Bubble Behavior?

This is a confession. About a week ago I caught myself starting to get caught up in the hysteria currently surrounding precious metals. As I was browsing the online store of a bullion company, looking at silver coins, it dawned on me; am I participating in bubble madness?!

Back when gold was under $1,000 and silver was wallowing in the $13-14 range, I was content with the small amount of precious metals I owned through the Central Fund of Canada (ticker symbol CEF- split evenly among gold and silver bullion) and a few assorted coins. It was enough to diversify out of equities and the dollar somewhat, but not to the extreme where I expected society to collapse at any moment. Just last week though, with gold and silver hovering near $1,200 and $20 respectively, I suddenly felt the urge to consider adding more. Then, as I thought back to the principles of Graham, I realized how illogical my thinking was.

I like to poke fun of market bubbles and the people who perpetuate them, many of whom end up buying high and selling low. Last week served as a good reminder of how incredibly easy it is to fall in this trap though.

“It’s different this time…”

So goes the dangerous reasoning that ensures that bubbles happen repeatedly. And who knows, maybe it is different this time. Maybe gold is headed for $2,000+ in a matter of months, $5,000 by the end of next year, and hindsight will tell me I’m mistaken for not buying now. That doesn’t change this fundamental fact though- those who become more attracted to investments as the prices rises are doomed to eventually lose big. That’s like rushing to the store to load up on cereal because the price was jacked up. Ridiculous, right? Investments get riskier as their price rises and less so when the price falls, but we often act in the exact opposite of this truth.

The problem is that the “it’s different this time” argument sounds more and more appealing as the bubble continues to inflate. We fear that we’re missing the boat. The market gets more press time, further making us want a piece of the action. It starts to seem fail-proof. The fundamentals between $1,200 gold and $1,000 gold a few months ago weren’t that much different; a weakening dollar, an ever-growing federal deficit, financial industry worries, central bank gold-buying, etc. But more people want gold now than they did several months ago mostly because it has been thrust into the spotlight, even though it’s riskier now than it was earlier. If it’s not already in a bubble, my prediction is that this self-perpetuating cycle will continue until it does pop somewhere down the line.

I heard a commercial for some gold company claim- “with gold is setting record highs, there has never been a better buying opportunity”. I wonder how many gold coins they’ve sold with this completely backwards reasoning?

If you were bearish tech stocks in ‘99 or housing market in ‘04, you might have been considered loony at the time. Fast forward to today, and now you seem like a genius. Could the same thing happen with metals?

Thankfully I came to my senses before I bought anything. In fact, I decided to take a small profit on some (but not all) of my CEF holdings- about 17% in roughly 16 months. If it turns out we are in a bubble, I’ll get to reenter at a much better price. If metals continue their incredible run, hopefully I can avoid doubting my decision to sell and safely ignore the growing frenzy.

Why TD-Ameritrade Rocks

When I began investing a few years ago, I settled on TD-Ameritrade as my broker of choice. They’re the only broker I’ve ever used, but it’s hard to imagine one that I’d be happier with. I would (and I do) recommend them to investors of all experience levels. There are a couple key reasons why:

1.) Their commissions are straightforward:

Their fee-structure is pretty easy to grasp: $9.99 per trade, no strings attached. Other brokers (ahem, E*Trade) advertise a lower cost, but only if you make a certain number of transactions per time-period (think day-trader); most of us would be charged a higher rate ($12-15) that not-surprisingly isn’t advertised in commercials.

2.) No maintenance or inactivity fees:

Some brokers not only charge you when you trade, but charge as well when you do nothing in the form of inactivity fees (I believe E*Trade is guilty again) . Apart from the fact that it royally sucks to be charged to do nothing, it promotes the active-trading behavior that is likely to get many inexperienced investors in trouble.

3.) Excellent customer service:

The first time I called their customer service center, I was pleasantly surprised to hear a fellow American on the other end of the line. When you simply want an issue addressed as quickly as possible, it’s always helpful to talk to someone who is fluent in English. I’ve called them with a range of questions regarding my account, and have always been satisfied by the timely and effective responses on their end.

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I am in no way connected to TD-Ameritrade relationship that would compromise an objective review (though if you are considering signing up I’d be happy to provide a referral code ). I’m just a satisfied customer who figured I should spread the word on a quality service. Others may have catchier commercials, but I don’t think TD-Ameritrade’s substance for the money can be topped. There’s plenty to keep in mind when it comes to investing- you know you’ve found a good broker when it isn’t among these concerns.

Cocktail Party Index Investing

So let’s say you’re a humble index investor. You dollar-cost average into your funds, then spend your afternoon shooting a 97 on the links while questioning why you ever took up the stupid sport in the first place. You don’t think about your portfolio all that much, because heck, barring a complete economic meltdown, your wealth will grow steadily over time. For the most part, life is good.

But then there’s that one jerk. Maybe it’s your coworker, neighbor, or brother-in-law. Whoever he is, listening to him is downright unbearable.  Watching Jim Cramer for 6 hours straight would be a relief after hearing his nonstop commentary on the markets and updates on his high-flying holdings.

You know that, in all likelihood, this blowhard isn’t half as successful as he claims, and your portfolio will easily achieve higher returns over time, but it still drives you nuts. But since Lloyd Christmas is competent enough to follow your investment strategy, you can’t exactly offer up much of a rebuttal.  Or can you?

Introducing-  The Cocktail Party Guide to Index Investing:

No more modest passive investing…

Here’s what you do:

1.)  If you haven’t already, invest in the Vanguard Total U.S. Stock Market Index Fund (VTSMX), or the ETF (VTI). You now own almost every publicly traded company in the US, but keep this fact on the down-low.

To seem more legitimate, make sure it looks like you are spending quality time online researching your next killer investment.

2.) When you’re “researching potential investments”, find the hottest performing U.S. stocks over the past few months or so.  A quick Google search for ‘hottest’ or ‘best-performing stocks’ should do the trick.

3.) Brag about the performance of these high-performing stocks.  It’s technically not lying- you did make 165% over the last month on your internet small-cap!  Never mind the fact that you own it indirectly, and in a miniscule amount; your 1/37th of one share accounts for something like .00013% of your entire portfolio.

4.) Dodge the tough questions.  Inevitably, your “success” will draw plenty of attention, so you need to be prepared to deflect any and all questions that threaten to expose you for the poser you are.

Since you only mention your best-performing investments, people will ask about any bad calls you’ve made.  Do anything possible to interrupt the conversation at this point.  Only you need to know that your shares of Lehman Brothers, GM, and Fannie Mae went up in smoke!

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And that’s pretty much it.  Your index investing strategy, as bulletproof as it is, is only slightly less boring than driving a minivan.  But now at least you can talk a good game!  :)

The Problem With Index Funds: The Lloyd Christmas Effect

I could sing the praises of index funds and ETFs (especially Vanguard’s) all day long.  It’s hard to beat instant diversification and the dirt-cheap fees that characterize passive management.

But the incredibly simple nature of index investing also happens to be its greatest weakness.

There’s no challenge in searching through potential stocks, trying to pick a winner. The adrenaline rush that you get when you plop down your hard-earned cash on shares of XYZ Widget Company is missing.  The riskier route that is individual stock-picking appeases our ego a lot more than owning a tiny fraction of thousands of different companies.

We can all imagine the guys who stand around at a cocktail party or at the water cooler bragging about their supposedly highflying investments, exaggeration all but guaranteed. Then there others who may not discuss their financial activities much, but sit around at night playing with the technical indicators in their new E-Trade account, wondering what the day-trading baby’s secrets are.

Index investors, on the other hand, could care less about flaunting or attempting to demonstrate financial prowess. Heck, it takes up so little time that they can largely forget about it. While others are talking about making riches in the stock market (I doubt many actually are), or plotting their fail-proof route to investing success, index investors are actually doing it- slowly but surely, without even giving it nearly as much thought.

Over the long haul, index investors are many times more likely to have succeeded in creating wealth than their active-trading buddies, but it’s hard to impress others (or yourself) with a K.I.S.S strategy.  When’s the last time you heard somebody bragging about matching the market?  Probably never.  You might as well brag about being able to read this page.

And this is a problem.

When matching the market is easy as pie, many people will conclude that such a strategy is below them.  I’m guessing this mindset is much more prevalent among people who are well-educated and intelligent, and it gets many of them in trouble.

You surely remember Lloyd Christmas (Jim Carey), the insanely awesome but extremely dim-witted protagonist in Dumb and Dumber. The fact is, Lloyd could probably invest for success if he acknowledged his blatant lack of mental capacity and invested in an index fund or two.  Yes, I’m confident that a man who fell of a jet-way could save up some money, contact a fund company, and become an index investor.

The Lloyd Christmas Effect, as I’ll call it, is the challenge to our ego upon realizing that someone with a ridiculously low IQ could succeed as an index investor. Of course, I’m guessing few people actually make a connection between Dumb and Dumber and investing, but I’m probably far from being the only person to realize how incredibly simple and even thoughtless passive investing can be.

Given that we laugh at the stupidity of Lloyd Christmas, while generally thinking of ourselves as smart individuals, it can be difficult to accept such a simple method as a weapon of choice. Our intelligence is hardly tested, so it seems reasonable to believe that we could do better. And we probably could; I’m not trying to discredit active investing, but instead point out one of the biggest and most common flaws of those who partake in it- overconfidence. It’s not that we aren’t capable of beating the market- it’s that we tremendously underestimate how much consistent effort is required to do so.

If we can accept two facts….

1.) That passive investing is the clear choice for most people.
2.) That even Lloyd Christmas, or the Cavemen from the Geicko commercials, could do it.

…then we’re set.  Humility would do many an investor a lot of good.

There is one thing all index investors can brag about though: beating nearly every mutual fund over time.

Note: Despite the name of this post, this issue isn’t the only problem of index investing. A little while back, I wrote about basically the exact opposite issue.

Why Hasn’t Index Investing Exploded in Popularity?

ETFs have been around for quite some time now, and index funds for even longer. It is now possible for even the smallest investors to own a thoroughly diversified portfolio that tracks the market indices. So why hasn’t the mainstream public swarmed to these investment vehicles?

Sure index investing keeps growing in popularity, but much of this growth is probably accounted for by institutional buyers like life insurance and pension companies. There aren’t many individual investors out there deliberately seeking out these funds and investing their money. Millions even have access to these funds through their employer-sponsored plans, but still don’t make use of them. It’s ridiculously easy to set up a dummy-proof investment strategy all but certain to deliver long-term growth, so it’s unfortunate that so many neglect to do so.

I don’t believe the financial sector in general wants people to realize how simple investing can be, for an obvious reason; their profits largely depend upon making people believe that investing has to be difficult. Several examples:

1.) Financial advisors need people to feel ill-equipped to manage their own investments. The less confident their clients are about their own abilities, the better chance a financial advisor has to profit off of them.

2.) CNBC and all other investing networks and programs need investors to overcomplicate things. Passive index investors don’t waste time watching the garbage on CNBC, waiting to hear about their investments. They’re out doing something more enjoyable.

3.) Online brokerage firms’ profits depend upon getting people to sign up for accounts and squander half their investment capital on transaction costs They love to perpetuate the message that you can only win by ‘taking control of your investments’ by becoming an active trader (I’m thinking about those E-Trade commercials with the day-trading baby).

Td Ameritrade probably hates buy-and-hold customers like myself who only have a handful of transactions a year (I used to do otherwise, but I’m beginning to wise up now). They honestly don’t care too much if their customers succeed; what they want is to rack up as many $10 commissions as they can.

4.) Mutual fund companies need us to believe that their so-called professional management is the ticket to investing success. They love to hype the extraordinary market vision they have as financial gurus. What they don’t tell you is this; almost no mutual funds manage to beat the market consistently for a considerable length of time, especially when expense ratios are figured in.

Don’t get me wrong- mutual funds were without a doubt one of the most incredible financial innovations of the 20th century. They can be a highly useful tool for long-term wealth creation. However, with very few exceptions, they have proved mathematically inferior to passively managed funds.

Scare tactics:

The extremely broad investing field thrives by making it all seem threatening and complicated. The industry spends billions upon billions of dollars each year propagating this message, so of course it’s going to make regular John and Jane investors feel overwhelmed and intimidated.

John and Jane could set up a incredibly easy plan that invests passively in the indices and basically runs on autopilot, saving them money, time, and stress. Instead, it’s more likely that they opt to turn their investment decisions over to a financial advisor who charges $75 commissions or buy a mutual fund with a 2.5% expense ratio (or heaven-forbid trying to become a day-trader in their free time). The sharks in the investment field claim yet another victim…

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Are Stocks Worth It?

With diligent research, rational and emotionless decision-making, and unwavering persistence, it’s possible to manage a portfolio that regularly ‘beats the market’, whatever market you may be referring too. Beating the market is the name of the game in the investing world. If you can do it on a consistent basis, you’re winning…right?

Not necessarily.

There are several important, but often overlooked, factors to ponder.

1.) Time-

If you aren’t actually passionate about deeply researching investments, then the use of that time must be justified by other reasons. I myself am not particularly fanatical about poring over financial statements and slogging through annual reports. Therefore, I’m not going to spend 5-10 hours a week doing just that unless I reap significant rewards because of it.

Let’s assume the benefit of foresight. Over the next 10 years, the S&P 500 will return an average of 8%. With my 5-10 hours of weekly research and active investing techniques, I average 10%. Was that worth it? For me, the answer is probably no; I’ve sacrificed far too much time for a result that isn’t all that much better than I could have gotten by simply buying the indexes. However, if I were to average 20%, easily trouncing the market return, the decision is a bit more interesting.

Time is the most precious, finite resource we have. It needs to be accounted for. Passive investing is attractive because you can match the market with a very, very small time investment.

If you outsource your investing to a financial advisor, you save time for yourself, but your advisor will make sure his or her time is adequately compensated for through substantial commission costs, far higher than what you will pay through a quality online discount broker.

2.) Stress-

A buy-and-hold index fund strategy is about as stress-free as investing can be. The global economy as a whole, as well as any sectors you may be playing with ETFs, are your sole concern (admittedly, worrying about the global economy can become stressful).

If you hold individual companies though, you clearly have an interest in the general health of the economy as well, but there are also many smaller variables at play; management decisions, lawsuits, recalls, patents, competitors, acquisitions, mergers…the list goes on and on. It’s a tedious (and pretty much impossible) process to stay informed of all the important developments related to your investments, and all these extra variables are a potential source of stress.

If Merck is a cornerstone in my portfolio, I’m naturally going to be alarmed when a newly released drug leads to a recall and widespread lawsuits. I might even lose some sleep when my shares plummet 10-15% in a single day. On the other hand, if I own every single publicly traded stock in the United States, these micro-variables aren’t worthy of my concern.

Needless to say, many investors thrive on the thrill that active investing can be. I’ll be the first to admit, putting money down on stocks is far more exciting than dollar-cost-averaging in index funds, and for many the higher risk is part of the fun. For others though, working to beat the market isn’t worth the added stress; they have no desire to burden themselves with unnecessary worries.

3.) Taxes- (for taxable brokerage accounts)

An actively managed portfolio will include more transactions than a passive one, as the investor takes profit on winners, cuts losses on losers, and rebalances from time to time. This means a more time-consuming and pricey experience come tax season. Uncle Sam gets to enjoy your success as well.

With a strict index buy-and-hold strategy, the only taxes you have to pay on a yearly basis are on any dividends received or the occasional capital gain distributions. If you do sell some shares at some point, it’ll probably be a long-term capital gain (> 1 year), meaning a much lower rate. In contrast, a heavily managed portfolio is bound to incur much higher short-term capital gain taxes.

Then there’s the time and money spent on actually having the taxes prepared, which isn’t insignificant either.

Unless your returns beat the market by a fairly sizable margin, the government’s cut can ensure that you do no better than the indexes. Never forget to leave taxes out of the equation; the IRS sure doesn’t.

Also keep commissions in mind. For both taxable and tax-advantaged accounts, those commissions will add up over time depending upon how much trading you do. Between taxes and commissions, a big chunk of profits from active investing can be quickly eaten up.

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All in all, I think there is more than enough reason to question the standard of investing, especially when so few people have a proven track-record of beating the market. This is a bit troublesome for someone who not all that long ago could see myself working one on one with clients in a fairly typical financial advisor position. How many financial advisors do you expect are out there advocating strictly passive investing? Probably none that are still in business- it’s hard to earn much in the way of commissions doing that!

Personally, I don’t have any desire to pore over financial statements and annual reports for hours on end, looking for often deeply hidden clues that could indicate the difference between a successful and a poor investment. There’s a reason why I quickly dumped accounting after briefly considering it as a second major; I find it boring. I love studying fundamental economic variables, but I lose interest quickly in a sea of data.

At this point, unless I knew I had a high probability of significantly trouncing the market on a consistent basis, I’m not going to consider active investing to be worth my time. I’m not suggesting that everyone automatically do the same. What I am recommending is a thorough consideration of this issue.