October 2008

This Week in Headlines: Just A Bunch of Noise

Headlines from the past week:

  • This Monday: Dow Slides 203 Points [source]
  • Tuesday: US Stocks Explode Higher, Dow Surges Almost 900 Points [source]
  • Wednesday: Dow Decked in Final Minutes; 280-Point Gain Becomes 74-Point Loss [source]
  • Thursday: What GDP Slowdown? Dow Advances 189 [source]

Jeez. What a rollercoaster. No wonder people are stressed.

Want to know how to sleep easily when your IRA/401k’s value keeps bouncing all over the place?

Ignore It. Completely.

…because, for most of us, it’s absolutely irrelevant what the market did this week. It’s irrelevant what it did this month. In fact, it’s irrelevant what it will do in all of 2008.

Unless you’re planning on taking your money out soon (because you’ve retired and need to use it for living expenses, not because the market has gone down), it doesn’t really matter what the market is doing. All that matters is where the market will be 10 (or 20, or 30, or 40) years from now.

My bet? It’s going to be up. A lot. So I think I’ll keep investing and ignoring the news.  It can be fun to be Oblivious. (And it’s a heck of a lot easier than worrying.) You might want to try it. :)

October 31, 2008 0 comments

A Tip for Young Investors: Get Your Time Frame Right.

One of the very first things you need to figure out when you’re starting to invest is what time frame you’re looking at.  Are you going to need this money six months from now, two years from now, or 30 years from now? The answer makes a big difference as to which type(s) of investments to use.

In a post a few weeks back, Trent from The Simple Dollar explained this concept using a wonderful analogy for investing:

Think of the stock market as being kind of like a coin flip. Think of each year as being like a single coin flip, where a heads flip will get you a 15% gain and a tails flip will get you a 10% loss. The more times you flip a coin, the more likely you are to get a roughly equal mix of heads and tails results.

Since I’m thirty years away from retirement, I have a lot of coin flips ahead of me. I’ll likely see some runs of heads and some runs of tails, but over that long period, it’ll approach an even split in flips. That even split will mean a pretty good return on my investment.

But let’s say you’re now five years from retirement. That means you have only five coin flips. There’s now a measurable chance (a little over 3%) that all of your remaining flips will be bad, losing you a significant amount of money. Instead of being a volatile investment, it moves more towards being a gamble.

I absolutely love the way he explains this concept. It sums up perfectly why you want to avoid stocks if you’re going to need your money in the next few years (and, conversely, why you want to go heavily into stocks if you have many many years ahead of you).

I do, however, want to highlight something in the analogy that (I believe) is a mistake that many people make when planning their investment strategies.

If You’re 5 Years from Retirement, What’s Your Investing Time Frame?

It’s easy to say “Well, I’m 5 years from retirement, so I can’t afford to have my investments go down. I’d better not use any stocks.” In fact, during my time as a financial advisor, I heard many people say exactly that.

But here’s the problem with that type of thinking: You don’t sell all of your investments the day you retire. Or, to look at it differently, your investing time frame isn’t from now until the day you retire. It’s from now until the day you die. I don’t know anybody who expects those to be the same date. (Edit: I suppose I did have professor in college who always said that he planned to teach until the day he dropped dead in class.)

How About Some Numbers?

According to the National Center for Health Statistics, in 2005 (the most recent year for which I could find data), the average 65 year old was expected to live another 18.7 years. From what I’ve heard and read over the last few years, it seems that most people in our country are seeking to retire by age 60 or earlier. That means that we need to be planning for retirements that are at least 20 years long.

So what’s the investing time frame for a person who is five years from retirement? Well, it’s a heck of a lot longer than five years. It’s probably something closer to 20 or 30 years (or more).

So What Does a 20-Year Time Frame Mean?

Two things, I think:

  1. There will be plenty of time for the volatile returns from stocks (or stock-based funds) to level out.
  2. It’s likely that cost of living will double (or more) during that period due to inflation. So fixed income investments aren’t going to cut it.

My takeaway from all this? Plan on owning equities (stocks) in retirement. Lots of ‘em.

What do you think? What do you think your portfolio will consist of as you approach (and enter, and proceed through) retirement?

October 29, 2008 2 comments

Why Dollar-Cost-Averaging Works: A Look at the Numbers

Five Cent Nickel recently wrote a post about making money in a flat market by investing through the decline. Nickel shows that if you dollar-cost-average into a fund (index or otherwise) and the market declines, then returns to its original point, you will have made money.

It’s an excellent post (and quite timely), but it only looks at one of three possible ”flat market” scenarios (the scenario in which the market starts at one point, declines, then comes back to where it started). If the opposite thing happens (ie, the market starts at one point, goes up, then comes back down), and you were dollar-cost-averaging into the market, you would have lost money. Why does it work that way?

Let’s Look at the Numbers.

When dollar-cost-averaging, the two things that determine whether or not you make money are:

  1. Your average cost per share.
  2. The ending price per share, and how it compares to your average cost per share.

Just by taking a quick glance at a hypothetical market chart, we can see how dollar-cost-averaging works in each scenario.

Scenario 1

This chart uses the numbers from Nickel’s original post. Even without doing any math we can see that, if purchases were made at each of the four points, the average cost per share purchased would be somewhere between the high point of $100/share and the low point of $66.5/share.

As a result, with an ending share price of $100/share, it’s obvious that the investor would have made money.

Scenario 2

This chart examines the opposite scenario: One in which the market starts at a point ($100/share), heads upward for a bit (to $150/share), then back down to its original price.

In this case, we can see that the average purchase price per share must be somewhere between $100 and $150.

With an ending price of $100/share, this investor has lost money.

Of course, real life isn’t very often like scenarios 1 or 2. That is, the market doesn’t seem to move in only one direction, then back to where it started. Typically, it’s all over the place (but slowly trending upward).

Scenario 3: Why Dollar-Cost-Averaging Really Works

Here we see a much more likely scenario, one in which the market moves both up and down over a given period. This time, we’ll actually have to do a little math to see what happens.

Let’s say our Oblivious Investor is happily dollar-cost-averaging into her index fund at a rate of $10,000 every year.

The first year, with a per share price of $100, her $10,000 buys her 100 shares.

In the second year, with a per share price of $150, her $10,000 only buys her 66.67 shares.

In the third year, with a per share price of $50, her $10,000 buys her 200 shares.

And at the end of the third year, the price returns to the original $100 per share. (So, still a “flat market.”) By this point, our Oblivious Investor has invested $30,000, and she owns 366.67 shares.

Dividing $30,000 by 366.67 shows us that her average per share price is just under $82. With a current market price of $100/share, our Oblvious Investor has made money. And this is in a flat market! It only gets better once we take into account the fact that (over time) stock market returns are positive.

Buy Low, Sell High (Without Even Trying!)

The reason dollar-cost-averaging works so well is that–if you invest steadily over a given period of time–your dollars will be able to buy more shares when the market is artificially low, and less when it is artificially high. In other words, you’ve set it up so that you’re automatically “buying low.” No need for complicated investing strategies. No need to try and time the market.

What about you? Have you had success with dollar-cost-averaging? Or if you’re new to this, do you know anyone who’s been DCA’ing into any funds for an extended period of time? If so, how’s it worked out?

October 28, 2008 5 comments

Timing the Market is a Loser’s Game: What We Can Learn from Dollar-Weighted Returns

If you’ve ever had any thoughts about trying to time the market, I’d suggest first doing some research into dollar-weighted returns and what they tell us.

What Are Dollar-Weighted Returns?

Almost without exception, when you read about the return that a fund earned over a period of time, you’re reading about time-weighted returns. Time-weighted returns answer the question, “If I invested $1 at the beginning of the period in question, what return would I have earned on that $1 over the period?”

Dollar-weighted returns answer the question, “What did the average dollar invested in this fund earn over the period in question?” In other words, if a fund grows from year to year (by more people investing money in it), each successive year will be weighted more heavily in the calculation of dollar-weighted returns.

In essence, what dollar-weighted returns show us is what the average investor in the fund actually earned over the period.

Pretty cool stuff, eh? Unfortunately, most fund companies don’t show us the dollar-weighted returns that their funds earned. Why do we suppose that is?

Dollar-Weighted Returns Are Almost Always Lower

For the most part, dollar-weighted returns of a fund are significantly lower than time-weighted returns. (In fact, I have yet to see a single situation in which a fund had a higher dollar-weighted return.)  Why is that? It’s because people (on average) tend to throw money into a fund after a good year and pull money out after a bad year. People try and time the market, and people lose.

But that’s only with individual funds. What happens when we take a look at the market overall? Interestingly enough, the same thing happens. According to a study done a few years back by Ilia Dichev (an Accounting professor at the University of Michigan), the time-weighted return of the market from 1926-2002 was 10% per year. The dollar-weighted return, on the other hand, was only 8.6%. That means that on average, everybody underperformed the market by 1.4% per year (not including investment costs).

This may seem counter-intuitive, as it seems that–in the aggregate–investors’ performance must match that of the entire market. Unfortunately, that’s not quite true. The reason for this aggregate underperformance is that companies tend to issue new shares of stock when the market is up, and they tend to buy back shares of their stock when the market is down.

So what’s the lesson?

My takeway is that I think I’ll stick with Oblivious Investing: Investing regularly into diversified mutual funds and passing on any attempts to time the market.

What are your thoughts? Have you ever tried to time the market? And if so, how’d you do?

October 27, 2008 2 comments

Financial Crisis vs. Economic Crisis

The news over the last several weeks has been overwhelmed with headlines about our current financial crisis. Many people have panicked and pulled their money out of the stock market, opting to hold cash instead.

Those people seem to be misunderstanding two things:

  1. We’re having a financial crisis, not an economic crisis.
  2. When you buy a stock, you’re buying a company’s future earnings.

This is a Financial Crisis

It’s only the financial markets that are in complete turmoil. Our economy (while not exactly flourishing) isn’t having any sort of meltdown. According to the US Bureau of Economic Analysis, our inflation-adjusted GDP has still shown positive growth so far this year. Our unemployment rate is just a hair over 6%. Our average unemployment rate from 1948-2007 is 5.58%, according to the Bureau of Labor Statistics. This is hardly the worst we’ve ever seen.

So why would this affect your investing strategy?

Because You’re Buying Earnings, Not Price Fluctuations

As Warren Buffett (probably the greatest Oblivious Investor) so often reminds us, when you buy a stock, you’re buying a company’s future earnings. The long-term profitability of an investment is determined by the long-term profitability of the company, not by the short-term fluctuations in the company’s share price.

So if you’re invested in index funds (or other broadly diversified mutual funds), you’re banking on the long-term earnings of our economy overall. Or, to put it differently, you’re making a bet that over the long run, our country’s companies will continue to be profitable. And so far (with the exception of what’s happened to a handful of companies in our financial sector), I’ve seen no evidence to indicate that our economy’s overall profitability is likely to be any worse than it’s been in prior decades.

The big takeaway: All this news is just noise. It will pass. The businesses of our country (and other countries) will continue to earn profits. I’d like to have my share of those profits. What about you?

October 26, 2008 5 comments

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