Investing


About Bernard Madoff’s Victims

As the news broke this morning that Bernard Madoff had been convicted of engineering the largest-ever Ponzi scheme and sentenced to 150 years in prison, articles began to crop up reminding us about the victims’ fate: since the Securities Investor Protection Corporation (SIPC) will only guarantee up to $500,000 per eligible claimant, all those who invested higher amounts are set to recover no more than pennies on the dollar out of the remaining funds.

For some weeks now, the victims have been conveying their anger and sense of injustice at the loss of what often amounted to their life savings. But while I sympathize with them up to some extent –clearly, nobody deserves to be wiped out of the money they had invested in good faith-, I can’t help wondering about the reason they trusted Bernard Madoff’s firm in the first place.

Accessing Madoff’s fund was not easy for individual investors. The process to get into the fund was shrouded in secrecy, with Mr. Madoff making a point of being all but unapproachable to his clients. But for those who were able to make it through the apparent obstacles –sometimes lured by the appearance of exclusivity-, the rewards were plenty.

According to Robert Chew’s thought-provoking article in Time -where he gives a first-person account of how he became one of Madoff’s victims-, when he first invested in it the fund had been providing generous returns for decades, “ranging from 15% to 22%”.

It doesn’t sound very plausible to come across an investment which consistently provides such extraordinary returns regardless of the stock market’s performance. Madoff, however, managed to convince his clients that he and his colleagues had discovered a system to consistently outperform the market. What made these claims believable to many rich investors was the idea that such opportunities are indeed available to a few chosen and very rich people like them. As Robert Chew acknowledges referring to himself and other victims, “we deluded ourselves into thinking we were all smarter than the others”.

It is not my intention to generalize or blame the victims for the consequences of Bernard Madoff’s hideous actions. Many of them didn’t even know the funds they were buying had stakes in Madoff’s organization, and even the ones who were duped by him directly have the right to wonder how the Securities and Exchange Commission (SEC) allowed the Ponzi scheme to go on for more than 40 years. However, if any good can come out of this tragic story, I hope it’s a reminder to all investors that the old saying remains valid: if it seems too good to be true, it probably isn’t.

For more information on Bernard Madoff’s victims, check the following sources:

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The Ultimate Depression Survival Guide:

Protect Your Savings, Boost Your Income, and Grow Wealthy Even in the Worst of Times

On the road to $1M rating:

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As you would expect from somebody who thinks we’re experiencing the “Second Great Depression” of modern times, Martin Weiss is more than a little angry with the people who got us into this mess. He starts the book with a description of the doomsday scenario that awaits us in the aftermath of the current financial crisis. And while he describes, he rants at the list of those responsible for it:

  • The US Government, who have thrown good money after bad in an effort to bail out banks, brokerage firms, insurers, mortgage brokers, automakers, and any other company who could just about argue that they are “essential” for the economy or “too big to fail”. The result? According to Weiss, sixteen times our biggest-ever federal deficit.

  • Alan Greenspan, who, by keeping interest rates artificially low in the firs half of the 2000’s, contributed to the subsequent consumption spree, housing bubble, and lowest household saving rates ever seen.

  • The Federal Reserve and the Treasury Department, who first decided to let Lehman Brothers fail, then backtracked in the face of the ensuing panic and threw themselves into bailing out the entire financial system with the Troubled Asset Relief Program (TARP).

  • The “Government-bred monopolies, corruption, fraud, and cover-ups” that stained every part of the financial system, from Freddy Mac and Fannie Mae to private mortgage lenders, rating agencies, banks, and large companies’ CEOs.

  • Consumers, who were willing participants in the massive money illusion that followed the outrageous stock-market returns on the 90’s and the housing bubble and endless supply of cheap credit of the 2000’s. We convinced ourselves that a lifestyle based on raiding our homes’ equity and maxing out our credit cards was not only reasonable, but also sustainable in the long run.

The list is longer and more detailed, but I wouldn’t have space here to go through it all. Suffice it to say that every single one of corporate America’s big shots is named in the book at some point or another.

No bad for an introduction, especially one that’s intended to convince the reader that a depression is inevitable, and that this particular book holds the secret of how to benefit from it. But the whole description of how we got into this mess doesn’t come across as particularly far-fetched. I found it often illuminating, and suspect that the reality may be even darker than Weiss suggests.

The rest of the book covers methods to protect or even increase your income during an economic downturn. I particularly liked the fact that it’s full of practical tips and helpful resources.

For example, you think your money is not secure on a commercial bank? Weiss guides you through the steps to open an account with the US Treasury Department. You think Wall Street is going to go down in the second part of the year? You find a list of more than 50 index and sector inverse ETFs, whose value increases when the value of the underlying index or sector plunges. Many books wouldn’t care to explain inverse ETFs work, let alone give compile for you a catalogue of ticker symbols. I appreciated the unusual level of detail.

So while I’m still not convinced about the imminence of a depression that “threatens to rip through our lives with the force of a hurricane”, I prefer to be cautious than sorry, and the book taught me a couple of tricks to hedge my savings against economic downturns. Even if you’re convinced that a bear market is just around the corner, there’s no harm in being prepared for the opposite, and this book is the place to learn how.

TALKBACK

  • Do you agree with Martin Weiss that the current crisis will be followed by a long period of depression?

  • Would you bet on stock prices going down in the second half of the year by buying inverse ETFs?

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One Up On Wall Street:

How To Use What You Already Know To Make Money In The Market

On the road to $1M rating:

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This is one of those classics that every wannabe investor should read.

The book is best known for its proposition that small investors have an edge over professional ones. David Lynch’s viewpoint is that small investors are best placed to discover thriving businesses that become favourites of the public long before they show up on Wall Street’s radar.

Say you are a school teacher and notice that all the kids in your class have started talking about a new website that allows them to intereract and help each other while they do their homework. Thanks to the website, solving problems has become “cool”, and what’s more, even parents seem to be delighted that their kids are logging onto it every afternoon.

You realize that there can be thousands of kids around America talking about the same thing. The site is placing adds of carefully selected products, which you estimate must be generating generous revenues.

So you go home and do some research. You discover that the website belongs to some obscure IT company whose shares have been selling at around $1 since it became public 10 years ago. You find that the financial health of the firm is sound and, what’s more, you already know that they have stumbled across their big breakthrough with the new website.

At this point you can do two things:

You can wonder, “if this business is such a good prospect, why hasn’t Wall Street discovered it yet? How come its shares are still trading at such low prices?”. The answer, according to David Lynch, is that professional investors have innumerable restrictions on the types of stocks they can invest in. An emerging social network will be considered too risky a prospect in Wall Street until at least a couple of respected analysts have recommended it and several institutional investors have followed through and included it in their portfolios. By then, however, the share price of the firm will have risen to $5, so you’ll have missed an opportunity to grow your money fivefold.

The other thing you can do is, of course, buy shares on the company, sit down, and watch the share price rise.

This is the theory. Paradoxically, while this vindication of the power of the small investor is the main reason why I have seen the book recommended, it’s not the part of the book I found most useful.

Maybe it’s just me -I’m not known for being too perceptive of things happening around me-, but even in hindsight the only company I have come across in the past that had me thinking “wao, this is gonna be big” was Google when I first discovered the search engine in 2002. And whether this would have led me to buy shares when they became public in 2004 is anybody’s guess. (Google’s share price had risen sixfold by the end of 2007).

But even if, like me, you don’t find this part of the book so useful, you’d still be wrong to stop reading, as you’ll miss the best treatise on investing I’ve ever read, full of insights that led me to buy my first single stocks after a long period of investing exclusively through mutual funds. More on this in a later post.

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The Gone Fishin’ Portfolio:

Get Wise, Get Wealthy…and Get on With Your Life

On the road to $1M rating:

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[Data and figures last updated on July 26th, 2009]

In The Gone Fishin’ Portfolio, Alexander Green sets himself to introduce “an effective yet simple approach to investing [that will] generate exceptional results during both good times and bad”.

If you’re as skeptical about me about any how-to-beat-the-stock-market promise, you’ll be wondering whether this is possible at all. The answer depends, of course, on what is meant by exceptional results. In the book, these are defined as returns that will outperform those of the S&P 500 every year. And to make it even more tempting, the author promises his strategy is so easy to follow that you will need less than 20 minutes a year to implement it.

With this definition in mind, does Alexander Green deliver on his promise? I decided to check by myself and found out that, from 2001 up to today, the answer is a resounding yes. Below I explain in detail the methodology I followed to reach this conclusion.

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I have used publicly available information from Yahoo! Finance to compile the series of historical prices for all the mutual funds in the Gone Fishin’ strategy and the S&P 500.

Assuming that all dividends from the funds are reinvested, I have computed the yearly returns for the Gone Fishin’ strategy and those of the S&P 500 from 2001 to 2009 -some of the funds in the strategy didn’t exist before this date. For all years from 2001 up to 2008, the yearly returns are measured from the first day in the year the market is open (usually January 2nd) to the first day in the following year that the market is open (usually January 2nd). For 2009, the returns are measured from January 2nd up to July 24th.

I have used two different measures to compute the returns, which differ slightly in the way they account for dividends. The first is a “naive” one, which I call basic. The results of the basic comparison are shown in the graph above. The second measure is based on the computation of the internal rate of return (IRR), and it’s displayed in the graph below.

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It is clear from the graphs that every single year since 2001 the Gone Fishin’ strategy has outperformed the S&P 500. In the year 2008, the returns of the strategy were below -30%. However, it still delivered better returns than the S&P 500, which is what Alexander Green promises in this book. And so far in 2009 the Gone Fishin’ strategy is outperforming the S&P 500 by 10.00 or 9.61 percentage points, depending on whether the basic or the IRR-based measure of returns is used.

The results are even more striking in view of two facts:

  • Implementing the Gone Fishin’ Portfolio strategy is easy and relatively cheap, because it consists of a mixture of index funds with a combined annual expense ratio of 0.23%.

  • By investing in many different sectors, from large and small caps in the US to developing markets, from inflation protected to high-yield corporate bonds, etc., you’re exposed to usually negatively correlated returns, and hence are using diversification to reduce your overall risk.

It is worth to remind ourselves at this stage that past performance does not guarantee future results, so there’s no way to check whether the Gone Fishin’ strategy will continue to work in the future. But given its track record in the past 8 years, together with the added risk diversification, I’m currently implementing it with the savings in my 401(k). Given that it’s my future pension that is at stake here, I intend to keep checking the strategy’s record regularly, so make sure to come back for updates of this post.

If you enjoyed The Gone Fishin’ Portfolio, On The Road to $1M recommends:

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Not All Target-Date Funds Are Created Equal

I want to dedicate this post to an article I read this Wednesday on CNNMoney.com. The story is so serious that I’m surprised it hasn’t had more coverage in the press. According to the article by Mina Kimes –“Target Funds Miss the Mark”-, target-date retirement funds have sustained significant losses in the last year due to their heavy exposure to stocks.
Why is this significant in a time of market meltdown? The answer is that these funds were not supposed to be so heavily invested in stocks in the first place. Target-date retirement funds are aimed at individuals saving for retirement. Their main characteristic is that they offer to adjust their investment mix as your retirement date nears, so that you’re less and less exposed to market fluctuations the closer you get to retirement age.

For instance, a person who is planning to retire 30 years from now would invest in a target fund called something like “Target Retirement 2040”. The fund would be investing mostly in stocks today, but then gradually switch the investment mix towards less risky assets, like bonds and cash.

On the other hand, a person intending to retire in the next couple of years would have chosen a fund called “Target Retirement 2010”, and should expect it to be mostly invested in bonds and cash by now. In this way, the money earmarked to finance retirement would be shielded from the disastrous consequences of a sudden market decline taking place when retirement is looming.

So much for the theory. According to Mina Kimes, the reality is that many target-date funds were overinvested in stocks at the beginning of 2008. The advent of the stock market crash caught the 60-year-old investors to whom these funds were marketed with an investment mix that would only have been fit for 30-year olds -who have plenty of working years in front of them to recover from these losses.

The article singles out two target-date funds that held a very risky asset mix given their target dates:

Fidelity Freedom 2010 Fund (FFFCX) is designed, according to the Fidelity website, “for investors expecting to retire around the year 2010”. The fund was 50% invested in stocks in March 2008, and more than 45% in December of the same year.

AllianceBernstein’s 2010 portfolio (LTDAX), was 57% invested in stocks in February 2008. According to its website the fund “gradually adjusts the strategy to a more conservative investment mix [so that as you move into retirement] your strategy becomes more focused on protecting principal and generating income”.

It’s no surprise, given these risky asset allocations, that the two funds lost 25% and 33% last year, respectively, even though their investors would have been planning to retire in less than a year from now.

It is worthwhile mentioning at this point that an investor will not typically need all the money in a retirement fund the year they retire, but will instead gradually draw down their assets during a period of 20 to 30 years –so that investors in these target-date funds will have time to recover part of their losses even after retirement.

It is also important to note that other target-date funds have been following much more sensible investment strategies given their investors’ ages. Both Wells Fargo’s Advantage Dow Jones Target 2010 (STNRX) and Deutsche Banks’ DWS Target 2010 (KRFAX) had the majority of their holdings in bonds at the beginning of 2008, and had significantly smaller losses of 11% and 4%, respectively, last year.

However, I can’t imagine how terrible it must feel to discover that, after doing your due-diligence and choosing a fund that promised to protect your retirement income, a large chunk of it has been lost in the stock market crash. I wouldn’t be surprised if, as a consequence, some of these investors had had to delay their planned retirement date.

I hope this article serves as a warning of the risks of leaving your investments in auto-pilot. Unless you’re only investing in index funds, it’s worth checking the speedometer from time to time.

See also Philip Moeller’s blog entry and this article from SmartMoney.com for more on this topic.

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The Gone Fishin’ Portfolio:

Get Wise, Get Wealthy…and Get on With Your Life

On the road to $1M rating:

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An investment strategy the promises to beat the S&P 500 year after year? Hmmm. I always run a mile when I hear similar claims. If not even most of the best fund managers are able to consistently outperform any price index, could this book teach any amateur investor how to do it?

Still, the strategy in this book seemed to be backed by reasonable arguments, and I thought that even if it didn’t manage to outperform the S&P 500 every single year, it may be at least work as a means to diversifying risk, so I continued reading.

The first part of the book is a 101 investment course for those who want to manage their own money without putting too much effort into the process. The author introduces us to mutual funds, the method of entry into the stock market that doesn’t require you to read a single annual report or even follow the Wall Street Journal. By pooling the money of thousands of investors, mutual funds allow you to buy into hundreds of stocks at once, giving you the following benefits:

  • a share of a mutual fund buys you a piece of each company owned by the fund. If you wanted to buy shares of each one of the companies separately, the result would likely be prohibitively expensive.
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  • the fund makes all investment decision so that you don’t have to keep track of every single stock.
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  • funds are a great way of diversifying risk by owning a piece of many different businesses at the same time.
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  • there are mutual funds that invest in all types of securities, including stocks, bonds, Treasuries, etc. There are even funds that mix different types of securities (e.g. stocks, bonds, and cash) among their holdings.

There are two main types of mutual funds: actively managed ones and index funds.

  • Actively managed funds are administered by a manager who actively tries to outperform a particular index. The manager will trade the securities owned by the fund on a regular basis, trying to select the best-performing ones in the hope of beating the market.
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  • Index funds aim to replicate the movement of a particular index, usually by holding the same securities and in the same proportion of said index. This job can easily be done by a computer, so index funds generally have lower associated fees than actively managed ones.

The Gone Fishin’ Portfolio strategy consists on buying a certain mix on index funds, which the author strongly recommends over actively-managed ones. I, for one, completely agree with his view. There’s plenty of evidence out there that most managed funds fail to outperform their benchmark index in the long-run (for more on this, check out this article from the New York Times).

There are, of course, some actively-managed funds that will be able to beat the benchmark for several years in a row, but you have no guarantee that the particular fund you choose will be one of those. Moreover, picking up the “good” managed funds will require all the research and time investment that you wanted to avoid in the first place by investing in mutual funds.

After this very useful introduction to investment through mutual funds, the author dives into The Gone Fishin’ strategy. And the question is, of course, does it work? More on this here.