Tag Archives: investing

Rising Rate ETFs

In a Weekend Investor article in the Wall Street Journal, the author Joe Light describes how trends in bond ETFs are changing amid the expected rise in interest rates in the near future. ETF, which is an acronym for Exchange Traded Fund, is essentially a portfolio of assets that typically track some underlying index. For instance, if you were to purchase one of the popular SPDR S&P 500 ETF (pronounced “spider”), you’re essentially buying a small piece of every company within the S&P 500 stock index basket. There are many benefits to buying a low-cost ETFs, including the possibility of diversification and liquidity. A good primer on ETFs can be found from the youtube channel of Blackrock, which is an asset management firm and industry leader in ETF investments. 

ETFs can offer investors greater liquidity than through investing in individual securities because, while the overall size of the ETF may be large, the size of the holdings of any given asset within the ETF is much smaller. For instance, if someone purchased $1Billion worth of single company, or a small portfolio of companies, and later decided to sell all of their shares at once in what is called a “fire sale,” then the added supply of shares in the market would cause the underlying asset prices to drop. In this case, the investor might have to sell for a significant loss to get his/her money out right away. However, if one bought $1 Billion worth of  SPDR “SPY” ETFs based on the S&P 500 and decided to sell the whole ETF at once, the prices of the underlying assets might shrug off the effects. In this case, you may have only invested $2 million in each company (assuming equal weights within the portfolio), which is typically not enough to dramatically affect the supply and price of an asset.

An ETF can cover a range of assets as narrow as a single industry such as oil and gas, or as broad as an entire market, so an investor can essentially choose how diversified their portfolio is. For instance, if you were an investor that had purchased a diversified international equities index fund, but were hoping to also hedge your investments against fluctuations in stock market, one could buy a bond ETF that would be composed of assets like Government Treasury Bonds, Corporate Bonds, or asset backed securities.

While bond portfolios might in normal times make an attractive investment for those wishing to diversify their portfolios, many investors are currently hesitant to touch them due to expectations of a rise in interest rates in the near future, given the U.S. Federal Reserve’s decision to begin to wind down its quantitative easing purchases. So if the artificial demand for bonds created by the FED will soon be lifted, likely causing bond yields to increase and prices to drop, how can a bond investor sensibly make money on these trades? The answer is hedging.

Many companies including Blackrock and WisdomTree Investments have launched plans for hedged bond ETFs that will protect investors from the ever-more-likely drop in the price of bonds. One such ETF is called a zero-duration ETF, which is a portfolio that both goes “long” on bonds (meaning you purchase bonds) while going “short” on certain bonds and derivatives (such as by shorting U.S. treasuries or Treasury futures contracts). In this case, a short is when you borrow a share of an asset, immediately sell it, and then pledge to the lender to return the share at a later date by purchasing another share at (hopefully) a lower price. This “hedging” allows investors to essentially place bets on both sides of the market; if interest rates and bond yields fall, then the investors profit from the rise in the price of their bonds, but if bond yields rise then the investor can offset much of the losses in their bond portfolio by the increased return from their “short” bets.

While there are many benefits to hedging, including in using hedged bond ETFs like the zero-duration ETF, the costs are also larger. Hedges can add to the cost of a portfolio because the investor must purchase instruments such as futures contracts, or place money on margin to short an asset (margin is somewhat like a security deposit; in the case that an investor can’t afford to buy back a share that it borrowed from the broker, the broker gets to keep the margin). If investors invest in high-fee hedged ETFs without looking at the annual management fees, then they might be disappointed in the size of the returns after the wealth managers take a cut. Overall, there’s a price to safety in unstable markets, so investors would be wise to consider all of the investment choices available to them before they let a broker touch their nest eggs.

Passive Over Active Investing

In the investment world, there is an ongoing dispute over passive investing. Basically, the evidence shows that passive investing (through index investing) out-performs active investing. This is one of Burton G. Malkiel’s main arguments in “A Random Walk Down Wallstreet.” He famously claims that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts” (pg. 26). As Professor Kimball has also reiterated numerous times, getting rich in the stock market by carefully selecting specific stock, is simply a matter of luck. This is the basis for Malkiel’s claim that index investing is the best way to go.

First, it is important to understand exactly what index investing is. As defined by Investopedia, an index fund is “a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.” Index funds are known for having low costs and for being handled passively, meaning there is no active management like in active stock portfolios. Here is where financial advisors come in. The argument behind whether indexing is a better strategy is mostly alive because advisors benefit from charging high fees when managing active portfolios. They do not benefit from suggesting to clients to invest by indexing, because they gain lower fees from doing so.

And as Malkiel (as well as Professor Kimball) likes to point out, financial advisors who claim to be able to make you enormously rich in the stock market, following their pretty formulas, are full of it. Of course, there is a basic science to it: buy low, sell high. But besides this, it is pretty much up in the air. An article in Forbes does a nice job of explaining the benefits of indexing, and the lies told by advisors about it: “exhaustive academic studies covering the active versus passive debate going back many decades…ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance.” It is interesting that the author acknowledged that skill may be a factor, but then states it is impossible to differentiate between skill and luck. Indeed some people are probably very skilled in managing active investments, but the likelihood of finding an advisor like this is so low that it is not worth the trouble. Either way, if you were to find such an advisor (like was pointed out) it is impossible to know the difference between luck and skill. Unless, of course, you are willing to trust in their luck.

The five lies outlined as being frequently used by advisors in order to sway investors away from indexing are the following:

1. Active US stock funds beat the market over the past decade.

2. Index funds will always achieve below average returns.

3. Indexing doesn’t work in inefficient markets such as small cap or international

4. Active managers perform better in bear markets

5. Warren Buffett has beaten the market and this proves indexing doesn’t work

I encourage you to read the reasoning behind recognizing these claims as lies. For the sake of longevity, I won’t get into them. But it isn’t so hard to understand the concept. And it makes sense that active investing is encouraged by those who benefit from high fees (advisors). It seems that the only reason for this argument to even be an argument, and not a fact, is that there is a clear conflict of interest with those involved. Finally, I’d like to point out that I have nothing against advisors, and I plan to go into the field myself. But I certainly think there are better ways to perform this service, that doesn’t involve deceiving clients in matters like this one.

(Revised) The Best Time to Start Investing For Retirement Is Now

While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs?” when starting our savings. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.

Kelly Greene from the Wall Street Journal explains in her article “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should adopt a “U-shaped” pattern in which they invest mostly in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.

This is perhaps useful advice for those who are nearing retirement and worried about their savings, but a more practical factor to consider, especially if you have a long ways until retirement, is how early can you start investing. After inflationary effects, you might want to start earlier than you once thought. In order to illustrate, I ran a short MATLAB analysis of the S&P 500 returns from 1947 (post-WWII) to 2013 using data from the website of Robert Shiller (Nobel Winning Economics Professor at Yale). To obtain the real price level of the S&P 500 index, I first converted the historical S&P500 prices to prices in 2013 dollars using the Consumer Price Index obtained from the Federal Reserve Economic Database (FRED). Here we use the following equation to put all prices in 2013 dollars.

Screen Shot 2014-03-10 at 2.42.18 PM

If you plot the real prices alongside the nominal prices, you get something that looks like this:

S&P 500 Nominal and Real Prices

It’s pretty obvious that inflation eats away at your return. If you invested in 1947 and cashed out in 2013 you would have had only around an 803.8% return over this 66-year period after inflation, rather than the 9633.1% return you’d expect nominally. We can back out the compounded annual percent return by rearranging the equation:

Screen Shot 2014-03-10 at 2.42.30 PM

Using this equation we find that the annual nominal return over this period excluding dividends is ~ 7% and the real annual return is only around 3.35% (see my code for calculations). Therefore, holding on to a few shares of stocks isn’t going to make you as rich (as quickly) as you might think, so it’s even more important to start saving as early as possible. No wonder why Brett Arends of the Wall Street Journal thinks that a lot of amateur investors don’t understand how large their long-term annual returns are likely to be.

It’s also easy to see that when you buy matters. If you bought the S&P in 1973 and sold in 1983 you would have lost roughly a third to a half of your real purchasing power. You would find similar results if you bought in 1999 and sold in 2009, so timing and luck do matter. It also important to take into consideration what you buy. The only ways around this scenario is to a) be patient and don’t sell in a panic, and b) invest in a portfolio that’s diversified across many different markets so that if one market sinks, your entire portfolio isn’t washed away. As Professor Miles Kimball mentions in his blog post “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” this can be done by investing in a low-cost international index fund that diversifies not only across industries but across international markets.

Overall, despite all the popular investing tips that are thrown around by professionals and pundits, it appears that there’s no time like today to start intelligently planning and investing for the future.

The Best Time to Start Investing For Retirement Is Now

While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs” when setting up our mandatory retirement accounts. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.

Kelly Greene from the Wall Street Journal explains in her article, titled “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should invest in stocks in a “U-shaped” pattern in which they invest more heavily in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

This makes sense given the fact that many baby boomers are expected to live into their 80s, meaning that if they retire at the traditional age of 65 they may require a retirement account that could last them upwards of 15-20 years. In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.

It seems that stocks should remain a critical part of ones portfolio even after retirement, so what portion of one’s portfolio should one keep in stocks when one is far from retirement? In his article “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” Professor Kimball explained that 100% of his paper assets are currently diversified stock market index funds. If we look at this decision using knowledge gained from Burton Malkiel’s “A Random Walk Down Wall Street,” this appears to be a strategy that returns relatively high rewards for low risk. Why? First, there is the decrease in risk that comes with investing in a diverse index fund. By splitting up the investment among dozens of different companies, one can reduce the probability of losing a substantial amount of money in the presence of a random occurrence such as a hurricane or a not-so-random occurrence such as bankruptcy. According to Malkiel, a portfolio of around 60 well-diversified securities (meaning their returns are largely independent) will eliminate nearly all of the unsystematic risk (risk that your portfolio will be in jeopardy after a calamity hits one stock). The systematic risk, or risk that may occur as a result of stock market shocks, can be further diversified away by investing in many different markets, such as by investing in U.S. and European stocks. Kimball’s investment in the Fidelity Spartan International Fund allows him to reduce the risk that a collapse in one stock market or one economy will negatively impact his annual returns. Beyond risk, it’s also important to consider the rate of return of the fund when choosing where to place one’s savings. In his book, Malkiel cites the research of Jeremy Segal, the author of the investment book “Stocks for the Long Run.” Segal calculated the returns of a variety of assets from 1800 to 2010. He concluded that if one invested $1 in the stock market in 1800, after compound interest that $1 would have grown to over $10,800,000 in 2010. If one had invested that same dollar in bonds, which was the next largest gainer, it would have only grown to $27,604. This demonstrates that out of all basic investment instruments at the disposal of the average investor stocks bring the highest returns. So by investing in a well-diversified international stock fund, such as the Fidelity Spartan International Fund, an investor may expect much higher returns with a relatively low level of risk.

Buffett vs. Malkiel – Opposing sides of the EMH, Remarkably Similar Advice

 

In his book “A Random Walk Down Wall Street,” Burton Malkiel argues the validity of the Efficient Market Hypothesis (EMH) and offers some strong and convincing evidence that it’s almost impossible to beat the market. In the chapter “Potshots at The Efficient-Market Theory, Malkiel fights arguments against the EMH from professional investors and behavioral economists, explaining how most investing strategies fail to produce results in the real world, using real money, and reflecting the very real effects of transaction costs and taxes. As evidence, he explains that the large majority of mutual fund managers typically sport returns that largely underperform the market.  From his analysis, he showed that 76/119 mutual funds surveyed, or around 63%, underperformed the S&P 500 index over the period from 1970-2009. Of the mutual funds that were able to beat the market, only 5 funds saw returns that were 2% or greater than the returns of the S&P 500 index. Essentially, you could count the number of truly successful professional fund managers on one hand. If you were the typical investor in mutual funds over this period, you’d have the right to be upset with your portfolio manager. Overall, from this data Malkiel suggests that this shows convincing evidence that the EMH holds and that if a portfolio manager successfully beats the market for any length of time that it’s largely due to luck.

On the other side of the argument you may find Warren Buffett, whose investment performance has apparently trounced the returns of the S&P 500 over the past 20 years. Buffett has spent his career arguing for, as well as avidly practicing, the art of value investing. Fortune magazine recently published an excerpt from his 2014 annual letter to investors in his company, Berkshire Hathaway, in which Buffett outlines a few of his notable real-estate investments that taught him the important investing lessons that helped bring him success in the coming decades. As you may find in his popular article “The Superinvestors of Graham-and-Doddsville,” like Malkiel, Buffett also despises academic and professional investing techniques suggesting the ridiculous notions that the day of the week affects investment returns or that investing in “hot” companies will lead to financial success. He also rejects portfolio measures like the CAPM (Capital Asset Pricing Model) or covariance in returns among securities as reliable ways to analyze equity returns, favoring instead measures of value of the underlying assets. Buffett explains in his fundamentals of value investing that he typically chooses assets based on their future productivity and cash flows. On the other hand, Malkiel argues that this isn’t a reliable strategy as valuation measures such as price/earnings (PV) and price/book value (PBV) only correlate with returns during unique periods  (although even Malkiel explains that one of personal cardinal rules of investing is to choose companies that have good growth prospects that are undervalued by the market).

Screen Shot 2014-03-16 at 12.05.06 AM

 

– Investment performance of Buffett’s Berkshire Hathaway Co. from the past 20 years.

Where they also appear to differ is in whether winners in the stock market are truly good or are simply lucky. In 1984 Buffett famously writes of a thought experiment in which every U.S. citizen enters a “double or nothing” game in which they try to guess whether a coin will land heads or tails up, starting with a prize of $1 that doubles each round. After 20 rounds of flipping, only 215 winners would remain (based on an initial U.S. population of 225 million in 1984). Buffett agrees (and I believe Malkiel would too) that most of these winners would have been the product of luck, but most would likely be touting their success as the result of skill. Where Buffett differs is that if you found upon examination that 100 of these contestants came from the same small town, this would suggest further examination of this town. Buffett likens this situation to a scientific inquiry about the causes of a cancer that causes 1500 cases a year; if you found that 400 of those cases appeared in the same little mining town, doctors would be really interested in examining the water there. Buffett also explains that this incredibly rare event could still occur by chance: perhaps there were a central figure whose coin-flipping calls everyone in the town followed, meaning that in this case the unusual result would still be based on chance and the same underlying random distribution. But Buffett also considers an alternative scenario where 99 of the investors were under the tutelage of a common intellectual patriarch who taught them fundamental methods by which to analyze coin tosses. If each of these investors went off on their own, as Buffett explains, and based on their own analyses came upon the same result, then you would find this to be a record that may not be explained by random chance. This is one part of Buffett’s example that I find hard to swallow: although the individual investors supposedly came upon the same conclusions independently, wouldn’t the 99 other investors simply be betting in the same way as the leader? This would not be inconsistent with a series of random coin tosses. So perhaps Buffett was alluding to the idea that the stock market, unlike the coin tosses, was not truly a random process (which would be consistent with his argument against the EMH).

Despite their intellectual battles over the EMH, after reading some of both Buffett’s and Malkiel’s work, I was surprised to find that although they seem to differ on some of the general theories of investing, they espouse rather similar investment wisdom. For instance, both Buffett and Malkiel suggest investing in a low cost index fund, to ignore predictions about long or short-term price changes, and to make as few trades as possible. They both encourage diversification of one’s investments and to do enough due diligence to make sure that you’re investing in assets with growth at a reasonable price (A.K.A GARP, which is a strategy that even Malkiel advocates for in Random Walk). Overall, it’s likely that Buffett gained his success from a long-run rising market and other random effects, but his investing advice appears to fall in line with some of the conclusions that Malkiel demonstrates, so it seems unclear as to who “wins” this argument.

In conclusion, regardless of one’s beliefs about the issue, it’s still important to take the EMH into consideration when making one’s investment decisions and to recognize that there are common strategies that individuals can use to most safely and effectively manage their money even in the face of a random market (so long as they have realistic beliefs about what kind of returns they can expect, and the inherent risk of their decisions).

 

Valuation: A Primer Part 1

A few weeks ago, I wrote a post about the current stock market valuation in which I discussed the key value drivers for equities. The two driver I discussed in that post were earnings, which can drive a stock’s price higher as they grow, and multiples, which can expand as investors change their expectations of the future. Valuation is a specific interest of mine – next year I will be working as an investment banking analyst and valuing companies and their assets is one of the most important functions of an analyst. After reading the first several chapters of the assigned A Random Walk Down Wall Street, I felt that valuation could be an interesting topic to explore in more depth in one or more blog posts.

In the first chapter of Random Walk, Burton Malkiel discusses two conflicting views on valuation. The first approach is what Malkiel calls the “castles in the air” theory. The basic premise of this valuation approach is that the value of an asset is only what other people are willing to pay for it. Malkiel is highly critical of this approach and claims that investor’s borderline irrational gravitation towards a “castles in the air” approach to investing is the cause of a great deal of financial misfortune. The key problem lies in herd behavior and what Keyne’s referred to as “animal spirits”. Investors judgement can be clouded because they use the price of the asset itself as a determinant of what they are willing to pay. When prices are going up, investors look favorably on that asset and are willing to pay more to own it in the hopes that it will continue to rise. Sometimes the price owners of the asset are hoping to sell at exceeds what any potential buyer is willing to pay – investors have figuratively built themselves a “castle in the air” and the bottom falls out when no one is willing to buy in and fuel the trend. When this happens the decline can be just as dramatic as the rise in price.

The alternative valuation approach that Malkiel presents is the firm foundation theory. This theory, which Malkiel claims to have more merit, is based on the belief that an asset is worth a certain “intrinsic value” and investors should not pay more than whatever this value is. In practice, the intrinsic value of an asset is usually considered to be the present value of the future income that asset will generate.

Based on my experience about what investment banking practitioners use to value companies, I agree with Malkiel that the firm foundation approach to valuation has more merit than the “castles in the sky” approach. The problem is, however, that valuation is as much art as it is science and so neither method can be completely relied upon. While it is easy to say that you should only pay the intrinsic value for an asset and no more, it is impossible to know exactly what that value is unless you have perfect information about the future. The financial world is full of risk and as investors, we can only hope to make intelligent decisions about risk in order to maximize returns.

Safe Investments? – WSJ Reaffirms Common Investing Wisdom

This week both the Wall Street Journal and Forbes magazine featured articles offering investors somewhat sobering, yet unoriginal, wisdom: the buy-and-hold strategy isn’t a “get rich quick” scheme. In his article in the Wall Street Journal, Brett Arends begins by pointing out that a lot of amateur investors don’t understand how large their long-term annual returns are likely to be.

Arends explains that money managers often point to historical data dating back to before the great depression that shows that stocks have produced on average around 10% per year in the long run and that bonds have produced around 5% annually. This is true, you can simply look back to any historical stock chart to see that the prices of the Dow Jones or S&P 500 indices have mostly steadily risen, albeit with more than a fair amount of volatility, since the great depression. He first points out that this ignores the effects of inflation, which eats away at the real value of one’s stock returns. This is important because, after all a 100% return in the stock market wouldn’t matter if the price of all goods and services rise 100% as well. Once one strips off the effects of inflation, investors should more realistically expect stock returns of around 1.5-2% a year plus dividends, which according to Arends’ numbers averages out to around just 3.5% annually. Of course, common knowledge affirms that inflation is always an important factor to consider when looking at one’s investment performance.

He later remarks that although you might expect to make around a 10% annual return on average by buying a general stock index, depending on when you entered the market you might actually face a much higher or much lower return. For instance, if you had invested in a “balanced fund” of 60% stocks and 40% bonds in 1988, you would have made an inflation adjusted return of 218% if you had sold it all just 10 years later. If instead you invested in the same fund in 1971, after 10 years you would have lost 25% over this period if you sold in 1981. This highlights the fact that due to the volatility, or swings in the prices of stocks and bonds, one’s returns depend on when one first entered the market. This is just another piece of common investment knowledge: buy low – sell high, and one’s timing of the market matters (although it might be more due to luck than skill).

In order to confirm these statements, I ran a short MATLAB analysis of the S&P 500 returns from 1947 (post-WWII) to 2013 using data from the website of Robert Shiller (Nobel Winning Economics Professor at Yale). To obtain the real price level of the S&P 500 index, I first converted the S&P500 prices to 2013 dollars using the Consumer Price Index obtained from the Federal Reserve Economic Database (FRED) http://research.stlouisfed.org/fred2/series/CPIAUCSL where,

Screen Shot 2014-03-10 at 2.42.18 PM If you plot the real prices alongside the nominal prices, you get something that looks like this:

S&P 500 Nominal and Real Prices

It’s pretty obvious that inflation eats away at your return. If you invested in 1947 and cashed out in 2013 you would have had only around an 803.8% return over this 66-year period after inflation, rather than the 9633.1% return you’d expect nominally. We can back out the compounded annual percent return by rearranging the equation:

Screen Shot 2014-03-10 at 2.42.30 PM

Using this equation we find that the annual nominal return over this period excluding dividends is ~ 7% and the real annual return is ~3.35% (see my code for calculations). Therefore, holding on to a few shares of stocks isn’t going to make you as rich (as quickly) as you might think.

It’s also easy to see that when you buy matters. If you bought the S&P in 1973 and sold in 1983 you would have lost roughly a third to a half of your money. You would find similar results if you bought in 1999 and sold in 2009, so timing and luck do matter. So blindly investing in an index fund isn’t a fool-proof way to make millions: what else is new? Useful information, but it’s not really uncommon or original, and even undergraduates can figure this stuff out.

John S. Tobey of Forbes makes a similar argument in his article “The Risk Behind Buffett’s Advice.” For many of the same reasons presented by Arend, Tobey tells investors to say “No, thanks” to Buffett’s buy-and-hold advice since not all investors will make money over their (often rather short) respective investment timelines using this strategy. While I think this assertion is a bit excessive, I do agree that investors should conduct the proper due diligence when choosing where to put their money. So I would agree with the additional criteria that Tobey proposes that investors use, including:

  1. Choosing the right index (S&P500, Dow, ETF?)
  2. The use of dividends (reinvested or distributed?)
  3. Investment Fees
  4. Taxes on investment income
  5. Willingness to stick to a plan (avoiding bubbles and investment fads, and not selling your stocks too early or for a loss).

I was initially under the impression that this was common investment knowledge, since Burton Malkiel wrote about these factors in his book “A Random Walk Down Wall Street” way back in 1973. So why are these authors still writing about this? My thought is that many investors and readers who are interested in finance are bombarded with misinformation from many different sources. Financial newspapers show eye-catching headlines describing the next Google, Netflix, or Tesla that will make investors gobs of cash. Stock index tickers show huge annual gains or losses in the S&P 50 or the Dow that obscure the long-run trends and ignore fundamentals. Financial advisors may advertise their phenomenal one or two year track record while obscuring their much smaller long run returns. Overall, it seems as though sorting through the garbage bin of financial advice is a hard task. So although authors like Arends and Tobey aren’t saying anything completely new, it’s important for them to repeat these important lessons so they don’t get lost in the trash.  

 

Effects of Interest Rates on Commodities: Opportunity to Invest?

The end of the “commodity supercycle,” the period from the late 1990s to the financial crisis in 2008 where many commodities enjoyed double-digit annual growth, has loomed ominously over the  market for the past 5 years. Now, many investors remain cautious of commodities, especially since the commodities market have lagged the broader market since the crisis. Despite the negative outlook, according to Murray Coleman of the Wall Street Journal, many financial analysts and advisors are beginning to feel more optimistic about many commodities, especially in segments such as oil production and mining for select metals. For example, last week Wells Fargo Advisors began suggesting that clients add the “PowerShares DB Base Metals ETF” to their portfolios. As Sameer Samana, a senior international strategist at Wells Fargo Advisors, explains: “we’re finding that inventories in copper, zinc, and aluminum are coming down as growth in the U.S. firms, especially in housing and autos,” he says.

Although I typically remain skeptical of most financial advisors who interview with the press, this optimism towards certain metals, such as Aluminum, doesn’t seem to be completely unfounded. Suppliers of aluminum are likely to find new customers in the auto industry, as many automakers are switching to aluminum in the manufacturing of automobile bodies in order to trim weight from the vehicles and enhance gas mileage. For instance, the Tesla Model S, the Audi A8, and the whole Jaguar lineup are made largely from aluminum bodies. Furthermore, the largest boost to aluminum demand may come from Ford Motor Co., who has recently announced that it will begin to build its popular F-150 pickup truck lineup using a body and bed made almost entirely of aluminum. The upgrade to an aluminum body trims nearly 700 pounds from the F-150 body, which may lead to potential improvements in fuel efficiency. Given the new usage of aluminum in auto chassis, and the popularity of many cars being manufactured using aluminum, Samana’s argument that inventories [in aluminum] are coming down as automakers see increased growth seems plausible.

Another factor that may have a big impact on mining projects in the near future is the likely increase (albeit gradual) in the interest rate as the Fed begins to slowly unwind its Quantitative Easing program. To further illustrate, I’ll start with a hypothetical scenario in which an entrepreneur stumbles upon a large deposit of aluminum ore today and is deciding whether or not to invest to develop the aluminum mine. The entrepreneur knows a few things about mining and about the state of the economy, which closely match present conditions in reality:

  1. Interest rates will continue to be low (~0% for the next, say 5 years)
  2. After 5 years, the interest rate will likely increase as a result of the Fed unwinding its QE position (for simplicity, we’ll assume that the interest rate will be 5% in years 5-10)
  3. The entrepreneur is independently wealthy, so he doesn’t have to borrow from the bank to finance his venture
  4. Barriers to entry in the mining industry are very high, and it takes a large initial sunk cost and time in order to get the mine up and running producing aluminum. We’ll assume it takes exactly 5 years of development before a mine starts producing revenue
  5. The entrepreneur always has the opportunity to invest at the risk-free interest rate, such as in U.S. treasury bills.
  6. When considering whether or not to develop the mine, the entrepreneur discounts his anticipated cash flows (positive and negative) by the equation:
  7. Finally, mining for aluminum the traditional way is a low margin business, so per-ounce revenue is close to per-ounce marginal costs.

In this scenario, since it takes 5 years before the mine is operational, the entrepreneur anticipates strictly negative cash flows each year over this period. He also knows he always has the option of investing at the risk free rate, so he calculates the discounted cash flows for each period as a way to incorporate the opportunity costs associated with choosing to develop the mine rather than store his funds in T-bills. Since the interest rate is ~ 0% over the first year (we’ll say he takes on the entire cost the first year, so no discounting), the discount rate of his negative cash flows is 1: (1/(1+0.0)^5 = 1). He knows that his cash flows are negative for this period since he’s spending a lot to develop the mine (cash flows are negative and large, with no discounting). At year 5, the interest rate shoots up to 5%, so the discount rate over this year is 1/(1+0.05)^5 ~ 0.7835 (we’ll assume he gets all of the next 5 years cash flows all at once in year 5). Also, since the margins are slim, he knows his profits are small and positive (and also heavily discounted because of the higher interest rate) compared to his initial expenditures. Without doing any calculations, he knows this is a pretty bad scenario, since he’s incurring large negative cash flows now at little to no discount in order to earn small positive cash flows in the future at a high discount. Overall, it looks like becoming a new supplier of aluminum may not be a good proposition over this period.

If many other suppliers have the same mentality of the entrepreneur in this example, we might expect that supply of aluminum will decrease in the near future (shift in supply leftward). Furthermore, if many auto manufacturers switch to aluminum in the near future, there may be an increase in demand for aluminum (shift in demand rightward). These two shifts would lead to an increase in the price of aluminum. Overall, based on this information, it would appear that investing in commodities (as an investment vehicle, not as a supplier of commodities) might be a good investment in the near future (5-10 year range).

“How” to Invest in Emerging Markets

Emerging markets sell-off began a few weeks ago with volatility not appearing to die down anytime soon. This was due to a variety of factors that spanned from a Fed announcement about cutting down its bond buyback program to political corruption. But a WSJ article headline “How to Invest in Emerging Markets Now” drew my eye. “Wow I can make money!” I thought to myself. But after reading blurb after blurb of the article I came to the very end disappointed with the lack of a “how-to” that I was promised.

This brought my recollection back to reading this past weekend’s paper about “A Word of Advice.. On Advice” by Joe Queenan. As his argument pertained to personal investing advice, no one with good advice to give will give it… openly. Asymmetric information is the basis for financial gains through trade (like arbitrage).

Lets say this was a “how-to guide” though. Like was mentioned in class, a lot of American’s don’t have enough in foreign assets. This is basically shooting themselves in the foot. Diversifying risk is an important principle of investing and emerging markets are a good place to start. So this sounds like a good idea for someone like me to try and make some profit. Even with emerging market’s currencies appreciating against the US dollar in the long term, many other students and I don’t have the assets to actually do anything very profitable.

The equation for ROR (rate of return) is exhibit A. The cost of investment isn’t just the money put into the markets. Its also the time to manage the portfolio. It’s the opportunity cost we have as well. During what some consider the most valuable portion of our lives, is it worth it to forgo other opportunities with money and invest? Is it worth it to start serious saving? Some shmuck college kid like me with hardly at money, isn’t going to get much of any where with oversea assets, taxes and fees to their government’s content. It’d be nice to even try to break even there.

But this doesn’t sound right… I heard time after time again that saving is crucial. But especially now, where returns on investments aren’t high and my bank’s saving accounts interest is hardly above zero, perhaps I should be spending my money now and enjoying my life to the fullest. Now is the time to spend money for those overseas trips and not save in overseas markets.

Remember: The usual rules of investing apply. After fees, active investors on average underperform low-cost index-based funds—even in emerging markets.