The Little Book of Safe Money
Jason Zweig

“The keys to investing are simple: diversify, keep costs low, buy and hold.”

“Like dieting, investing is simple but not easy.”

“It is absolutely mandatory for you to keep a reservoir of liquidity in your portfolio at all times.”

“No matter how valuable an investment may be or appear to be, it’s of no practical value to you unless it’s liquid when you need to cash out.”

“The biggest single holding in your portfolio is you: the income that your career will generate over the rest of your life.”

“Anyone whose human capital is vulnerable to the escalating cost of living should consider investing heavily in TIPS.”

“Wall Street is forever inventing another newfangled way to promise higher yield at low risk.”

“In Japan at the end of 1989, the leading Nikkei 225 stock index was at 38,915.87; two decades later, it languishes below 10,000.”

“Invest as if stocks are likely-but not certain-to beat all other assets. Keep some money in bonds, cash, and real estate just in case they do better.”

“Stocks are not certain to outperform bonds and cash no matter how long you hold on.”

“Men should make a special point of having their wives review any choices the husbands regard as a sure thing.”

“It is irresponsible for a husband to keep such tight control of the family’s investments that his wife will find them completely unfamiliar after he is gone.”

“In the stock market, much of what seems to be patterns is, in fact, just random noise.”

“You should never act on an investing idea the same day you get it.”

“Never invest in anything on the recommendation of a friend or family member alone.”

“Commit to a dollar-cost averaging or automatic investment plan that require you to add a little bit of money every month.”

“If you are investing for retirement 30 years away, buy a total stock-market index fund and hold it continuously for the next three decades.”

The Millionaire in You
Michael LeBoeuf

“Money should be invested passively. Passive investing means buying and holding no-load, low-cost index mutual fund with performances reflecting that of entire markets.”

“Don’t waste your time playing the market. Own the Market, live your life and enjoy the journey.”

“Taylor Larimore–summarized the index advantage best: “Index funds offer much more than superior returns. They also provide maximum diversification, no overlap, no style drift, no manager changes, lower turnover, lower expenses, lower taxes, greater simplicity and peace of mind.”

“The master key to wealth can be summed up in just one word: Simplicity.”

“The main reason index investing is so successful is because fewer people have their hands in your pocket.”

“Timing the market is for losers. Time IN the market will get you to the winner’s circle, and you’ll sleep a lot better at night.”

The Only Guide to Alternative Investments
Larry Swedroe and Jared Kizer

“Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred.”

“When considering an asset class for inclusion in a portfolio, — investors need to consider the diversification benefit of the investment.”

“Recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence.”

“The evidence from academic studies demonstrates that equity REITs, both domestic and international, offer an attractive risk/return trade-off” and provide meaningful diversification benefits to portfolios.”

 ”The bottom line is that investors should consider devoting at least some significant portion of their fixed-income allocation to inflation-protected securities.”

” “Only informed and disciplined investors should consider including commodities in their portfolio.” 

“Unless they are highly risk-averse, investors should probably not buy an immediate fixed annuity until approaching age eighty.”

“Despite its low correlation with other portfolio assets, high-yield debt provides almost no unique benefit in terms of portfolio diversification.”

“In times of crisis, the markets for illiquid assets can virtually dry up.”

“For most investors the only way to obtain sufficient diversification of the risks of investing in speculative securities is through a mutual fund.”

“After ten years the survival rate of private firms was only about 34%.” (2002 study)

“Private equity investors forgo the benefits of liquidity, transparency, broad diversification, and the access to daily pricing that mutual fund investors enjoy.”

“Understanding the difficulty of identifying superior hedge-fund, venture-capital, and leveraged-buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high.”

“While preferred stocks offer relatively high yields, in general, they possess enough negative attributes to make them inappropriate choices for individual investors.” 

“One of the rules of prudent investing is to avoid complex securities because the complexity is likely to favor the issuer.”

“The bottom line on hedge funds is this: They are ’sinkholes’ for investors.”

“Variable annuities are products that are sold, not bought.”

“Variable annuities (VA) convert what would otherwise be long-term capital gains into ordinary income.”

“Education, or a good fee-only advisor who is not influenced by commission-based compensation, can be the armor that protects investors.”

To be continued …

“The traditional techniques for managing portfolio risk are asset allocation and diversification,” he says. “Those ideas aren’t ‘wrong’ but they’re not good enough for today’s markets …. stock options provide the safety net that most folks need.”

Consider the following guest post from Mark, on the collar technique:

Option collars represent a basic, easy to understand and implement strategy that guarantees the safety of your stock market portfolio. Guarantee is a strong word, but it’s the truth.

Here’s how it works: You own 100 shares of stock, or, for passive investors, an ETF that mimics the performance of a broad-based market index. It may be SPY (S&P 500), IWM (Russell 2000) etc. The only requirement is that the ETF has listed options.

Next, buy one put option, giving you the right to sell those 100 shares at a predetermined (strike) price. Then sell one call option, granting someone else the right to buy your 100 shares at a predetermined (strike) price.

Often you collect enough cash when selling the call to pay for the put. That gives you the collar at no cash cost. The put strike price sets the maximum loss and the call strike price sets the maximum profit.

Such safety does not come free, so what’s the cost? There are two costs. First, as with any insurance, choose the deductible and decide how much you are willing to lose if the market tumbles. A reasonable choice is 5%, but it’s up to the individual investor. The second cost is the necessity to limit upside gains. You profit on rallies because collars are slightly bullish, but gains are strictly limited. No more +30% annual gains for collar owners.

Options have limited lifetimes, so this trade must be repeated at a time interval that suits you: one month, one year, or longer.

This is a very brief discussion, but what you get is guaranteed protection coupled with limited gains. Is that for you?

For an example, see this post by Mark. He also has written several books on options, such as the Rookie’s Guide to Options, wherein can be found more discussion of collars.

Risk budgeting is employed by “sophisticated pension plans seeking to maximize their potential returns.” Instead of using a fixed asset mix, they use “constant risk rebalancing” to manage asset allocations.

“Traditional money management often ignores the fact that markets are sometimes more risky than at other times,” notes Yamada. During the tech bubble, those investors guided by a fixed asset mix were trimming equity weights back to a preset allocation such as 60% stocks and 40% bonds. But those guided by risk budgeting would be cutting back on stocks even more and taking stock allocations below 60%.

PŮR’s risk budgeting approach uses volatility as an indicator to make “subtle shifts in the portfolio.” Volatility may be defined as the 252-day moving average of standard deviations of daily changes in the S&P 500 Index. The CBOE Volatility Index (VIX) may also be OK to use “in a pinch,” but has greater variation.

“Before the “tech wreck” the technology sector was 8% of the S&P 500 Index and at the peak it was over 30%! At the same time, the 252-day moving average of the S&P 500 volatility moved from about 12.5 to over 15,” says Yamada.

“When volatility, as defined above, is falling or stable, a more positive market is suggested. More importantly, when volatility is rising, assuming less portfolio risk is indicated.”

Adds Yamada: “We think timing the market is generally a ‘mugs’ game. It’s expensive and hard to do consistently. However, as a form of insuring a portfolio against big negative downdrafts, volatility is an interesting indicator.”

His firm is also investigating use of the ‘VIX ETFs’ (VXZ and VXX) in this context too.

Lifecycle funds (LCFs), also known as target-date funds (TDFs), are basically packages of equity and bond mutual funds that shift toward the bond funds as the investor approaches a retirement date. The idea is to put the asset allocation decision on cruise control, to automatically shift toward more conservative investments as the investor ages – as classic asset allocation theory prescribes.

It’s now becoming more apparent that asset mixes in LCFs can vary from provider to provider, and be rather aggressive in some cases. In the U.S., for example, it was found that 2010 target-date funds (one year to retirement) had allocations to equities ranging from 8% to 68% and those at the high end of this range experienced huge drops of 40% or more in 2008. If someone is a year away from retiring, they shouldn’t be loosing 40% of their wealth, so something seems amiss here — hence the recent scrutiny by politicians and regulators.

I never was a fan of lifecycle funds anyways. For the following reasons:

1. asset mixes: they shouldn’t be based just on one’s age but include other factors (that may change over time), such as size of nest egg, personal health, type of job, etc.

2. inflexibility: one’s preferred retirement date may change from the date selected in a LCF and/or one may want to delay the phasing out of equities when in a bear market, like now

3. high fees: mutual-fund management fees in Canada average around 2.4% annually — and then there will be another fee on top of this for the “wrap” portion of the LCF

4. other investments: asset mixes in LCFs are usually designed as if the holder had no other assets; but if they do have other investments, an annuity or a pension, the LCF mix may be inappropriate

5. opaqueness: it sometimes is not easy to see what’s inside – i.e. asset mix and/or cost; it’s hard to compare LCFs from one to another

While we might avoid LCFs, we should not eschew the benefit of shifting toward more conservative assets as we age. And this is easy to do with a diversified basket of low-cost index funds or exchange-traded funds based on concepts like the Couch Potato Portfolio.

All it takes is a commitment to spend a few minutes a year to rebalance the portfolio. Don’t let inertia or bull markets take you off the path — don’t be like one in four U.S. investors approaching retirement age (56-65) in 2007. On the eve of the bear market, they had more than 70% in stocks, according to the Center for Retirement Research at Boston College.

Notice how all of the above approaches put the emphasis on picking stocks? Yet, academics and a growing number of investors say stock picking plays a minor role in the variability of investment returns. More important factors are asset allocation, diversification, and cost minimization.

A better way to teach children investing, then, may be to set up a portfolio of index funds (say along the lines of the Couch Potato Portfolio). They can be purchased in small amounts at low cost. Dividends can be automatically reinvested, commission-free.

In Canada, they can also be held inside an RESP to collect government education grants and compound tax-free. The account will not only teach the value of saving, diversification, and asset allocation but also provide funds for university courses. A couple of stocks picked without regard for diversification, asset allocation, etc. has a greater risk of not compounding as well, and could end up discouraging saving and investing.

But wait for it. When the dollar fell 30% in real terms from 1985 and 1991, the trade balance went from a deficit equal to 3.5% of GDP to approximately balance. This time around oil prices have climbed and masked some of the reduction. And most of the dollar depreciation since 2002 has come in the second half of the period (converse of earlier devaluation) — so much of the effect is still to be felt (given long lags of up to two years in the impact of exchange rate changes).

Extrapolating from the 1985 to 1991 experience, John Lipsky, First Deputy Managing Director of the International Monetary Fund (IMF), expects the U.S. trade deficit will decline in coming years to under 3% of GDP. For investors, this means a promising asset class going forward could be U.S exporters. As Lipsky said: “If the decline in the value of the dollar is supporting a narrowing of the … U.S. current account deficit, it is thereby helping to promote an inevitable shift in the sources of growth between tradable and non-tradable sectors in both surplus and deficit economies.”