Bombs away, dream babies

Somewhere between Wonderland and Through the Looking-Glass, Alice called us all out when she confessed, “I give myself very good advice, but I very seldom follow it.” Which of us has not had to admit the same in the face of a self-inflicted bit of financial folly? And today, as the world seems to spin around us with the confused fury of a storm at sea, how can we keep our path true? I offer up an observation for your consideration.

The term “Madness of Crowds” originally entered my vocabulary as a teenager when I read – admittedly somewhat fitfully – Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841. Though much of the book is now long forgotten, the chapters describing a history of financial bubbles remains often quoted by really smart guys like Michael Lewis. To quickly summarize the substance of MacKay’s idea with a quote from the book, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Though MacKay discusses the Dutch Tulip Mania of the 1630’s and Mississippi Company Bubble of the 1720’s, we need only look back to the DotCom crash of 2000 and the subprime chaos of 2008 for a personal and up-close look at our own propensity to become part of a crowd that ultimately gets roughed-up financially. Yet there is another way to consider this tendency as it occurs in a less visible but equally damaging way.

This current bull market, starting in 2009 – now the second longest run on record – was missed by many who clung to the notion that the future would look like the immediate past, a very common bias we all suffer from to varying degrees. As measured by the American Association of Individual Investors (AAII), while markets have doggedly moved up to all time record highs, the percentage of their members with a bullish sentiment has been under 50% for 108 weeks. So it is not necessarily that we suffer a financial loss from following the crowd, but that we lose opportunity.

Probably worth noting that in 1845, four years after MacKay published his book on the madness of crowds, he had the following to say about what would become known as the British Railway Mania, “There is no reason whatever to fear a crash.” He was wrong. Later editions of his book include a section about the Railway Mania crowd that he ultimately joined. Go ask Alice, indeed.

Finally, this week’s issue of Barron’s includes a letter to the editor noting that many of the pundits who rallied against a Trump presidency are now beneficiaries of the post-election rally. Specifically, according to Bob Barcell from Fort Collins, CO, “By my reckoning, over half of Barron’s top 50 bullish picks for 2016 owe better than half of their gains to the Trump Bump. Outside of Gotham, it is nothing short of sidesplitting to watch you breaking your collective arms patting yourselves on the back for the results of the thing you railed against, told us couldn’t happen, and swore we would regret if it did.”

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Something to think about

When you finally make the transition from individual stocks and traditional mutual funds to exchange-traded funds (ETF) as the bulk of your investment portfolio, the next step is to start thinking about asset allocation. While it is perfectly reasonable to expect that a handful of ETFs could be sufficient to ensure a solid long term return, it isn’t so much fun if you’ve ever enjoyed “playing the markets” over the years. So the chance to add a little alpha, if you are so inclined, is still possible. Even with an ETF portfolio.

As an example of how this works, let’s propose we become socially responsible investors. No, seriously, in one way or another, we all tend to embrace some investments and shun others for motives more emotional than logical. As noted here at Invest-Notes previously, tobacco stocks are eschewed. This is not a particularly smart decision; over the last five years Reynolds American (RAI) has doubled in price while offering a dividend north of 3%. But something just doesn’t feel right about profiting from a company whose primary product is cancer. Then again, as a long time owner of Heineken (HEINY), the same could be said about a company whose business is selling alcohol – and their five-year return isn’t nearly as compelling.

Okay, so you have an S&P 500 ETF, a couple of others offering international exposure and maybe even a bond fund (don’t laugh, think about it). Yet within the S&P are eleven clearly defined sector groups such as health care, energy, consumer staples and the new kid on the block, real estate investment trusts (REIT). Since the associated sector funds can move independently from the overall direction of the market (and the S&P 500), there can be opportunities to increase dividend yields, bargain hunt among sectors or lower volatility.

Here are two ways to think about framing your search criteria for investment options. First, consider the example above; no tobacco stocks. A decision is made to exclude an industry (or sector) based on personal preferences, not expected performance. A compelling example, despite your feelings about Islam, are the several U.S. mutual funds boasting impressive track records that look to sharia law to determine what stocks to exclude from their portfolio, such as alcohol and traditional banking stocks (because, loan interest = usury).

A second option is to include sector funds – or individual stocks – because they bring added value to your portfolio. The most obvious application is adding a sector fund that has recently underperformed. This is not unlike rebalancing, where on a regular basis winners are pared as losers are added, benefiting from reversion to the mean over time (while not personally a fan of this technique, it remains a viable option for inactive investors in retirement accounts). Another option is to include an individual equity for providing a meaningful dividend. I have some REITs and old fashion blue chip stocks for this role.

If you are less inclined to pick and choose, a variation of this idea is to split your regular investment in a core fund to 75/25, with 75% going to your core holding and 25% going to one of the sectors currently underperforming. Again, this is a way to harness the potential of mean reversion over time.

Yet regardless of whether you choose to hold a small group of well diversified ETFs that you purchase regularly over time, or take a flyer – regularly or occasionally – on a couple of additional holdings with a potential to provide value, your decisions should be made thoughtfully, and in keeping with your overall investment goals.

What, you have no investment plan? Ignore all of the above and get to basics.

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Back to Basics

In response to my musings on the Index of Revolutionary Potential, “Karcher’s college roommate” has asked what I plan on doing about it. Fair enough, Bruce.

First, I’ll be making the maximum contribution to our IRAs in January. Rather than wait until the beginning of the following year (ah, the folly of youth) to make our annual contributions, it should be taken care of first thing in a new year. And with traditional IRAs we also get the deduction against earned income. The reasoning here is simple; the longer your money has a chance to be invested tax free, the better your chances of long term success in saving for those golden years (this as an option to saving for retirement).

Now this does not mean that all the funds are immediately invested. I’ll generally spread the (mostly) ETF purchases over the first couple of months of a new year. But don’t take my word for it. Take a look at a five-year chart of the S&P 500. Except for 2015, where the S&P ended the year where it started – around 2000 – the other four years saw nice returns from investments made early in the year. And of course, in 2016 the massive sell-off in Jan-Feb has been followed by massive gains into the close of the year.

More importantly, while lots of folks have anxiously waited for a big sell-off to get invested, the S&P has moved from about 1250 in January of 2012 to around 2250 as of yesterday. As we’ve discussed here many times, markets tend to go up more often than they go down – especially over meaningful periods of time. So if you want to do some “market timing” try timing your purchases to the times when you have money to invest. A smarter guy than me has some good thoughts on this topic (see Ritholtz link below).

Second, I won’t be paying much attention to the numbers on the dial. There was a lot of excitement when the S&P 500 cracked the 2000 mark for the first time back in 2014. And still, the S&P was at 2000 again this summer. Unless you are highly skilled in the alchemy of gematria, focusing on an index’s current numerical status isn’t so much help. It is more important to be aware of trends in overall market movements, where momentum can be a powerful force and not so hard to divine (see Seth Masters link below). This applies to both the main indexes like the S&P 500 and Dow Jones, but also to individual asset classes such as energy, technology or finance.

Finally, I’m going to be watching (as James Thurber put it) not back in anger nor forward in fear, but around me in wonder during January. Until there is a bit more clarity around what our incoming president will do versus what he’s said he’ll do, I’ll stick with the discipline of making those IRA contributions early in the year, but probably sit tight until February before wading back into equity markets. Which means I can spend some time thinking about asset allocation (to individual asset classes such as energy, technology or finance), another discipline that doesn’t always get the attention it deserves from individual investors.

  1. Barry Ritholtz has an interesting perspective, “I am always astonished when I hear that new market highs are a reason to avoid equities”:

  1. Solid reasoning from a reasonable investor, “But what we can say with confidence is that we will ultimately end up going through the 20,000 level more than once because there will be more volatility ahead”:

This Saturday, December 17, 2016 I’ll be featuring the music of Lee Morgan on the jazz radio show Straight Ahead, at 8:00 am (central time zone). You can stream it live via the internet at, or play it back anytime during the week by accessing the archives at

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Is revolution in the air?

First, there’s a backstory to make it crystal clear that I have taken someone else’s idea as the basis for this commentary. Surprisingly, trying to explain who was actually responsible for the original book excerpt took the better part of an afternoon and ended up being as long as this Invest-Notes post. You can read the curious story by clicking Art-Notes in the navigation bar at the top of this page.

This essay is based on a book excerpt (from 1806, maybe) arguing that the series of riots leading up to, and then causing the French Revolution of 1789 can be explained by mathematics. The parallels to events like the Dot-Com bust, the U.S. housing crisis, the financial mayhem in Greece, the Arab Spring and Occupy Wall Street shouldn’t be shrugged off as outliers after being followed by Brexit and the election of Donald Trump as president. Revolution is in the air, again, and the idea posed in 1806 (maybe) feels eerily prescient.

Essentially a case is made that the cause of the French Revolution was population growth. An estimated increase of the general population in France (of as much as 70%, maybe) during the fifty or so years before the revolution, suggests there were too many people chasing too few jobs, leading to stagnant or declining wages. Conversely, you also had more people chasing fewer goods, in this case corn and milk, leading to higher prices. In 1790 it wasn’t so easy to increase the number of cows or arable land.

But there is an all too familiar twist on this hypothesis, even in 1789 – technology. Improvements (relatively speaking) in health care and hygiene meant more people living longer and lower infant mortality rates. At the same time, the steam engine and other industrial revolution breakthroughs meant fewer manual labor jobs (for most people at the time). From this fact-set the author proposes “the index of revolutionary potential.” Here I’ll simply quote from the book:

“If there are high wages and low prices, this index is low, and one can expect no revolution; if there are low wages and high prices, this index is high and revolution can be predicted…”

While the actual population of the U.S. isn’t expanding dramatically, there seems to be a growing number of people needing a job with decent wages. Not just new members to the labor force, like Millennials, but lots of people who have been downsized, laid-off or are not prepared for retirement – financially or mentally.  Again, it feels like mathematics is the bad guy in all this.

Add to that the reality of a spread between earnings of workers and bosses being wider now than in a generation. Now occupations like legal services are finding themselves threatened by low-cost overseas outsourcing. The movement of consumers from shopping malls to the internet is relentless and gaining momentum. Even the way we save money and then invest it is evolving faster than we can keep up with. The easy money to be made in emerging markets and places like China and Brazil is gone. And yet we understand intuitively that change can mean opportunity.

The point of these musings is to challenge you to take the sound advice offered a generation ago by humorist James Thurber, “Let us not look back in anger, nor forward in fear, but around in awareness.” Think about what this fundamental shift in the world economic order is going to mean for you, your occupation and your investments. It was easy for the Monday morning quarterbacks in 1990 to talk about what it meant “back in the day” when the Baby Boomers and women entered the workforce in huge numbers – remember the 1970’s recession (and burn, baby, burn)? Or the housing bust of 2008? Too many buyers with incomes incapable of affording the overpriced homes available? Sure sounds like “the index of revolutionary potential” to me.

So in 2016, we have a global aristocracy who seem out of touch (the 1%), governments not much trusted by their people (the driver of populism), and lots of workers convinced there are few opportunities to earn decent wages (the driver of protectionism). Despite the rhetoric from the recent U.S. election, the drivers that led to the creation of the “middle class” don’t exist anymore and aren’t coming back. Once again, technology – robotic assembly lines, e-commerce and clean energy – is causing dislocation for people who are today’s equivalent of manual laborers. The world isn’t flat anymore, entire industries are being marginalized and a lot of people are just pissed off without knowing what to do about it. So what are you going to do different now it’s clear that change, and maybe revolution, is in the air?

Terrific interview with Jack Bogle, who didn’t create ETFs, but was in the vicinity:

You may be the 1%:

Okay, even if you aren’t in the 1%, you can still live like it:

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Why bother?

After the last 72 hours, it might be worth taking a few minutes to reflect on why we should even bother to risk the hazards of equity markets – because it can be easy to come up with reasons not to. We all know that neither humans nor markets are rational entities and we all know the folly of arguing with fools and knaves. Events that “cannot happen” do so with regular frequency and beg the question of, “Why bother?”

Well, though it hasn’t been so obvious recently, the most important reason is inflation. As Warren Buffett likes to point out, a dollar he earned 75 years ago only has the purchasing power of a dime today. With lifespans getting longer the value of hard-earned savings can become worth less over time, putting your lifestyle at risk. So at a bare minimum, we need to earn enough on our savings to avoid an erosion of purchasing power. Over meaningful periods of time returns on equities have proven to be one of the best ways to beat inflation. Just ask anybody who decided ten years ago to count on bonds to fund their retirement.

Now, a long time ago in a galaxy far, far away, this is what having a savings account in a bank was all about. You deposited the excess of your earnings with a bank, or that nostalgic entity, a Savings and Loan. Their job was to do due diligence identifying new and existing opportunities, mostly local, in which to invest the pooled savings of their customers. The bank’s depositors, in turn, were paid interest on the money entrusted to the bank, thereby, linking their savings to the profits of the bank and its investments (mostly loans). This was the best option for most people because it was safe, easy and much less expensive and risky than trying to trade individual stocks. And bank savings account weren’t much impacted by events like election outcomes.

As an example, the most visible use of bank deposits at one time was for home mortgages. But as reported last week in the Wall Street Journal (link below), for the first time in over 30 years, banks provided less than half of all mortgage loans. Add to this the challenges faced by banks in conforming to the many “new rules” established in the aftermath of the economic crisis in 2008-2009, and the ways in which financial institutions can invest their customer’s savings has been diminished. Today asset managers like Blackrock and Vanguard, mutual funds and exchange-traded funds are perceived as viable alternatives for individuals to invest their savings.

All of which brings us back around to the debate of active versus passive investing. Putting money in the bank is passive. And a recent Buttonwood column in The Economist (link below) demonstrates again that for most people, passive is the better option when choosing asset managers. In the on-going debate over exchange-traded funds versus mutual funds, here is another example of how the fees being charged by mutual funds can hurt the typical investor. While it has been suggested here at Invest-Notes that investing is about using your money to make money, Buttonwood offers a more nuanced definition of what long-term investing can achieve, or lose, based on something as basic as the cost of stock ownership.

So we should invest for a couple of logical reasons: to stay ahead of consumer price inflation, and to put money to work multiplying itself for our future benefit. Always remember, spend less than you make, and save the rest somewhere you will be least likely to overreact to unexpected events. Frankly, nobody has a clue what’s coming next, and knee-jerk responses to surprises, fear, politics, or the latest prognostication from pundits will only ensure you have an effective way of failing to achieve your financial goals.

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Skeletons walk where questions begin

“Avoid the unforced error, nail the basics and don’t take outsized risks” might be the best advice the individual investor can follow. An often-underestimated influence on equity and bond markets is the heavy hand of luck. Frankly, you can do everything “right” and still get bad results. And since luck can’t be controlled, knowing how to react – whether that luck initially appears to be good or bad – can separate winners from losers. But just because something can’t be controlled doesn’t mean it can’t be managed.

We all know bad things happen that are beyond our control to foresee or influence. Fires, floods and financial crisis come to mind. So we buy insurance, avoiding home purchases in areas prone to flooding and create investment portfolios that are well diversified with a healthy dose of cash savings. But what else?

One of the best thinkers on this subject, and a terrific writer to boot, is Michael Mauboussin. The man knows how to think about how we think – especially as it relates to investing. I read his terrific 2012 book, The Success Equation, when it first came out. Subsequently the opportunity to hear him talk about his book in person helped to clarify some of his more nuanced arguments and observations.

One of the many surprises that will be found in The Success Equation is an important reason why individual investors should look to exchange-traded funds as their best bet to achieving financial goals when using the stock markets. Discussed in many recent posts here at Invest-Notes, by choosing to invest in indexed funds smaller investors earn the market averages over time with much less risk or cost than owning individual stocks or traditional mutual funds. Remember, for as long as equity markets have been measured, they have gone up more often than they go down.

As noted a couple of weeks ago in The Economist, 70% of U.S. stock markets are now owned by large institutions like Blackrock, Vanguard, Fidelity, pension funds and hedge funds. That percentage was just 35% in the 1980’s. This means the self-described investment professionals are competing against each other more fiercely than ever before. As Mauboussin intriguingly suggests, the more skill involved in a competition the bigger the impact of luck on the outcome. For the individual investor, luck is a bad strategy.

Put another way, you don’t have to compete against the younger incarnations of Arnold Palmer or Muhammed Ali to succeed in building wealth over time. You don’t have to go at risk trying to pick up a couple of extra points against the pros, and face the risk of being seriously hurt – also known as suffering a permanent impairment of capital.

By systematically analyzing the outcomes of investment strategies – repeatedly and over time – we can create mental models that help anticipate the unexpected (to minimize risk) while expanding opportunities (to maximize upside). You can easily improve your overall return just by minimizing costs like fees and commissions (nail the basics). You can stay calm and remain inactive during times of great stress (avoid unforced errors). You do not have to go head-to-head with the pros (no outsized risks).

As Rudyard Kipling noted a century ago, just ”…keep your head when all about you are losing theirs…”

NOTE: Apologies for the long absence from this page, but a quick look at Jazz-Notes (link in menu bar at the top of this page) will explain where I’ve been. Hope you get a chance to check out my weekly radio show, Straight Ahead, on KRTU 91.7 FM. Live on Saturday at 8:00 am central, or on-line anytime at

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You should be very afraid

The surprisingly insightful book, Being Right or Making Money, features observations as relevant today as they were when first published in 2000. Ned Davis (of the eponymous market research firm) explores a range of often contradictory investment styles to uncover the common thread allowing each to succeed.

Davis argues that, time and again, the most successful investors, regardless of their style, emphasize the need to be risk averse. All these guys (and in this case, they are all guys) talk about controlling their losses. To manage risk is to make certain that no single investment can so badly impair your overall financial health that recovery is uncertain. In the investment business, this is referred to as “a permanent impairment of capital” and “blowing up.” We must strive to avoid both.

Okay, the thought exercise for today is to pretend you’re a billionaire. Take all your assets, especially the paper ones (like cash savings, stocks and bonds) and your home equity, and add four zeros to the value of each one. Now determine if anything appears out of whack. With a billion dollars to invest, should someone actually put three quarters of it into a single stock? Or hold only gold coins? Or own a home that constitutes 90% of their net worth? When evaluating an investment opportunity always consider the impact a total loss of that asset will have on your overall financial situation. To succeed as an individual investor it is essential to avoid the temptation of focusing on how much an investment could make until after determining what that investment could end up costing.

As Davis reviews the methods employed by successful investors including John Templeton, Warren Buffett, Peter Lynch, George Soros and others, he mentions (without naming names) one who commented that he had never met a wealthy chartist, a wealthy chartist who laughs it off and dismisses the idea of value investing, to which a value investor jokes about the delusions of momentum investors. Davis’ conclusion from these conversations was to look beyond the methods employed and instead focus on how those differing styles could all be successfully implemented.

Yet regardless of their style, four attributes are common to all of these investors:

  1. Use objective indicators. It is important to learn what is real and what is imaginary; gut reactions are not a reliable tool. Biases kill.
  2. Discipline. Once you have a system, stick with it until you have documented results gathered over time that prove change is needed. Never guess.
  3. Flexibility. Being wrong is acceptable, but staying wrong is not. Things change so get used to it, and believe that managing the tension between this rule and #2 above are likely the only chance you have at success. Know thyself.
  4. Be Risk averse. As mentioned by so many great investors, “I am always thinking about losing money as opposed to making money” and “We are cowards. We hate to lose money.” Be scared.
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Who are you?

First, let’s be clear on the difference between an investor and a speculator. Though both use similar techniques, their goals are not the same. Ideally we all make a habit of taking some of our income and setting it aside as savings. Once a critical mass of savings is accumulated there becomes an opportunity to use some of these funds to invest. As often discussed here at Invest-Notes, we advocate considering three primary asset classes for creating and accumulate wealth. Paper assets like cash, stocks and bonds; real estate like homes, rental property and raw land; and other items of value that can be monetized as needed like gold, jewelry and fine art.

Most Invest-Notes readers that I know personally, and those I’ve spoken with, are investors. Their goal is to build wealth over time in a prudent manner to provide for future events like purchasing a second home, helping the kids pay for college or funding their retirement. This requires a regular savings program with the proceeds invested thoughtfully in all three of the asset classes mentioned earlier. It is understood that the greatest chance for success will derive from consistency over meaningful periods of time.

Speculators on the other hand tend to be people kidding themselves that big, short-term bets within any of these asset classes is actually different from wagering in a casino on games like roulette. In both cases the possibility of permanent impairment of capital is the most likely outcome. Using the vernacular, a big bet begets a big loss that makes it impossible to get wealthier over time. Investors are betting on discipline while speculators are betting on luck.

There are however spaces within the spectrum between investor and speculator occupied by people often identified as traders. The obvious suspect is a hedge fund operator. These guys (and they are almost all men, which should tell us something) make big bets based on, for example, deep research underpinned by mathematical models. While attempting to create wealth over time (like an investor) they often try to do so by making outsized short-term bets (like a speculator). And like actors or musicians, where a few become wildly successful, most just don’t make it.

Yet there are times when an individual investor can make a controlled bet on a short-term opportunity. An example would be the purchase of a stock shortly before earnings are reported, with the idea of selling the equity after the earnings announcement regardless of outcome. There are documented examples of stocks that routinely exhibit extreme price action around earnings reports. So an investor who buys an equity based on some insight (real or perceived) with a very small portion of their portfolio (less than, say 3%) in anticipation of an expected outcome (good or bad) can be termed a trader.

Here’s the logic to this assumption. First, the likelihood of a stock going to zero after an earnings report is very small. Worst-case scenario is likely to be a loss of 10% to 20% of the value of the total purchase price. Similarly, unexpected good news will often provide a price gain in the same percentage band. This suggests the most extreme result of a $5000 bet would likely mean making or losing around $1000. And there are additional tax implications based on what type of account the trade is made in. But someone mindful about all possible outcomes of making a bet that won’t have a long-term negative impact on their net worth is not being unreasonable. At least that’s what I tell myself as I generally make a half-dozen earnings season trades annually.

Okay, now to the point of today’s note. The lessons learned from what happened after the Brexit vote might be applicable to a trader’s bet on the outcome of the September meeting of the Federal Reserve (that would be Janet Yellen and team). First, since “nobody knows nothing” as the saying goes, betting against a No Vote carried very little risk since the consensus was so sure of itself. The market impact of a Yes Vote would likely have been negligible since it was expected. Even a bet on a drop of the British Pound, or stock markets in general, were unlikely to generate a big loss. Any bets on the No Vote delivered huge gains for a handful of smart (and lucky) traders.

Second, the ensuing panic over the following week appears to have provided a very good entry point for long-term investors. While I didn’t have the foresight to bet against the No Vote, on both Friday and Monday I added VOO to a couple of IRA accounts. And in analyzing how the Brexit vote played out, it suggests to me a model for what could happen if the Fed decides to raise interest rates at their September meeting. Though, of course, everyone knows that won’t happen. But if it did…

One knee-jerk reaction to a rise in interest rates could be a spike in the value of the dollar – the opposite of what happened to the British Pound after the No Vote. There are a couple of exchange-traded funds (ETF) that move in concert with interest rates as well as the value of the dollar that I’m reading about. And though very dangerous, there are a couple of ETFs intended to deliver returns 2x and 3x the actual percentage increase. Of course this also means double or triple your losses if you get it wrong.

Similar to the reaction caused by the No Vote, a surprise decision to move rates higher – and frankly, even just the suggestion that it could happen in 2016 – would likely drive markets down, possibly dramatically. Having some cash at hand that can be used for adding to long-term holdings during any major sell-off might also prove to be a good bet.

On a different note, all jazz fans are invited to invest some time on Saturday’s with my new radio show, Straight Ahead. At KRTU 91.7 and streaming live online for those of you not in San Antonio, hear great jazz recordings from the 1950’s and 60’s compared and contrasted with new jazz from the 2000’s. Kicking off at 8:00 am, you won’t need any coffee to get your weekend started. And check out the new page in the menu bar above, Jazz-Notes.

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The difference between banks and buildings

There is a big change coming soon for a widely used equity index (the benchmark for many exchange-traded funds (ETF)). First a quick review of the Global Industry Classification Standard (GICS), a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS is set to add a new sector for the very first time. The original ten sectors are: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities.

The Big Daddies of indices, S&P Dow Jones and MSCI, use these classifications to determine (using an example from a Barron’s article by Chris Dieterich), whether Wal-Mart should be identified as a Consumer Staple, or a Consumer Discretionary stock. With the equity holdings of hundreds of ETFs based on the composition of these ten sectors, definitions matter. So, Wal-Mart (WMT) is a Staple and Home Depot (HD) is a Discretionary. Clear as mud?

The Financials Sector is about to undergo a huge transition on August 31, 2016, when Real Estate Investment Trusts (REIT) get their own sector. REITs are entities that own real estate related investments and often pay sizeable dividends. Owners of shopping malls and strip centers, mini-storage facilities, office buildings, actual mortgages, industrial warehouses, apartment complexes, long-term care facilities, timberland and now buildings occupied by the computers that make-up “The Cloud,” these stocks have often been considered niche investments.

As banks have struggled since the market mayhem of 2008-2009, the Financials Sector has been bolstered by the solid performance – and dividend payouts – of the REITs in their midst (about 20% of the S&P 500 is real estate related stocks). So Financial Sector ETFs like Vanguard’s VFY and State Street’s XLF are likely to see increased price volatility and lower dividend payouts going forward.

And tax ramifications for the holders of these and similar indexed funds benchmarked against the Financials Sector are possible. All ETFs using the Financial Sector as their benchmark will need to remove (sell) REITs, which could have capital gains implications. Additionally, players like Vanguard and State Street will also need to purchase REITs for use in their new REIT Sector ETF offerings. Expect price volatility in REITs over the next couple of months.

With a change to the GICS being made for the first time, the impact on the benchmarked ETFs are uncertain. All Financial Sector ETFs were recently removed from the portfolios I’m responsible for (though not individual REIT stocks). And I’ll be very interested to see what the new REIT Sector ETFs look like.

A caveat: While Invest-Notes has long extolled the virtues of real estate in an investment portfolio, there is an important distinction to make between owning equity REITs, private REITs and a physical structure, like an office building or a vacation home. Equity REITs are stocks and subject to market whims, corporate shenanigans and dividend cuts. Private REITs are typically limited liability partnerships with steady payouts but are extremely risky for investors unfamiliar with this asset class – there can be Hotel California kinds of risk, where you buy-in but can never cash-out. Owning individual physical properties has its own challenges, rewards and tax implications. All three types of investments have long been in my personal asset collection, and also in some managed portfolios, but are definitely not right for many investors.

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The “benefit rich” investment, Part 3

Investment Thesis

So where do we go from here (as Bobby Womack so beautifully sang)? Warren Buffett, as usual, has the simplest solution; put 90% of your savings in an S&P 500 index fund and 10% in a bond fund.

A quick reminder, taken straight from the Morningstar web site, “The S&P 500 is the most oft-cited proxy for the U.S. equity market and is viewed as an indicator of the economic health of the nation. Although not as old as the Dow Jones Industrial Average, the S&P 500 is better diversified and market-cap-weighted, which makes it more representative of the U.S. market.” As mentioned here many times, the S&P 500 is my preferred measure of U.S. markets. And it has historically gone up more often than it has gone down.

Note the S&P index is capitalization weighted, which in plain English means the bigger the company, the larger a percentage it comprises within the index. For example, Apple (AAPL) is one of the biggest companies in the world and as such has the biggest weighting in the S&P index. AAPL makes up almost 3% of the total holdings in the S&P index, while Pepsi (PEP) constitutes less than 1% of the total holdings. Simply put, if AAPL has a bad day, it has a bigger impact on the total value of the index than if PEP takes a hit to its share price.

Now, I’ll suggest for most folks VOO is a better holding than SPY – explained below – but for those wanting something a little less plain vanilla, there is also RSP. And this is where the fun starts, understanding and choosing between ETFs that look alike, but really aren’t. SPY is the oldest and largest of the S&P ETFs, though to quote Morningstar, “structural issues hinder its efficiency.” It is also the most widely traded ETF, consistently matching the daily volume of Apple (AAPL). It charges 0.09%, which is half of what it charged when launched in 1993. But us individual investors should focus on lowest cost, not the best liquidity.

Vanguard offers VOO, with a lower cost (0.05%) and better track record matching the returns of the S&P 500 index over time. This remains the core holding in all of the accounts I manage, with VOO typically comprising at least 50% of the portfolios. And while there are no plans to sell any current holdings of VOO, as I add shares, I’m now selectively buying Guggenheim S&P 500 Equal Weight (RSP), with expenses of 0.40% for some accounts. Why pay the higher fee for an S&P fund?

A couple of weeks ago, the S&P 500 was down 0.33% and both VOO and SPY were down 0.37%. RSP was up 0.18%. The two biggest holdings in the S&P 500 index are AAPL and Microsoft (MSFT), both of which, for different reasons, took a hit to their share prices. The perfect example of why capitalization weighting has its problems. Time has tended to favor RSP over the big boys. On the other hand, RSP pays a lower dividend than SPY or VOO.

Interestingly, since starting this series on ETFs I’ve been asked specifically by different readers where to put $5000 to $10,000 today, right now. Note that after one of the most volatile markets in memory – the worst start to a year for the S&P 500 ever, followed by a breathtaking rally in the Spring, and now Great Britain collectively loosing its mind – markets are simply back where they were at the beginning of this year. It could easily be argued that the turmoil in Europe is going to be good for the U.S. since where else is safer to invest? Of course there is the wackiest presidential election of my lifetime to survive…

To Buffett’s point, for folks starting out, or just making some moves to invest this year’s IRA money, simple is best. With any rise in interest rates likely off the table this year, 90% in VOO and 10% in SHY sounds about right. If you already have a well-diversified portfolio, you might consider a couple of bets for the mid-term. Companies that tend to make most of their money in the U.S. are an interesting idea.

On Friday, at down 500-points on the Dow Jones Index, I bought some XLY, a consumer discretionary indexed fund with top holdings that include Amazon and Home Depot. This is a bet on America. I also purchased a slug of RSP at the same time. And for those with a bit more cash to park, well, Berkshire Hathaway is as all-American as it gets, and at $140, it’s looking pretty good (BRK.B). That is after all where Mr. Buffett keeps most of his investable assets.

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