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Bucks: Why E.T.F.’s Won’t Solve Our Behavioral Problems

April 15, 2013 by Leave a Comment

Carl Richards is a certified financial planner in Park City, Utah, and is the director of investor education at The BAM Alliance. His book, “The Behavior Gap,” was published this year. His sketches are archived on the Bucks blog.

It’s tempting to think that the next new investment product is the solution to our behavioral problems. So it’s no surprise that I’m getting this question a lot: Do I need to invest in exchange-traded funds?

The fact that lots of people are confused about what E.T.F.’s are — they’re essentially index funds that trade on an exchange like stocks — and why investors might want them is no surprise. To add to the confusion, last week CNBC announced it was planning to design and offer its own E.T.F.’s. Seriously? Their announcement about the benefits of E.T.F.’s offers a great example of why people are so confused.

Here are some of the advantages CNBC cited:

1) E.T.F.’s offer diversification.

Sure they do, but this is nothing new or unique to exchange-traded funds. Traditional mutual funds were invented to offer diversification. Sure, you can now trade an E.T.F. that invests in only sugar. There’s also an E.T.F. for those “long-term investors” who want exposure to the inverse price of silver with a whole bunch of leverage. Is this what we’re talking about when we say E.T.F.’s offer diversification? In fact, there are more mutual funds to choose from than the number of stocks listed on the Nasdaq and New York Stock Exchange combined.

2) E.T.F.’s are low cost.

It’s true that some E.T.F.’s are an additional, low-cost alternative to index funds. Plus, you might be able to argue that the added competition from exchange-traded funds has driven down the cost of mutual funds. Remember, however, that there are also some very expensive E.T.F.’s and some extremely cheap mutual funds.

3) E.T.F.’s allow intraday trading.

Stop and think about that one for a minute. If you’re investing for the long term, why do you care if you can trade your investment every hour, minute and second of the day? The benefit of intraday trading only matters if you’re an active trader. And if you are, E.T.F.’s will just let you cut your own fingers off that much faster.

4) E.T.F.’s allow your adviser to place you in the right fund at the right time.

This is code for something that virtually no one can successfully do: time the market. Claiming that exchange-traded funds allow an adviser to add value by placing a client in the right fund at the right time is not only wrong, it’s dangerous. Any adviser who claims to be able to time the market is an adviser you should run from. Advisers are valuable if they can help you avoid the costly behavioral mistakes we all tend to make, not because they claim to be able to outperform the market.

All the hype about E.T.F.’s is just throwing more fuel on the behavioral fire (see intraday trading, market timing). Ultimately, E.T.F.’s are just another tool that should be evaluated alongside all of the other tools available to help you reach your goals. To be clear, I’m not saying that all E.T.F.’s are bad. What I am saying is E.T.F.’s alone won’t solve our most vexing investing problem: our own behavior. In fact, they might just make it easier to behave badly.

For most long-term investors, exchange-traded funds don’t offer significantly different benefits over other low-cost funds. So my answer to the E.T.F. question is pretty simple: just because everyone else is doing it, doesn’t mean you should.

Article source: http://bucks.blogs.nytimes.com/2013/04/15/why-e-t-f-s-wont-solve-our-behavioral-problems/?partner=rss&emc=rss

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Yale Endowment Posts Return of 21.9%

September 29, 2011 by Leave a Comment

The endowment of Yale University turned in a much improved performance in its latest year, though still not as strong as the broad stock market.

After two years of unusual weakness, the endowment, run by David Swensen, posted a return of 21.9 percent for the fiscal year ended June 30. It edged out the 21.4 percent posted recently by the Harvard University endowment, which remains a bit bigger.

The double-digit gains came in a strong year for the United States stock market. For example, the Wilshire 5000 Total Market Index had a total return of 31.99 percent in the same period. Yale’s gain helps make up some lost ground. The endowment posted a return of 8.9 percent a year ago, even as many endowments generated returns of 9 percent to 14 percent. The previous year had been an even bigger setback. In 2009, Yale’s endowment, with considerable investments in real estate, commodities and timber, fell 24.6 percent.

For the moment, Yale has outperformed other universities over 10 years, with an average annual return of 10.1 percent. Harvard now has a 9.4 percent annualized return over 10 years. Some other stellar performers, including Princeton and Columbia, have yet to report.

Mr. Swensen is the pioneer of the concept of institutional diversification into assets like timber, hedge funds and private equity, and the Yale endowment is considered a barometer of the effectiveness of that approach.

The average annual return for endowments and foundations with more than $1 billion in assets was 19.38 percent, according to data compiled by the Wilshire Trust Universe Comparison Service. Over 10 years, the average was 5.99 percent.

After subtracting operating expenses, the value of Yale’s endowment is now $19.4 billion.

Led by Mr. Swensen for 26 years, the Yale endowment has maintained its diversified portfolio despite the strong headwinds in the financial markets in the last few years.

Its domestic stock holdings gained 24.5 percent last year, or 7.4 percentage points less than the broad Wilshire 5000 index. But the endowment had just 7 percent of its holdings in domestic stocks.

The endowment said it had a bigger gain from its foreign equity holdings, which represent 9 percent of its assets. Foreign equities generated a return of 40.7 percent, exceeding its benchmark index.

After a year of losses, the private equity portion of Yale’s portfolio generated a return of 30.3 percent. Private equity is the biggest asset class, representing 34 percent of Yale’s portfolio. Real estate, the next largest asset class, accounts for 20 percent of Yale’s holdings.

Article source: http://feeds.nytimes.com/click.phdo?i=8a935d76b26b8977529f3f9693b0f3d0

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Bucks: Why (and How) Diversified Investors Win

September 7, 2011 by Leave a Comment

Carl Richards

Diversification remains one of the most fundamental investing principles, and it’s often one of the most misunderstood. In order to understand diversification you first have to take a comprehensive view of the process of planning a portfolio.

Investors tend to view individual investments in isolation. This often happens because of the focus we place on finding the best overall investment versus figuring out how individual investments work together for the benefit of the whole.

Instead of looking at investments in isolation, we should consider them part of a much larger tapestry, and make sure that the overall picture reflects intelligent portfolio design concepts backed up by an academic approach.

Diversification’s primary power is that it lets us reduce risks that are avoidable.

These avoidable risks include:

  • Betting on a particular industry or sector. We see this in the form of trying to pick the next hot sector, like technology, banking or oil stocks.
  • Market timing. Most of us believe that you can’t figure out when stocks will zig and bonds will zag. At the same time, we’re often quick to latch on to anything that might look like detailed research about the direction of the markets. In reality, it’s nothing more than a guess.
  • Owning individual stocks. While it’s certainly not impossible to identify the next Apple, history proves that it’s highly improbable. Placing large, concentrated bets on individual stocks can be a path to incredible wealth, but so can a single spin of the roulette wheel (if you get lucky).

The magic of diversification is that you can take two individual investments, which when viewed in isolation are individually risky, and blend them in a portfolio. Doing so creates an investment that’s actually less risky than the individual components and often comes with a greater return. In finance, this is as close as we get to a free lunch.

What Diversification Looks Like

Here’s what a sample, diversified portfolio might look like.

First, let’s start with two, undiversified portfolios. Portfolio A is invested 100 percent in United States stocks, as measured by the SP 500-stock index, and Portfolio B is invested 100 percent in international stocks, as measured by the MSCI EAFE index. We’ll use 34 years (1976-2010) for our sample period since it’s the longest period available for which we have data from MSCI EAFE.

During those 34 years the SP 500 had an annualized return of 11.17 percent, and international stocks had an annualized return of 10.72 percent. (All of the portfolios mentioned in this post were rebalanced quarterly. And yes, I know that you can’t invest in an index per se, but you can buy index funds and similar vehicles for next to nothing.)

Now let’s look at the risk associated with each of these hypothetical investments.

Although there are many ways to view risk, for our purposes we’ll focus on the number of negative quarters and volatility as measured by standard deviation (the lower this number is, the better). From 1976-2010, the SP 500 had 42 negative quarters and a standard deviation of 15.39 percent. International stocks had 45 negative quarters with a standard deviation of 17.26 percent.

As you can see, each of these portfolios look risky individually. But the magic of diversification is that when we blend them, the whole is better than the sum of its parts.

So let’s create Portfolio C using use a fairly standard 60 percent allocation to the SP 500 and 40 percent allocation to international stocks. Now this portfolio gets a return of 11.21 percent. While that’s not much better than the SP 500 alone, in terms of risk, this 60/40 portfolio only had 37 negative quarters with a standard deviation of 14.45 percent.

That may not sound like much, but it is indeed a free lunch. This portfolio returns at a higher rate with less risk using the simple concept of diversification.

Reducing Risk

When I talk about diversification, I often get told that it’s been irrelevant over the last 10 years, particularly during the global credit crisis in 2008-2009.

Sure, you can see the  benefits of diversification clearly when you’re focused on different types of stocks. But in times of large systematic risks to the stock market (like what we’ve seen during the last five years), the value of diversification among equity asset classes can often go away.

So while it is still a valuable exercise to carefully plan your equity portfolio to take advantage of a free lunch where you can, the real power of diversification comes in the form of risk reduction when you start to mix stocks and bonds.

Let’s compare the 60/40 stock portfolio we built above (Portfolio C) to a portfolio where we add 40 percent in bond exposure.

Remember that Portfolio C generated a return of 11.21 percent with 37 negative quarters and a standard deviation of 14.54 percent. When we blend in a 40 percent allocation to bonds (in the form of the Barclays Capital Aggregate Bond Index), creating Portfolio D, we get a return of 10.4 percent. That’s not much lower than the all-stock portfolio, and we reduce the number of negative quarters to 35.

But the real impact is in the risk reduction we see in the form of a much lower volatility as measured by standard deviation at 9.48 percent. In other words, the ups and downs of Portfolio D will be much less sharp than Portfolios A, B, and C.

While I’m not suggesting that this portfolio is right for every individual or serves as a predictive model, the historical data at least show how being diversified can give you a way to protect yourself from many of the random events that have ruined fortunes.

Plus, diversification allows you to position yourself to take advantage of the returns that equities tend to deliver, balanced with the safety that high-quality bonds provide.

Article source: http://feeds.nytimes.com/click.phdo?i=b9b51585aed35f5609003e2be6b2c179

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