.1% while actively managed mutual funds typically have an expense ratio between 1 and 2%. So to outperform the market, an actively managed fund must not do better than the average stock in the index but must do so by one or two points. Assuming an average return of 10% for the broad market, an active fund must provide a 11 or 12% return; in other words they must be 10 to 20% better than the average. Among professional investors, it would be surprising to find individuals who are consistently 20% better than their peers. And in years when the market goes down across the board, you lose more money the higher your fund's expense ratio.

In addition to the core point of index-fund investing, A Random Walk covers a fair amount of ground in financial education. Malkiel starts by explaining several historic periods of rapid growth and sudden decline in asset prices from the famous Dutch tulips in 1637 through the global financial crisis in 2008. He then explains two general approaches to investing: Castles in the sky, also known as technical analysis, is focused on figuring out what price people are likely to pay for something in the near future, even if it's much more than the asset is worth. Firm foundations, also known as fundamental analysis, focuses on determining an absolute value of an asset based on facts about it, like how much money the company earns. Malkiel then argues against these approaches, proposing instead the efficient-market hypothesis. He uses both the theoretical basis of EMH and plenty of academic studies and comparisons of historical returns to make the case that long-term, low-cost index funds are the best investment vehicles. You can't beat the market, he argues, but you can match the market. And the market, over any long period in history, has done significantly better than other types of investments. The market doesn't need to be efficient for indexing to be a good strategy.

A Random Walk also has several chapters of practical advice on how to go about investing in the market. Though the book is primarily focused on stocks, Malkiel explains how to understand other types of assets and create a diversified portfolio. He discusses how to plan for situations when cash flow is needed like retirement and major expenses. He also broadly covers the impact of tax on investment returns (essentially: invest as much as possible in tax-free accounts like a 401(k) or IRA to take full advantage of compounding and reinvestment of dividends). Finally, he gives his thoughts on the near-term prospects for investing: the stock market is unlikely to grow at the rate it has for the last several years but will probably continue at a modest growth rate, less than 10% total returns. With low interest rates (though the Fed is expected to slowly start raising them), most bonds will not be very attractive for a while.

Having read the book, I've spent much of my free time in the last several weeks working out an investment strategy for some of the pile of cash sitting in my bank account. There are a few tricky aspects to this. First, my high tax bracket as a well-compensated programmer combined with historic low interest rates means that income-producing assets like bonds in a regular brokerage account would produce returns only slightly better than a certificate of deposit in an insured bank, meaning that interest rate risk leading to a decrease in the value of a bond fund could lead to a loss of money. So much for diversification of asset classes.

The second problem I'm encountering as I scour available ETFs is that recent security valuation history seems somewhat at odds with global economic trends. U.S. markets have doubled in value in the last five years despite stagnant conditions for the median American household. As one would expect, foreign developed markets haven't grown much, with the slow-moving Euro crisis playing a large role. Yet with most of the world economic and population growth growth coming in emerging markets in the last ten years (leading to the creation of acronyms like BRICS), emerging market stocks haven't been rising accordingly. One interpretation of these trends is that "emerging market growth" is mostly about folks in the third world having more money they can spend on products made by multinational companies based in the U.S.A. Another interpretation is that a lot of this economic growth is occurring among companies not (yet) listed on stock markets. While I think that's a great trend that may support sustainable communities, as an investor it's much more difficult to take advantage of ("obtain exposure to") such growth. A third interpretation is that the Giant Pool of Money went looking for the next target after the housing, commodities, and debt markets collapsed and the Pool decided that U.S. equities had the best chance for returns. As the S&P graph flattens out, the Pool may head off on the next quest for above-market returns, leading to a decline in U.S. markets and unhealthy growth somewhere else.

So what am I going to do about it?
I'm contributing as much as possible to my tax-free 401(k) with a several-decades-to-retirement allocation. That's the easy part.

I still think it's likely that I'll buy a house in Boulder, with a target date of 2018 or later to allow my sweetie to establish a stable job, reducing the risk that we'll decide that we need to live somewhere else. Three years is too short a period to rely on positive stock market returns, so I'm going to keep most of my pile of cash invested in cash.

I'm planning to take some cash and sell some company-granted stock (which has grown in value but isn't well diversified and can only be sold at certain times) and invest it in a variety of index-tracking exchange-traded funds, which are much like mutual funds but requiring smaller tax payments when not held in a tax-free account. I've spent several dozen hours this month looking at graphs and numbers and portfolio distributions and holding lists and building a spreadsheet. And due to the paradox of choice and information overload, coupled with the uncertainty of returns of a random-walk market, I'm not sure my plan is much better off than it was before.

My plan so far involves investing 45% in U.S. markets, 25% in the "All non-US companies" index plus major developed countries (which make up the bulk of the all-world index), 20% in emerging markets, and 10% in real estate investment trusts. Typical investment advice for someone my age would suggest 20% bonds, but with low interest rates and high income tax, I don't think bonds will be a good investment for several years. This portfolio isn't going to generate much current income in the near future, so it's not going to contribute to the house-buying fund but instead be treated as a long-term investment; a general bet on overall economic growth, particularly in the third world.

So what should you do?
First, take any investment advice with a healthy dose of skepticism. Don't bother reading most short-term focused writings (articles with titles like "7 Energy Stocks that are a Strong Buy" or anything on CNBC). Read books and articles like A Random Walk Down Wall Street that are focused on long-term investing and don't make bold claims about beating the market.

Second, take full advantage of workplace retirement programs. In the absence of a robust welfare state, the two tools most folks have for surviving old age are tax-free investment accounts and kids with good jobs.

Third, carefully examine any investment opportunities for cost. The more money you have to pay someone to manage your money, the less money you get from investments. Index funds tend to be the best investment choices.

Fourth, live below your means. There are hordes of people who would be happy to lend you money so you can make poor financial decisions.

Fifth, if you've got extra money to invest, think carefully about how you want to approach investing. Know that you're not likely to make a huge profit in the near future and that your investments might suddenly shrink if the global financial system suddenly discovers that was again acting on incorrect or incomplete information on a massive scale.
Comments 
1st-Feb-2015 05:10 am (UTC)
This was really useful. I'll go find a copy of that book. I appreciate it that you have done the research I've been putting off for years.
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