October 2008 Market Destruction

The title of this post demonstrates the emotion that can be generated by market moves. I am 56 years old and the recent market moves and current financial fragility is the scariest I've faced in my life time. Having said that, I've made the following adjustments to my portfolio during the October devastation:

• Beginning in July, I've steadily moved from bonds to stocks and continued doing so throughout the October down turn. By the end of October my portfolio was fully 75% invested in stocks, still below my 80% target, but well above the ~60% at the end of 2007.
• I have eliminated Large Cap Value and Small Cap styles, replacing them instead with Small Cap Value to represent both groups. I have also increased REIT's theoretical share to 16%.

While satisfied with the theory behind the above moves, from a percentage standpoint they are unlikely to have much impact upon overall portfolio performance. The moves during October represented less than 2.5% of the portfolio. The other thing that stands out is how scared I was - and continue to be - by the devastation suffered by my overall retirement portfolio. It is difficult to believe that this can be a "good thing" and that the portfolio can recover from a decline in value in excess of 30% in overall value. I suppose I've become resigned to the fact that there is no alternative and thus nothing that could have been done differently, then or now.

Current allocation:

Stocks: 74%
Total Stock Index (includes WF S&P500): 37%
Small Cap Value: 9%
REIT: 10%
International: 14% (Emerging: 5%)

Note: I sold Mutual Shares and Vanguard Index Extended, both held in my taxable account and use those funds to purchase:

Vanguard Tax Managed Capital Appreciation; and
Vanguard Tax Managed International

Unconventional Success

I just finished reading Unconventional Success by David F. Swensen, a fascinating, and ultimately, disturbing book. Swensen details the utter horrors visited upon the personal investor by Wall Street, the mutual fund industry, and the SEC. Any investor not using Vanguard index funds is doomed to have his/her wealth steadily transferred, by hook or by crook (literally) into the pockets of Wall Street. "Buyer beware" indeed.

The portion of the book I wish to memorialize here deals with portfolio construction and asset allocation. Swensen emphasizes that investors need to understand the "why" behind asset selection - to understand the investment attributes provided by a particular asset class. He identifies six core asset classes:

1. domestic equities
2. foreign developed market equities
3. foreign emerging market equities
4. real estate
5. US Treasury bonds
6. inflation-indexed bonds (TIPS)

The characteristics contributed by core asset classes include:

• substantial expected returns (equities)
• correlation with inflation (TIPS, real estate, and equities)
• protection against financial crisis (government bonds)

Swensen includes an entire chapter on non-core asset classes, explaining why each is not a good choice for inclusion in a portfolio. Of significant interest is the rejection of any kind of bond other than US Treasury bonds, with the sole possible exception of municipal money market funds. Non US Treasury bonds contain characteristics that make them a lose-lose situation for the investor - they have a zero upside with lots of down side.

Swensen does not include a discussion of asset styles such as growth/value or small cap/large cap in the chapters on core and non-core asset classes. The reader is left wondering whether such investments are worthy of inclusion in a portfolio. Swensen mentions styles only when discussing the importance that indexes be well designed - defined as an index that does not undergo undue changes in composition. He rejects style classes for the sole reason that the indexes themselves are poorly constructed (i.e. constructed in a manner that result in too much turnover and provide opportunities at time of index adjustment for market arbitrage - all at the investor's expense).

My Personal Model

First, a warning to my wife and children - DO NOT read this post and DO NOT attempt this at home. This post is for myself to help me realize - over time - how screwing around with investments does nothing but lose money. So, to my wife and children - stick with the post(s) that I have written for you - and ignore the posts that I have written to myself for they pose dangers to your financial health that you (and probably I) should not take.

While it may not be wise, I follow a more sophisticated allocation model. I probably do so out of impatience and an emotional need for "action" which is undoubtedly fool hearty. My model is grounded in two beliefs.

First, the stock market goes up and down and in theory you want to buy when the market is down and sell when the market is high. The traditional (and safest) way to do this is to set static percentage allocations and re-balance (buy/sell) stocks and bonds periodically (quarterly/annually) to re-establish the static percentages. This will automatically result in selling whichever asset is performing better relative to the other and buying the asset that is under performing.

My concept is to use adjustable re-balancing. In theory I want to actually increase my percentage allocated to stocks when stocks are under performing and to decrease my exposure to stocks when they are over performing. Thus, in a bear market with new 52 week lows being reached, I want to move more assets from bonds into stocks. Likewise, in a bull market with new 52 week highs being reached, I want to move more assets from stocks into bonds. Thus, if I want to generally hold 70% stocks, in theory I want to increase my stock exposure to 80% when stock prices are hitting new 52 week lows. On the flip side I want to decrease stock exposure to 60% when stocks are hitting new 52 week highs. What I have not yet worked out is a mechanical formula to accomplish this.

The second prong of my theoretical investment model is based upon "Modern Portfolio Theory" - the concept that different investments do not go up and down in tandem and that in a "perfect investment world", investment "A" would be the mirror opposite of investment "B" - both being opposite ends of a see-saw - so that when A went down, B went up the exact amount and vice versa. In the real world no such investment exists and, indeed, from my personal observation of long term charts, most investments go up and down together with the overall market. However, they do not go up and down to the same extent and some segments of the market will be out of favor for periods of time and then will eventually come back into favor.

Thus, there would seem to be a benefit to owning various market segments individually IF - and only if - one is buying low and selling high. Thus, my theory is when buying stocks in a bear market, it makes sense to buy those sectors of the market that have been hit the hardest and are thus cheapest. And, likewise, when selling stocks, it makes sense to be selling the sectors of the market that are over bought and selling at the highest premium. Of course, creating a mechanical model to accomplish this is the issue I am still working on. That model will call for most of the portfolio to be in Vanguard's Total Stock Market Index with smaller (adjustable) percentages allocated to small cap stocks, value stocks, small cap value stocks, REIT, and international stocks.

To My Wife And Children

I've created this blog - and writing this post - for my wife and children with the hope they find (and heed) these words after I'm long dead and gone.

Investing in today's world is very simple - but only if you faithfully follow - without fail - some very simple rules.


RULE ONE:
BUY ONLY INDEX FUNDS AND IGNORE ALL STOCK BROKERS/ADVISORS

I believe in what is known as the "efficient market theory". Simply put, it means that the market is efficiently priced - that all possible information is known and already factored into the current price - and that what the market does tomorrow is unknowable. Therefore although some "experts" may appear to have actually beaten the market in the past, in truth they merely represent expected statistical outlyers - the statistical minority that will be expected to flip "heads" 10 times in a row and thus "appear" to beat the odds.

The biggest single threat to your financial health is believing that "experts" can manage your money for you - that "experts" can recommend stocks or mutual funds to buy or sell. I call these so called experts "Wall Street Predators" because they can only make their living by preying upon financial ignorance. In a "just world" they would be declared illegal and would come with warning labels far more prominent than those forced on the tobacco industry - and trust me - they are every bit as dangerous, if not more, to your financial health as cigarettes are to your bodily health.

Don't be fooled. These so called "experts" do not exist. There will always be individual stocks that will beat the market but nobody can predict which stocks they will be. Likewise there will be individual mutual funds that will also "beat the market" but, once again, nobody can predict which ones they will be. So, principal number one - the one guiding rule that just never be forgotton - the largest danger to your financial health are the Wall Street Predators - stock brokers, stock brokerage firms, insurance companies selling financial products, load mutual funds and actively managed mutual funds, and all sorts of investment advisers - and this includes virtually all of the print and television media - they all want to sell you financial products and financial advice. Turn them off and tune them out. DO NOT use stock brokers. DO NOT buy financial products. DO NOT listen to the financial media whether that be on television or newspaper or magazine.

You invest one way and one way only. You use a mutual fund known as an index fund that holds every single stock in the entire stock market and thus you are investing in the market itself and it is managed by a computer, not by some person who believes he can predict which stock buy and which to sell. And you will use just one mutual fund company - Vanguard Mutual Funds - due to their unique "ownership" structure and devotion to the lowest management fees in the industry.


RULE TWO:
UNDERSTAND ASSET ALLOCATION

The second principle is the importance of asset allocation - in simplest terms the precentage of your money to put in stocks and the percentage to invest in bonds (and cash). The simplest - and perhaps best - approach for most investors is to own two funds - Vanguard Total Stock Market Index and Vanguard Total Bond Index. The investor need only determine the percentage of allocation between stocks and bonds.

The allocation decision, however, is itself a critically important decision. It has been well documented that the allocation decision - the percentage of a total portfolio allocated to stocks and the percentage allocated to bonds, will determine 90% of the portfolio's actual return (and the choice of which funds or stocks to own accounting for a mere 10% of overall return). Thus the stock/bond decision is a crucial one. For this reason, most investors (my wife and children) are probably best served leaving that decision to the experts and investing in just one fund - Vanguard's Target Retirement Fund (the specific fund determined by the target date of retirement). The Vanguard Retirement Fund is a "fund of funds" - it doesn't directly buy stocks or bonds - it merely buys other Vanguard funds (specifically the Total Stock Market Index, Total Bond Index, and Total International Index). The magic is that you leave to the "experts" the decision regarding the percentage allocation decision - which the fund determines by your "target retirement date".

Note that the choice of the word "retirement" is indeed unfortunate and should not be confused with retirement accounts. This fund is perfect for both retirement accounts (such as IRA and 401k accounts), and is equally appropriate for taxable accounts. Indeed, since the idea is that you are having the fund manager this theory of investment only really works if the investor makes this the only investment of his/her entire portfolio because the allocation decisions of the fund are made with the presumption that the stock/bond allocation is being applied to all of the investor's assets. Alas, most of us are unable to allocate all of our assets into one Vanguard fund because we don't control where our money is being invested.

An alternative is to own Vanguard's Target Retirement Fund and check it's allocation quarterly/annually and mirror that allocation in the rest of the portfolio. At this point in time I track Vanguard's Target Retirement Fund 2020 allocations as a guide to my own allocation decisions.

Recent Allocation History - July 2008

As of today (Aug 10, 2008), my portfolio allocation is 70% stocks / 30% bonds(cash). These are pre-tax allocations. I am working on post tax allocations which adjust for the taxes to be paid on taxable and non-ROTH retirement accounts. My current after tax stock allocation is 67%, although I not yet using those figures because I do not have historical comparisons nor am I satisfied I have made accurate projected tax calculations. It is interesting, however, to note the impact of tax on the allocations - in my case decreasing my stock exposure a full 3 percentage points (primarily due to the fact the bulk of my bond(cash) holdings are in non-retirement accounts).

The Vanguard Total Stock Market Index is 18.20% below its most recent 52 week high with certain sectors of the stock market down as much as 26.32% (Vanguard Int'l Emerging). Thus my model would tilt towards more fully invested (i.e. if my "norm" is 70% then I want to be reaching towards 80% in this down market). However, I started the year only 63% invested and thus have already moved a fairly substantial percentage into stocks as the market fell. Since I do not yet have my mechanical model in place, I am hesitant to move too quickly towards 80% and, as a result, may not take full advantage of the opportunity provided by this down market.

In May of 2008 I made the decision to diversify into Value, Small Cap, and Small Cap Value sectors of the market. I increased the exposure to Large Cap Value from 6% to 9% and initiated first time exposure to Small Cap Value at 2%. I also increased exposure to Small Cap from 2% to 10% in one fell swoop on May 12 and 13th. Worried that I had moved too much, too quickly, I reduced Small Cap exposure to 5% on June 9th. At the same time, I decreased international exposure from 17% to 15%. Overall stock exposure remained steady at 63%.

In July I put a toe in the water and invested in the REIT sector, starting out with a 1% allocation. Meanwhile by the end of July I had increased overall stock exposure to 66% while continuing to reduce international exposure to 12%. Overall asset allocation percentages by the end of July were:

• Stocks: 66
• International: 12 (emerging: 4)
• Small Cap: 5
• Small Cap Value: 2
• Large Cap Value: 9
• REIT: 1

I started "investing" some time around 1982-1983. My dad was dying of cancer and wanted me to have a crash course so I could help take care of my mother's investments after he died. I faithfully watched Wall Street Week with Louis Rukeyser every week and started reading the Wall Street Journal and Money magazine. I started investing in Mutual Funds and joined AAII. However I never read any investment books until April 2007 at which time I read perhaps ten investment classics through August of 2007. During that time I made serious adjustments to my portfolio which had gone completely un-managed for over a decade.

In May 2007 - just over one year ago - I was faced with a portfolio with the following characteristics:

• Stock exposure was 87% - probably too high for a 54 year old - and clearly done without any thought to what the exposure should be;
• Retirement accounts represented 70% of my portfolio, with no ROTH exposure;
• Individual stocks represented 20% of the portfolio, 10% of which was invested in my employer's stock;
• Index funds represented less than 1% of the overall portfolio.

Eighteen months later (as of August 10, 2008), stock exposure is 70% with the following changes in the overall portfolio characteristics:

• While retirement accounts continue to represent 70% of the overall portfolio, 7% of overall portfolio is now held in ROTH accounts. Note that a fundamental portfolio decision is to aggressively fund via the ROTH and both my wife and I are funding the maximum allowable by law. As this is more than we can afford to be taken from our paychecks, cash is moved from our taxable portfolio into our checking each pay period. Thus, we are in effect moving money from our taxable portfolio into ROTH accounts each pay period.
• Individual stocks represent only 2% of the portfolio almost all of which is in my employer's stock. Holding company stock is a big "no no". However, my company has a 15% corporate match for the taxable stock purchase plan. Normally it is my intention to zero out this account every quarter. I have not done so this past quarter because the stock is at all time lows and represents good value. Note, of course, that by not cashing out I am trying to "play the market" which violates all of my investment principles. However, it represents a very small portion of the overall portfolio and it probably makes sense to hold the stock for 1 year to obtain long term taxable gain treatment in any event.
• Fully 91% of the portfolio is now invested in index funds. This would be 100%, minus the employer stock, but for a 6% allocation in Mutual Shares, a large cap value fund that I have not sold for tax reasons.

My Recommended Reading

The books I want my wife and daughters to read:

Gregory Baer & Gary Gensler, "The Great Mutual Fund Trap" (2002)

John C. Bogle, "The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns" (2007)

John C. Bogle, "John Bogle on Investing : The First 50 Years" (2001)

Burton G. Malkiel, “A Random Walk Down Wall Street”

William J. Bernstein, “Four Pillars of Investing: Lessons for Building a Winning Portfolio”

Larry E. Swedroe, “The Only Guide to a Winning Investment Strategy You’ll Ever Need”

Ed Slott, “The Retirement Savings Time Bomb and How to Defuse It”

Recommended Reading from William Berstein

William Berstein, author of the Four Pillars of Investing, recommends the following books:

Investing Classics
1. Random Walk Down Wall Street by Burton Malkiel
2. Common Sense on Mutual Funds by John Bogle

Wallstreet in 1980s and 1930s
1. A Fool and His Money by John Rothchild
2. Where are the Customers' Yachts by Fred Schwed

Once in Golconda by John Brooks
How things got nasty between New York and Washington in the aftermath of the Great Depression and how Uncle Sam finally got his hands on Wall Street to the benefit of just about everybody

Devil Take the Hindmost by Edward Chancellor
A history of manias and crashes over the centuries. If this book doesn't bulletproof you from the next bubble, nothing will

Bernard Baruch; Money of the Mind; Minding Mr Market; and The Trouble With Prosperity - all books by James Grant
This man has a better grasp of capital market history than anyone else I know, and the quality of his prose is superlative to the point that it occasionally becomes distracting.

Capital Ideas by Peter Bernstein
An engaging history of modern financial theory and its far reaching influence on today's markets

Winning the Loser's Game by Charles Ellis
A succinct look at the essence of money management by one of the country's most respected wealth managers.

Global Investing by Gary Brinson and Roger Ibbotson
A panoramic view of stocks, bonds, commodities, and inflation the world over. Now more than a decade old, it's beginning to show its age but is still worth it.

Asset Allocation by Roger Gibson
An excellent primer on portfolio theory and the mathematics of arriving at effective allocations.

About This Blog

This is a personal blog to record my thinking about personal finance and investing and track moves in my portfolio. I also hope it will provide my daughters (and my wife after I'm gone) with guidance on how to save and invest their own money.

My initial thinking is that I will use this blog to record timely investment advice, reading recommendations, and most importantly, to allow tracking of the extent to which I allow emotions to impact my investments.