THE WALL STREET SELF-DEFENSE MANUAL

Introducing New Blog...Investment Intelligencer

Thanks for your interest in the Wall Street Self-Defense Manual.  This site contains more information about the book, including excerpts, the table of contents, and a welcome note.  It also contains links to other investing books and resources that I hope you'll find helpful.

I will continue to post additional book excerpts here for the next several months, and I will leave the site up indefinitely.  As of today, however, I am going to post additional market and investing commentary on a new site, Investment Intelligencer (www.investmentintelligencer.com).  Like the book, the site is designed for intelligent investors, and it will draw on smart ideas from academia, Wall Street, and the financial media.  It will pick up on many of the themes I discuss in the book, and it will also include analysis of some important fundamental issues.

Thanks again for visiting the site.  I hope you enjoy the Wall Street Self-Defense Manual, and I hope to see you over on Investment Intelligencer.

8-Year Old Investor Beats Market, Pros

It would be nice if that headline were a joke, but, sadly, it isn't.  How did he do it?  The same way most smart individuals do.  Paul Farrell explains.  By owning a diversified portfolio of index funds (the Vanguard Total Stock Market fund, the Vanguard Total International Stock Market Fund, and the Vanguard Total Bond Market fund).  Thanks to the bonds in the mix, the portfolio has a lower risk (standard deviation) than the S&P and has delivered higher returns.

This, of course, is the smart way to try to beat the pros (the dumb way is to try to out-trade them).  And the nice thing is, because the pros can't buy low-cost index funds, it's almost guaranteed to work.

New GMO Market Forecasts: Stock Investors Are Screwed

The methodologies underlying most market forecasts do not actually have much predictive value, and as a result, their predictions are no better than the standard market odds (and in many cases worse).  What are these odds?  To pick one example, the odds that the S&P 500 will go up over any given year are about 2-in-3.

One firm that produces forecasts using a thoughtful, defensible methodology is Boston's GMO.  The firm makes no claim about being able to predict performance over short and intermediate-term timeframes (Chairman Jeremy Grantham's recent foray into "Presidential Cycle" forecasts produced a few bad calls, so he sinced returned to his valuation-based knitting).  Instead, it estimates the likely performance of a half-dozen major assets over a seven-year period. 

Unlike most firms, GMO takes into account the business cycle, "normalizing" today's record-high profit margins under the theory that they will eventually regress to the mean.  (If they don't, Grantham is fond of saying, capitalism is broken.)  Work by Andrew Smithers of London-based Smithers & Co. has shown that such "cyclically-adjusted" analyses have predictive value, while those that look at a single year's earnings in isolation don't.  The one caveat (there's always at least one) is that this valuation metholody depends on mean-reversion.  On the rare occasion when things are, in fact, "different this time," it doesn't work.

In any case, GMO recently published its asset-class forecasts based on prices at the end of January.  For those who like their bad news delivered graphically, GMO's own publication is vivid.  For those who prefer text, here's a snapshot:

Real Seven-Year Asset Class Return Forecasts (Expected annual return over 7 years. Source: GMO)

U.S. Equities (Large cap):  -1.7%

U.S. Equities (Small cap):    -2.6%

Int'l Equities (Large cap):     -0.3%

Int'l Equities (Small cap):     -2.3%

Emerging Equities:              +1.6%  (Hallelujah)

U.S. Treasury Bonds:            +2.0%

The bottom line?  Unless you can limit your equity exposure to "high-quality" stocks, GMO expects you'll lose ground to bonds.   

Meet Your Competition: Deep Blue

One of the most pointless and misleading topics of conversation for amateur traders is the idea of a "level playing field."  Cynical amateur traders believe that the reason they lose to professionals is that professionals have "inside information" and other illegal advantages. 

Professionals do indeed have significant advantages, information and other, but most of them are perfectly legal.  Professionals routinely beat the stuffing out of amateurs not because the playing field isn't level but because the playing field's being level or not is irrelevant. 

The playing field in Yankee Stadium is "level."  If you and your beer-league softball buddies visited the Bronx, however, you would still get your clocks cleaned--and not because not because the Yankees cheated.  You would get them cleaned because the Yankees are the most skilled, best informed, best trained, most competitive ballplayers on earth.  And so it goes in the financial markets.

Today's Journal has an illustrative item about the computerized trading taking over the London futures markets.  Like your chances of competing against thousands of professional futures traders armed with such computers?  Then presumably you would also like your chances when playing chess against Deep Blue.

Futures Traders Take On Next Hot Model

By ADAM BRADBERY
February 19, 2007

LONDON -- The biggest trader in one of Europe's main futures contracts isn't a person -- it is a machine. So is the second. And the third.

Trading systems that use complex mathematical codes to quickly weigh a huge number of possible trades and execute them faster than a human are squeezing the independent trader as they change the way futures contracts are traded...

 

Put Your Favorite Guru To the Test

One common mistake investors make is assuming that, because their favorite advisor/guru/money manager has "made a lot of money," he or she is a stock-picking genius.  This assumption is great for money managers, as they collect fat fees on every dollar they manage.  It is not so great for investors, however, as they often pay too much for market-beating performance they don't actually get, or, worse, pay too much for past market-beating performance that wasn't really market-beating.

Assessing whether a manager has beaten the market is often more difficult than it seems, and any errors made in this process usually benefit the money manager.  To correctly assess whether a manager has beaten the market, you need to know:

• The appropriate benchmark against which to compare the manager's performance (all stocks, large-cap stocks, large-cap value or growth stocks, small-cap stocks, small-cap value or growth stocks, international, international small-cap, international value stocks, etc.) 

• The risk (standard deviation) of both the manager's portfolio and the benchmark.

Because different types of stocks have different risk/reward characteristics (and perform differently in a given period), electing the appropriate benchmark is critical.  If you choose the wrong benchmark, the manager may appear to be "beating the market" when he or she is actually lagging it.  Similarly, if the manager has taken more risk than the market (the benchmark), he or she has not really "beaten the market."  Higher risk usually equates to higher returns--but only in exchange for greater volatility.

An advisory firm called Index Funds Advisors has published a series of analyses comparing the performance of diversified portfolios of index funds with that of a few super-gurus: Warren Buffett, Ken Fisher, Bill Miller, Jim Cramer, etc.  The Buffett comparison is unfair, as the index-portfolio performance is compared against that of Berkshire Hathaway's stock instead of the performance of BH's book value.  The other comparisons appear fair, however. (See middle column, under "Benchmark Your Portfolio")

Check them out and watch the mystique of your favorite guru fade away...

Some Depressing Facts

The difference between investing intelligently and unintelligently can mean the difference between a comfortable retirement and an uncomfortable one.  Unfortunately, the way many people invest--hiring an average investment advisor and picking a few stocks and funds--is often not intelligent.  Instead, it is often risky, random, and expensive.

Most Americans wouldn't dream of buying a car by walking into a dealership, accepting every option and extra recommended by the salesman, and then happily paying the quoted price with no questions asked.  When it comes to investing, however, this is exactly what many people do. 

The best way to ensure that you invest intelligently is to know as much as you can about the source of investment returns, common investing mistakes, and the strategies that give you the best odds of success.  To start, here are some depressing facts:

• The average mutual fund is so expensive (1.5% of assets per year) that it will likely cost you nearly half of your potential retirement nest egg over 50 years.

• The cost of the average mutual fund combined with the cost of the average financial advisor will likely vaporize about two-thirds of your potential retirement nest egg over 50 years.

• The odds that you will beat the market over the long term by trying to pick "superior" stocks or funds are between 1-in-4 and 1-in-40.  The chances that you will hurt your returns by picking stocks, therefore, are between 75% and 98%. 

• If you are lucky (or skilled) enough to beat these long odds and the market, you will be rewarded with "excess" returns of 1%-2% per year.

• If you are not lucky enough, you will be punished for your failure with a return that lags the market by 2%-3% per year.  (Assuming you stick with the lousy stocks and funds.  If you sell them and try to buy better ones, as most people do, your return will likely be much worse.)

• The average hedge fund is so expensive that, for a taxable investor, the fund must post a 20% gross return to deliver the same net after-tax return as a low-cost index fund with a gross return of 10%.  (Most people ignore tax costs when raving about fantastic hedge-fund returns.  For a pension fund, this is smart, because pension funds don't pay taxes.  For a regular old taxable investor, it's delusional).

• The average hedge-fund fund-of-funds is so expensive that, for a taxable investor, the fund must post a gross return of 24% to match the net after-tax return of an index fund with a gross return of 10%.

• The apparently amazing returns of most star stockpickers are not the result of stock-picking skill but exposure to various risk factors (such as stock size, stock value, and stock momentum).  In most cases, these investors would have done better if they had just bought and held index funds with the same "factor" exposure.

• Most mutual funds get paid millions of dollars a year to subtract value.  One reason the mutual fund business is such a great business is that most mutual fund customers don't know or care.

• The only part of your investment return that you can directly control is costs.  (So don't be like the average boob, who ignores them).

• The standard P/E ratio is nearly useless as a near-term market prediction tool. (According to a correctly calculated P/E ratio, the U.S. stock market has been "overvalued" since 1986.)  The same goes for interest rates, changes in interest rates, and the "Fed Model."

• If you predict that the stock market will go up, your odds of being right are about 2-in-3.  If you predict the stock market will go down, your odds are about 1-in-3.  These odds don't change much from year to year. 

• The idea that a part-time amateur with an Internet connection and an e*Trade account should expect to out-trade a full-time hedge-fund manager with a $20 million annual research budget, a Rolodex full of industry and management contacts, and years of professional experience is, sadly, preposterous.  It is, however, common.

• The source of most investor returns is the market, not the investor's decisions.  Most investors reduce the returns they would have generated if they had just diversified their assets and let the markets do the work.

• The most intelligent investment strategy for most investors is to buy low-cost, passively managed index or "lifecycle" funds, such as those offered by Vanguard.

New Commentary

Thanks for exploring the site.  After the book is published (early January, 2007), I'll use this space to address reader questions and expand on some of the topics in the book.