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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The “benefit rich” investment, Part 2

How ETFs work

We’re going to walk a tightrope today as the conversation will be both mildly technical and somewhat over simplified. But the differences between a mutual fund and an indexed ETF are dramatic, and should be understood. Lower fees and costs – universally acknowledged as the single most controllable variable in determining investment returns – are the most commonly discussed benefits of using ETFs. But as the number of ETFs grow (remember, 1300 are pending approval), how an ETF is structured, and the kind of assets it contains, mean many are starting to not look much better than a mutual fund.

So, let’s look at a completely different kind of investment, commodities futures, as a way to explain how an ETF works. For our example, let’s assume you’ve decided to purchase a big slug of corn, betting on a drought to make the bushels more valuable when they are finally sold to a food producer to make Corn Flakes. A commodities broker will take your $10,000 and give you a receipt, with the corn in discussion stored in a couple of big silos in Iowa, as collateral.

Now, if in 90-days when the corn is sold it is worth more than you paid, you will redeem your receipt and earn a profit. If your bet on a drought was wrong, then you cash in your receipt for less than you paid and take a loss on the investment. But at no time does a truck show up at your house and dump $10,000 worth of corn in the backyard. The point here is that you never actually take possession of the corn. You simply trade – buy or sell at anytime during the duration of the contract – the rights to $10K worth of corn.

And herein lies the fundamental difference between mutual funds and exchange-traded funds. While the sponsor of an ETF – folks like BlackRock or Vanguard – have to own the actual stocks and bonds, you never take ownership of the underlying assets. Instead, you own the rights to a specific dollar amount of the pool of assets in the fund. You can buy in the morning and sell the same afternoon (not recommended). It is even possible to trade baskets of foreign assets when European or Chinese markets are closed. ETFs can be owned for hours or years.

A traditional mutual fund purchases (simplified for this example) a basket of equities they believe will out-perform the overall market. The reason shares of the mutual fund can only be bought or sold once each day, after the stock markets are closed, is because the fund has to balance the money coming in (people buying shares) and the money going out (people selling their shares) to ensure the amount of stocks they own equals the amount of money they have invested.

This need for balance then impacts all other investors in the mutual fund and can causes losses in the value of the fund, or create a tax liability even if you have done nothing. If a mutual fund uses leverage (borrowed money) a big redemption (sale of shares) can force the fund manager to force a sale that can impact the other shareholders. This means you can be hurt by the actions of other investors in the mutual fund.

Instead, like the example of corn futures above, while a sponsor such as BlackRock or Vanguard does take physical ownership of the stocks that underlay the ETF, you don’t. You can buy and sell your rights to the assets in the ETF, but you don’t ever take possession of the stocks. This also means the burden of taxes falls on the sponsor, not the investor.

If an entity like a pension fund wants to buy $100,000,000 worth of Vanguard’s S&P 500 ETF (VOO), Vanguard then purchases a hundred million dollars worth of the stocks that make up the S&P 500 index and issues shares. When the pension fund decides to sell VOO, Vanguard can liquidate what’s needed for redemption without impacting other investors.

As more investors, large and small, discover the many advantages of using ETFs their use will grow. Yet with less than 9% of all investable stocks and bonds currently inside of ETFs, it will likely be a long time before they become “too big to fail” as has been recently suggested.

Next up, “So, what do I buy?”

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The “benefit rich” investment, Part 1

When Investnotes made its first appearance ten years ago, the goal was to provide some guidance and insight that could be used by individual investors – the little guys – to create wealth over time by investing in stocks and bonds. In those days the focus was on individual equities and mutual funds. Yet the last few of years here at Invest-Notes have seen very little in the way of specific recommendations of stocks. And the suggestion to eschew mutual funds in favor of exchange-traded funds (ETF) has been made without specific guidance.

So its time to go back to the basics. Over the next few weeks you’ll find a wide ranging discussion of why ETFs are likely the best bet for investors of all sizes over the coming decades and which ones are most appropriate for achieving your investment goals. There is a lot to share and questions are welcome, as always.

We interrupt this program…. As I am wrapping up this series of articles, The Economist this week published an unexpected endorsement of the ideas you are about to enjoy. Serendipity indeed:


Much to my surprise, ETFs have been around over 25 years. That they have survived through some of the toughest markets in history – and not just the market mayhem of 2008-2009, but also the dot-com bust and flash crash – is evidence that these are robust financial products. Almost unbelievably, ETFs came about based on an idea floated in 1988 by the U.S. Securities and Exchange Commission (SEC) in their report on the reasons for the October 1987 crash, with the first ETF actually appearing in 1990 on the Toronto Stock Exchange.

Today, the Standard & Poor’s Depository Receipts known by its ticker of SPY gets credit as the first ETF, mostly because of the marketing splash created by its launch in 1993. SPY holds the same stocks, in the same quantity, as the S&P 500 index, which is quoted daily and considered the best proxy for how stocks are trading. Not initially much of a success, today SPY is the most traded security in the world with around $175-billion in assets.

The total holdings of all 1800 ETFs currently available is about 5% of the total float of equity markets worldwide (there are another 1300 ETFs pending approval from the SEC). And, less than 2% of all bond and commodity market assets are traded through ETFs. Yet at the end of 2015 there was almost $16-trillion invested in U.S. mutual funds while ETF ownership worldwide is just $3-trillion.

That ETFs come in so many colors and flavors means more, not less, due diligence is needed in making selections for your portfolio. But due to the many benefits offered by ETFs that are not available from individual stocks, bonds or mutual funds, for most individual investors they are a better bet for savings and retirement accounts. Advantages include ease of asset allocation (many are laser-focused), liquidity (easy to buy and sell) and tax efficiency.

The wealth of Americans reached a record of $88.1 trillion in the first quarter of 2016. What are you doing with your share?

In preparing this series on ETFs, many books and a lot of articles from Bloomberg and Morningstar were reviewed. If you’d rather not just believe me, check out these:

Eric Balchunas – Bloomberg analyst specializing in ETFs, he has been a thought leader in the field for over a decade. His book, The Institutional ETF Toolbox, is a terrific resource. While focused on major players, individual investors can glean a lot of insights for using ETFs.

Richard Ferri – Written in 2007, The ETF Book, was one of the first books to focus on ETFs and the value they can provide as an anchor to an investment portfolio. The founder of an investment advisory firm, this is a guy who uses ETFs in portfolios and gets paid to do so successfully.

David Abner – The ETF Handbook, even more so than Toolbox, is intended for professional traders and so much individual investors. Currently a Director at Wisdom Tree (one of the major innovators in ETF products) he has a front row seat to the rapidly evolving world of ETF products.

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Random acts of thought

It was reported that at the big Berkshire Bash in Omaha two weeks ago that Mr. Buffett said it didn’t matter who wins the presidential election in November, since it is unlikely to make any difference to him or his portfolio. Further, he repeated – and I remember hearing mostly the same thing while attending the Buffett Sideshow (as a locals refer to it) a few years ago – that America remains the best place on earth to invest. Same as it ever was. Berkshire Hathaway (BRK.B) is in most of the portfolios I manage.

One of the many “explanations” for the big market swoon at the beginning of the year was nervousness around the Chinese economy (remember when it was Greece?). This week’s Economist suggested that for all the hand wringing the most likely scenario for China over the medium term was a muddle through. Considering the opacity of available information, assume anyone with a detailed analysis of why China is doomed has something to sell you.

So, having just finished the last book written by Carl Sagan, The Demon Haunted World, the two observations above had special significance. First, Sagan – who I greatly admire even if we often disagree – spent a couple of chapters lamenting the state of science and math education in America. “We, as a nation, are falling behind the rest of the world,” he thundered. Yet twenty years later, Bloomberg reported this week on the number of middle class Chinese families sending their kids to the U.S. to attend school.

More to the point, America certainly appears to be the place where the best and brightest thrive. And tell me again which of the world’s most influential companies are not American? Each one an American company, members of the S&P 500 generate about half of their annual sales outside of the good ol’ USA. And as a measure of equity markets, these 500 entities account for about a third of the world’s total stock market value. Leaving aside the incentives of our national taxing authorities (IRS) that push companies to offshore their profits (and now increasingly, their headquarters), and for all our lousy test scores we remain the place where innovation happens and business gets done.

Yes, as a nation we face some serious problems. More important than income inequality is education inequality – the latter responsible for much of the former. There is an entitlement mentality eroding the can-do attitude best described by Walt Whitman as the foundation of this country. A dangerous narcissism fueled by social media grows unchecked. Our multi-tasking, always-on lifestyles prevent us from thinking critically, or worse, at all.

But pessimism is the easy way out. Listen to all the gloom-and-doom prophets and prognosticators, and you too will resign yourself to live in an ever-gloomier world. It takes hard work to be optimistic. Tune out the noise and negativity; focus on the things important to you and your circle of family and friends. Make the world a place you want to live in. You’ll find a lot of people will choose to join you. And go long the U.S.A.

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Save your money

Discussion of individual equities pretty much ended a few years ago here at Invest-Notes. This occurred for a couple of reasons that seem relevant considering the recent drawdown and equally dramatic rise in equity market prices. Most significantly has been our shift in ideas about portfolio construction. A decade ago the focus was on stock picking, with mutual funds used gingerly to provide diversification and access to market segments requiring specialized skills.

For example, one of the first Invest-Notes was about Third Avenue Value Fund (TAVFX). At the time, fund manager Marty Whitman was still at the top of his game and TAVFX was the epitome of deep-value mutual funds, specializing in companies facing complex legal challenges. Entering and profitably exiting a sizable position in TAVFX back in 2007 was due to luck. I was not so fortunate with the Third Avenue International Value Fund. Having been just a spectator since then, the recent fall from grace of a Third Avenue bond fund punctuates the decline of a once vibrant franchise, and serves as a shining example of why index funds should replace mutual funds in most portfolios.

The point here is that mutual funds are all about stock picking, which has been repeatedly shown to be a losing strategy over the long haul. Even the best and brightest will make mistakes, but fund managers get paid in down markets and even after making bad decisions. This is the ultimate expression of Nassim Taleb’s concept of the antifragile – taking advice that can hurt us from people who don’t have skin in the game. If a stock pick is going to be bad, I want to be responsible for the decision. And if you haven’t read the book Antifragile, think about it.

Evidence overwhelming supports the idea that low cost index funds are the best bet for individual investors, especially in retirement and savings accounts. Invest-Notes believes that individual stocks should only be used gingerly, and mostly to provide additional dividend income. Personally I still like to buy individual stocks, but the selection process has become more rigorous. And full disclosure, the IRA I manage for my wife, Karen, has no individual stocks or bonds. But it does contain the exact same exchange traded funds (EFT) as my IRA.

Frankly, an annual deposit of the maximum allowable contribution by law into an IRA or a 401K and buying a handful of low-cost indexed funds are about all anyone needs to be successful at funding a retirement. The one caveat is if you have not yet started saving for what will likely prove to be a life span longer than that of your parents, and your personal expectations you have a problem. This suggests starting another investment account where there is no maximum allowable contribution by law and putting money in to it regularly.

Which goes back to the oft-discussed topic here of working diligently to spend less than you make. Save now or pay later – if you can.

New stuff over at Art-Notes, if you are interested.

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Back to the basics, again

There are two half-finished Invest-Notes sitting on my computer desktop. One will likely appear soon, the other is toast. It has been as hard to comment on the market as to deal with it as an investor.

The last few weeks have proven a marvelous spectator event for any aficionado of equity and fixed income markets. Just about anywhere an investor could look displayed volatility and extreme price action. As noted here at the beginning of the year, either you should avoid watching market gyrations altogether, or do so daily but without reacting. I did both, and neither.

First, we can’t lose sight of the importance of saving money – this is, after all, the foundation of any future wealth creation. Both Karen’s IRA and mine have been fully funded for 2016. If you can’t live beneath your means then financial security will always be a dream. This doesn’t necessarily mean you have to live frugally, or endure unnecessary hardship. Just that you don’t live paycheck to paycheck. Ridiculously low interest rates are no excuse for piling up debt, and worse, leaves you vulnerable when the situation changes.

Second, you don’t just have to invest your hard-earned savings in the stock and bond markets. Our biggest investment of 2015 was to purchase an office for Karen’s growing company. Still I’ve designed a plan on how to invest that new $13K now in our IRAs. The point is to keep funding future financial needs even if a sudden, big slug of equities isn’t in the immediate plans. Regular, systematic equity purchases are the best bet, and dollar-cost averaging (DCA) has been encouraged at Invest-Notes for over a decade.

However, for those of us who enjoy the thrill of the hunt, times of volatility might mean taking a shot when others might not. As noted here, shares in my favorite S&P 500 ETF (VOO) were added to a couple of accounts back in mid-January. The price at that time was fifty-cents less than today’s close. While the price has been higher and lower since then, the early part of the New Year sell-off still looks to have been a decent entry place for accounts intended for the long haul. Remember, to win buy when stocks are going down, not up.

Similarly, the urge to trade was soothed by two bets in my trading account over the last couple of week. One turned a quick, small profit – commiserate with the size of the bet – and the other position, also profitable, is being added to and held (“When the facts change, I change my mind. You, sir, what do you do?”). The unremarkable results of my two-year experiment in day trading can be found in the Invest-Notes archive, but the ability to trade safely (no chance of permanent capital impairment) has probably been my most profitable investing activity outside of real estate.

Finally, here’s a nice, short article about Warren Buffett well worth a few minutes to read:

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