Why don't you invest in passive index funds?

***I first drafted this as a supplement to this post at this blog. Then today an interesting article was posted on Bloomberg.com about a research note published by Sanford C. Bernstein & Co. that is also related to differences in active and passive management (it comes from a unique perspective to be sure).***

There are many who advise individual investors exclusively buy "passive" funds like SPY, which describes itself this way:

There seems to be countless studies that prove that professional fund managers, after fees are deducted, are unable to predictably outperform this type of passive investment strategy. I agree that someone who wants nothing to do with evaluating investment options should seriously consider investing in such passive funds.

But I obviously believe that individual investors, with the right approach, can do better than both the pros and the benchmark. Why? Because we individual investors have only our own emotions to manage, which is sometimes quite difficult but always very doable. The pros have to account for the short term expectations of their fund investors. To do better than the benchmark, one has to invest differently from the benchmark. If the pros invest differently and do not guess (all short term investing decisions are essentially guesses) correctly, they will lose the funds invested. So no matter how sophisticated the pros are, they are doomed to mostly mirror the benchmark. Subtract fees and you predictably get a lower-than-benchmark return.

Individual investors can invest differently than the "market weighted" index because we can train ourselves to expect short term differences in performance versus the benchmark, and to not abandon the plan when these inevitable differences materialize.

But to "beat the benchmark" actually is not why I research, buy, and monitor individual stocks. I want to beat the benchmark. But more than that, I want to do all I can to ensure that the shares I own are of businesses with long term profit producing power that can fund distributions to shareholders like me for a long time. If I've done that, when prices plunge, I think I'll be better prepared to avoid panic selling than if my investing philosophy was solely based on passiveness and blind trust.

Continuing to invest and staying invested are the keys to achieving long term financial goals and are more important than how to invest, I think. Which reminds of a great passage from a recent post on a good blog:

KP Investment Club Meeting No. 2

Click here for an overview of what I covered in the second investment club meeting 

Don't "invest" in whole or universal life insurance

You probably will field your share of life insurance sales pitches during the next few decades. This article describes some unfortunate stories of policy holders whose financial plans were upended when the current unprecedented interest rate landscape squeezed the companies who sold them their "whole life" and "universal life" policies. The companies of course responded by squeezing their policy holders. The result in one case was a woman who, after paying more than $50,000 in premiums over several decades, faced steep hikes in future premiums. She "cashed out" rather than pay the higher premiums. Her take after forfeiting the death benefit was the remaining $4,000 in "cash value" left in the policy.

And this wasn't even the most startling story from the article. These paragraphs claim that prize:

Life insurance should be a simple product. It insures against loss of income from the loss of the life of a key bread winner. In essentially every situation I've encountered, "term" insurance is the product that fits this need.

But it is much more likely that the sales pitches you'll receive will position whole or universal life insurance as a long term investment vehicle. I think the only people who will argue that such policies are the best way to invest are insurance company representatives. I've never heard an investor, or an independent advisor to investors, suggest this as the way to best invest for the future.

Stocks vs. Other Investments

The following is a summary of a section of the book called Stocks for the Long Run by Jeremy J. Siegel. For the KP Investment Club members in NY, I have multiple copies of this book that can be checked out. 

In the book Stocks for the Long Run, the author Jeremy Siegel tells a story about John J. Raskob, who was a senior financial executive at General Motors. In the summer of 1929, a journalist named Samuel Crowther interviewed Raskob about how the typical individual could build wealth by investing in stocks.  In the interview, Raskob claimed that American was on the verge of a tremendous industrial expansion. He stated that by putting just $15 per month into solid common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years. He predicted an average return of 24%, which was unprecedented. At the time, these returns seemed plausible in the atmosphere of the 1920s bull market. Millions of people were putting their life savings in the market seeking a quick profit.

On September 3, 1929, just days after Raskob’s interview was published, the Dow Jones Industrial Average reached historic highs. A mere seven weeks later, the stock market crashed representing the most devastating decline in U.S. History. The market value of the world’s greatest corporations declined 89%. Savings were eliminated. Many people borrowed money to invest and were forced into bankruptcy.

Raskob’s advice was ridiculed and denounced for years to come. Senator Arthur Robinson of Indiana publicly blamed Raskob for the stock market crash. However, was this blame fair? Was Raskob wrong? Can everyone be wealthy by investing in stocks early and often? Or should people pursue ‘safer’ alternative investments?

Investing over time in stocks is a winning strategy whether an investor starts at a market top or not. If you calculate the value of the portfolio of an investor who followed Raskob’s advice in 1929, patiently putting in $15 a month into the market, you find that his accumulation exceeds that of someone who placed the same money in Treasury bills after less than four years. By 1949, his stock portfolio would have accumulated almost $9000, a return of 7.86 percent, more than double the annual return in bonds. After 30 years the portfolio would have grown to over $60,000 with an annual return rising to 12.72 percent. Although these returns were not as high as Raskob had projected, the total return of the stock portfolio over 30 years was more than eight times the accumulation in bonds and more than nine times that in Treasury bills. The real losers were the people who sold or never bought stock in the first place, citing the 'great crash' as the vindication of their caution.

Consider the table below. Siegel traces year by year how real (after-inflation) wealth has accumulated for a hypothetical investor who put one dollar in stocks, long-term government bonds, U.S. Treasury bills, gold, and U.S. currency over the last 210 years.

  

The table below depicts the total nominal (not inflation adjusted) return for indexes of stocks, long and short-term bonds, gold, and commodities over the last 210 years.

Summing Up:

In the short run, stock prices fluctuate and sometimes widely. However, as seen in the graph, over the long haul, stocks outperform bonds and other investments by multiples. The short-term swings in the market become insignificant when compared to the overall upward movement of prices throughout history.
 
Market timing isn't for me. My plan is to continue saving early and often, buy solid blue chip companies that pay dividends, ride the ups and downs, and allow time and compound interest to work wonders.    

How I invest, part 2: First the asset type, then the industry, then the company

If you missed it:
How I invest, part 1: Find the sweet spots

Investing is essentially deciding which alternatives to choose.

The highest level decision is how much to allocate to stocks, versus bonds and cash. 

The more you allocate to a diversified portfolio of stocks, the higher the long term return, assuming no panic selling or market timing:

Source: Stocks for the Long Run, by Jeremy Siegel

This type of long term return profile can be surprisingly hard to appreciate. We all understand the math. But at the same time we hear the standard advice to allocate a healthy portion of our portfolio away from stocks. A specific risk profile may argue for the need to include bonds. But in our first use of a "valuation tool," we'll learn how we can compare the expected return from stocks to that of bonds in a different way than is shown above. So when considering whether to accept lower returns in exchange for lower volatility, we can determine the relative value difference between investing in stocks or bonds.

Using "earnings yield" to compare the expected returns from stocks to that from bonds.

The forward PE ratio of the S&P 500, according to this nifty packet of information, was recently 17. We can invert that to get an "earnings yield" of 5.9%. Compare that to the 1.5% return available on 10 year treasury bonds to find that the current expected returns favor investments in stocks (over bonds) even more so than during the average returns experienced in the 200 years tracked in the image above.

Further evidence that the attractiveness of stocks, in comparison to bonds, is even more pronounced now than usual, can be seen in this chart, which plots the earnings and 10 year bond yields during the last 15 years or so.

Source

As is so often the case, the math makes it very questionable for a young investor to decide to invest in bonds in a portfolio that is designed to not be "touched" for many decades. Despite the commonly held belief that a "no bonds" portfolio is not recommended, I think that a well informed investor who is prepared to resist selling after the inevitable massive downward swings in stock prices can responsibly own no bonds. But I'm splitting hairs because even Vanguard, the market leader in responsibly providing financial services, suggests, by way of this 2057 target date fund, that a 25 year old hold 90% stocks in his portfolio.

Next consider the sectors and industries and their relative valuations

I focus on S&P 500 companies because I'm most confident it's there I'll find great information about high quality companies that will make great long term investments. The S&P 500 is a standard benchmark for judging long term performance because it includes 500 of the biggest US based companies, and there are many ultra low cost ways investors can "own" the index itself. It is very simple and straightforward to use that index as a benchmark for my long term performance.

The index consists of 10 "sectors," which as you see below range from ~5% to nearly ~25% of the entire index. The sectors and their relative weightings will not help decide which specific companies are good enough businesses selling at appropriate prices to make sound investments. But knowing the historical values of these large sectors, and understanding how to judge recent changes in value, can act as guideposts to make sure I don't make obvious mistakes.

For example, the "search for yield," a phrase financial commentators are using to describe the move by investors towards buying high dividend yielding stocks, has caused the index's two smallest components, Telecommunications and Utilities, to have the highest returns in the group during the last twelve months. (You'll notice it's always easiest for the smaller sectors or companies to have the highest percentage growth rates because of their smaller beginning bases.)

Telecom and Utilities have outperformed in the past year - Source

But during the past decade, these two sectors have performed the worst (in terms of return) in the group. That's of course the reason these are the smallest two sectors in the group.

Source

More research is needed for me to say this with certainty, but I would suspect that these two sectors, and on balance the companies within them, are currently traded at a much higher relative (to the other eight sectors) valuation than usual. *So if I were considering buying T or VZ, the only companies in these sectors that are currently in the universe of stocks I track, these "guideposts" would hopefully help me avoid the mistake of buying too high, or allocating too big a portion to these stocks.

*I don't own these stocks now. But I have and I may again.

Coming soon: 

How I invest, part 3: FB vs AAPL

Why both may be "good investments," but only one is in my strike zone

***Disclosure: I am not an investment professional and I don't write posts like these to suggest that readers buy specific stocks or do anything in particular with their specific financial plans. I don't know the specific details of readers' situations and needs, so they should take responsibility for their own financial decisions. I do currently own many of the stocks mentioned in this post.***

How I invest, part 1: Find the sweet spots

***Note: I have been writing parts 2 and 3 of this series, which will show the specific, step-by-step processes I use to invest. But the video Matt shared at the Facebook page Friday with the various interviews of Warren Buffett led me to make this post to go right at the front of what is now a three part series about "how I invest."***

How I invest, part 1: Find your sweet spots

In a way, investing to me is finding great companies that I understand very well. I make better decisions about a company the more I know about it. In the image to the right, from Ted Williams's The Science of Hitting, I imagine the companies and sectors I have invested the most time learning about (my sweet spots) are what Ted Williams called his "happy spot" in the strike zone.

I might not hit the investing equivalent of .400, like Mr. Williams did in 1941, investing in the sectors I am most comfortable with, but those are my best shots. And Warren Buffett explained in the video Matt shared recently that our advantage in investing, that Williams never had hitting, is that for us there are "no called strikes."




We don't HAVE to be Ted Williams. We don't have to chase suboptimal pitches when the count is against us by investing in things we don't understand. So we can approach investing decisions, which are ultimately uncertain but hopefully highly educated guesses at which businesses and leaders are most likely to win in the long term, with enthusiasm and an intellectual curiosity that is every bit as stimulating and productive as any hobby. This tweet may say it better:

Start with curiosity about the world.
Use basic math.
Save more than you spend.
Have fun finding stocks & own them.
Diversify broadly.
Smile

— The Motley Fool (@themotleyfool) August 6, 2016

We don't have to be world class stock pickers with knowledge of every detail of every industry. We do have to stop ourselves from making harmful decisions like selling during a panic or not saving enough. But by simply saving early, often, and substantially, and staying in the market, you will have pretty much won the battle, as long as you don't get too far out of your strike zone in making decisions about things you don't really understand.

Source: "The Most Powerful Force in the Universe" at tonyisola.com

So as you start analyzing the "intrinsic value" of companies, remember that you have already won most of the battle. And that because you are only going to swing at good pitches, you will get hits far more often than you strike out.

Coming soon: 

How I invest, part 2: First the asset type, then the industry, then the company

Coming later:

How I invest, part 3: FB vs AAPL

Why both may be "good investments," but only one is in my strike zone

Learning the rule of 72 may be a predictor of wealth and happiness

Matt recently shared the "rule of 72." Investing math can be fun because of the large numbers and the multiples of savings consistent investing brings. This post (http://tonyisola.com/2016/08/the-most-powerful-force-in-the-universe/) says that knowledge of compound interest can be a predictor of financial success:

So let's make sure we learn about compound interest, which Matt also told us Einstein called the eighth wonder of the world. 

Actually you already may be a wiz after being exposed to the rule of 72. Here is a question I bet you will answer correctly (and if you don't you'll probably immediately learn it and never forget it), one that supposedly differentiates between those with some genuinely useful knowledge that is a reliable predictor of success:

B is correct:

7 * x = 72

x = ~10 years

Again, the rule of 72 says your investments double every time the product (answer) is 72 when multiplying the years invested by the return on that investment.

Learning that much is simple enough. But the fascinating thing about this post is that simply possessing that knowledge evidently means so much:

And...

And finally...

OK, I'll stop now because the post itself is so much more interesting. He stresses the ways that people win and lose with compound interest, including timely examples like credit card and student aid debt. And he appeals to people of all ages with a positive, no-nonsense message.

Check it out here: http://tonyisola.com/2016/08/the-most-powerful-force-in-the-universe/

Slides from the KP Investment Club's first meeting

Here is a general overview of what I covered in the first Investment Club meeting at KP. thanks - Matt

Comparing dividend paying tech stocks to non payers

Sunday afternoon Matt told me that when it comes to tech stocks, he prefers companies that pay dividends. I agree because a higher than average dividend yield can be an indicator that a stock has value. Dividend payments, if they are stable and growing, can only come from a healthy business that produces reliable profits.

Examples of tech companies that have consistently made and increased payments include Microsoft, Intel, IBM, Cisco, and Apple. Alternatively, Facebook, Google, Amazon, and Netflix are examples of companies in that space that don't pay dividends because they are growing so fast that they use all their cash to reinvest in more growth opportunities.

Generally speaking, all of the companies listed above generate tons of "free cash flow" because of their sky high profit margins and ability to run their businesses without constantly investing in additional plant and equipment and physical inventory. The major difference between the dividend paying and non dividend paying groups is their maturity. A decade or more ago, the first group was growing like the second, and therefore using all of their FCF to reinvest in their opportunities, and none of it for dividend payments. Because these companies have captured such huge market shares in spaces that after long periods of growth have now slowed down, they now are sending payments to their investors. The latter group consists of younger companies that are solving newer problems and growing faster. One day, if they survive, they will be dividend payers too.

Another general distinction between the two groups of companies is the price-to-earnings ratios of the companies' stocks:

Just like a higher than average dividend yield can be evidence that a company's stock is not over priced, a reasonable P/E ratio, when compared to other investment opportunities, can provide an investor with some confidence that a "margin of safety" exists in these stocks.

Hours after our conversation Sunday, this feature about tech stocks that pay dividends was posted at WSJ.com. The article explores whether dividend paying tech stocks like those mentioned above have been over priced in what recently has been called a "search for yield" among investors turned off by historically low yields in the investment grade bond market. The article makes a key point that although the yields are attractive, there is always the risk that over short periods of time, the price fluctuations in the stocks may not be suited for investors with an immediate need to sell. But this consideration holds for not just dividend paying tech stocks, but all investments that aren't very short term, high quality bonds. Another solid point is that certain companies may not be able to sustain high dividend yields because their long term profits won't support them. Again, this is an always present concern for all investments (the "we can't predict the future" problem) that can only be addressed by doing research to reduce the risk of making too many errors, and, more importantly, buying many companies in the space to guard against putting too many eggs in the basket of those that do eventually fail.

But the most notable part of the article, which provides a clue to the missing piece in my comparisons above and helps answer the more important question of whether these dividend paying tech stocks are reasonably priced in the larger investment market (not only compared to the fastest growing tech stocks), and in relationship to how, historically, they have been priced in relation to that broader market, is this set of lines:

Along with some other homework, applying these same comparisons to the other dividend paying tech stocks can add confidence to our (Matt and my) beliefs that despite their strong recent performance, these are still reasonably priced investment opportunities.

Disclosure: I am not an investment professional and I don't write posts like these to suggest that readers buy specific stocks or do anything in particular with their specific financial plans. I don't know the specific details of readers' situations and needs, so they should take responsibility for their own financial decisions. I do currently own many of the stocks mentioned in this post.

***Special note: If you ever click on a link to a Wall Street Journal article and are denied access because you are not a paying subscriber, you can type the title of the article into Google and get a link to that article that is not protected behind a pay wall.***