2013-11: November 2013 What Works in Personal Finance Newsletter

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What Works in Personal Finance Newsletter


November 2013 Newsletter



You are a financial industry profit center


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Why allow the financial industry to help itself to your money? In case you did not notice, the financial services industry has not done the world any favors lately. The financial industry has probably not done you any favors, either. This industry will take as much as it can and then try to take more. Only you can protect your own wallet from an industry that overall has a highly negative “value-added” with respect to individuals.


Global securities markets have a dog-eat-dog ethos with winners and losers. Highly competitive and ruthless securities markets are necessary for efficient price setting and capital allocation. I applaud when full-time financial professionals engage in competition among themselves with knowledge, resources, and skill. However, when similar strategies are applied to individuals who lack knowledge, education, and resources, then this is an unfair fight.


When the inadequacies, ignorance, biases, and misconceptions of individuals are exploited systematically, this is deplorable. When financial industry marketing and promotions imply that there is a partnership or advisory role, but actions taken indicate that this is not the case, then this is moral bankruptcy. When the financial industry is so strong that it distorts or evicerates fairness in governmental regulation, then many of these deplorable behaviors are not criminal, simply because laws and enforcement are too weak.


The mass of American financial consumers are trusting, docile sheep regarding their personal financial affairs. The amount they are willing to waste on overpriced financial services is astonishing. Far too many US consumers pay far too much and get woefully little value in return from the financial services industry. The industry repeatedly scrapes the consumer excess off the table and stuffs it into its salaries, bonuses, and corporate earnings reports. The only salvation for some individuals is that eventually they will wake up and decide to stop paying their share of the tribute to this industry.


In the summer of 2007, I published a five-part article on The Skilled Investor website, that is entitled: “The Biggest Personal Finance Story of the Past 30 Years.” This story details how the public market value of the financial services sector had grown into another financial bubble in and of itself. While shareholders of financial firms may have been pleased, the rest of us were just feeding this beast. This financial industry bubble deflated somewhat during the credit crunch and Great Recession, but taxpayers bailed out the industry. Now, this financial services industry valuation bubble is inflating again. Since I published these articles, over four years have passed with a nasty financial crisis and recession thrown in. My opinion has not changed. Cut your investment costs to the bone.


Whole stock market investments versus strategy skews


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Investors who decide to pursue passive equity index strategies still have a few very important strategy decisions to make. They can choose to buy the whole stock market or to adopt a “strategy skew,” when choosing stock index investment funds. If an investor buys the whole stock market, they seek the market’s return without selecting any particular subset of the market or any investment strategy skew. Doing so is consistent with investment theory and the research evidence. The total stock market is expected to deliver an optimal risk-adjusted return less, of course, whatever minimal costs are associated with the passive broad market index funds chosen to implement this total market strategy. When winners are not identifiable beforehand, this strategy is optimal and efficient. (Hint: winners are not identifiable beforehand — particularly by individual investors.)


Certain factors or investment skews have been demonstrated in the research literature to have the potential to improve modestly upon the market’s risk-adjusted return. Sometimes known as the Fama-French factors, these investment strategy skews are: value versus growth, large capitalization versus small capitalization, and momentum. These factors may enable investors to improve upon the risk-adjusted performance of the overall market and deliver slight to modestly improved returns. However, to implement these skews or strategies is not costless, and therefore the incremental costs and taxes associated with these strategies also need to be taken into consideration. This article addresses the value versus growth and large-cap versus small-cap factors or skews. It is practical for passive index investors to adopt such skews through index funds, if they wish and if they are willing to take on the additional risk and costs associated with these skews.


The first step in achieving a fully diversified investment portfolio is to choose from among only very broadly diversified and low cost mutual funds and ETFs. The second step is to choose a mix of investment funds that tends to approximate the broadest markets. Various market participants and advisors advocate that investors favor one or more of a multitude of investment selection factors, when assembling an investment portfolio. Unfortunately, these selection factors often involve higher costs, lower diversification, greater risks, and more activity – without a reasonable assurance of improved total returns net of taxes and investment costs.


Learning about personal finance and investing


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If you have a desire to stay tuned to informative economic and investment information, I understand, appreciate, and share that desire. One of my goals over the past decade has been to understand the sources of available financial and investment information. However, I have reached the conclusion that 99+% of the financial information that is easily available through the media and the Internet is: self-interested and biased; superficial and non-implementable; historical in nature or just current “noise” reporting without any actionable utility; and/or poorly researched, just plain wrong or unmitigated rubbish. This paucity of genuinely useful information is understandable. The investment research literature provides no assurance that anyone has any real predictive insights to allows them to beat-the-markets or time the markets reliably and consistently over the long term.


However, I do believe that it is a virtue to engage in a lifelong effort to understand economics and investments, because of the significant impact of economics and investment upon our lives. Personally, I believe that this knowledge provides a very long-term economic perspective and allows one to rise above the constant pressure from the industry and the media to change something – change anything – with ones investments, without any rational reason other than to generate more revenue and profit for the industry yet not for you.


In addition to materials that I have published, here is a short list of my investment reading recommendations concerning other sources that I consider worthwhile. The online sources are all free. You could buy the books inexpensively on Amazon. To find investment research papers via Google Scholar, go to Google, click “more”, click “Scholar” and enter a search term. Look for most cited papers. Read abstracts, intros, and conclusions. This takes time, but you can find a lot of interesting and objective information on topics that interest you.


Choose the broadest available whole market diversification


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Another risk reduction objective should be to achieve the broadest possible securities market diversification within your overall portfolio holdings. Whenever several low cost investment funds are available, I suggest choosing the fund with the broadest market coverage. This reflects a preference for owning the entire market. Such funds are often named “whole market,” “total market,” or “multi-cap” funds.


Funds that invest in company size-based subsets of the market are usually known as “large-cap” versus “mid-cap” versus “small-cap” stock mutual funds or stock ETFs. Overall, it is important to hold all different sized equities roughly in proportion to the market capitalizations of these company size groupings. The investment research literature indicates that investors in funds with portfolios that are skewed by company size will experience greater volatility. Over time, as demand shifts from large-to-small or small-to-large capitalization companies, these portfolio are more variable compared to the returns of the overall market. Thirty years ago, research indicated that small capitalization stocks delivered excess returns that were disproportionately high even in comparison to the presumably greater risks of smaller firms. Research that is more recent suggests that this argument is much less conclusive today.


Other more hidden problems might arise, when investing in company size-based market subsets rather than in the overall stock market. When company size-based benchmark indexes change, the index funds that track those benchmark indexes must buy or sell to reflect these changes in their portfolio holdings. Changes in demand for particular stocks can create a potential advantage to traders who have anticipated these changes. This “front-running” could be detrimental to the performance of these company size-based index investment funds. When an investor holds low cost, passively managed index investment funds that represent all sizes of companies, it will not matter if individual stock prices change somewhat as companies are added or subtracted within subsets of the overall market. By owning the whole market, these potential hidden cost problems related to redefining sub-indexes just disappear.


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