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If you own a stock, bond or actively traded mutual fund, you are losing money Len Shapiro Neveh Shalom Men’s Club Dec.

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Presentation on theme: "If you own a stock, bond or actively traded mutual fund, you are losing money Len Shapiro Neveh Shalom Men’s Club Dec."— Presentation transcript:

1 If you own a stock, bond or actively traded mutual fund, you are losing money Len Shapiro, Neveh Shalom Men’s Club Dec 18, 2011 1

2 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 2

3 Intro: Bio Reed BS in Math, Phi Beta Kappa Yale PhD in Math Mathematical Economist Computer Scientist Former chair of CS Dept at PSU – Currently Emeritus Professor Former VP of Neveh, chair of Ritual Committee and Chevra Kadishah 3

4 Yidden You are welcome to ask questions during my presentation because that’s the Jewish way: Genesis 32:28, Jacob triumphs in his struggle with an angel and is renamed Israel. Exodus 32:9, G-d calls the Jews Am K’shei Oref, a stiff-necked people 4

5 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 5

6 Asset Classes: Types of Stocks (Partial Listing) 1.Domestic (=US) stocks – Large, middle and small capitalization (cap) – Each category could be one asset class, for example, domestic midcap is one asset class. 2.Bonds – US Treasuries, US corporate, international treasuries and corporate – Each category has various terms, like one year, or 3-5 years, etc, and various ratings, like AAA, junk bonds, etc. – Each category could be one asset class, for example, US Corporate 3-5 year junk bonds. 6

7 Asset Classes, Ctd. 3.EAFE: Europe, Asia, Far East stocks – Britain, Japan, France, Germany, Australia, Switzerland,Sweden, Italy, etc. – An asset class may or may not include large, medium or small cap. 4.Emerging country stocks China,Brazil,S.Korea,Taiwan,India,S.Africa,Russia,Mexico,etc. Again, an asset class may or may not include large, medium or small cap. 7

8 Asset Classes, ctd. 5.REIT: Real Estate Investment Trusts – Typically invests in large commercial, residential multiunit properties 6.Commodities: metals, foods, energy – An asset class may own companies, futures, or assets themselves – Futures are complex because of contango 8

9 Asset Classes, ctd. Asset Classes vary hugely in their rates of returns and risks. See the chart on the next slide 9

10 Asset Class Variation From Bernstein, “The Investor’s Manifesto”, 2010, pg. 15 10

11 Mutual Funds(MF)s vs. Exchange Traded Funds (ETF)s An ETF is bought and sold like a stock – bought and sold with the usual stock commission An ETF is bought through a stock broker Some brokers sell some ETFs commisson-free – Allows powerful strategies like covered calls A Mutual Fund – May have a front end purchase fee – May have an early redemption penalty – May have a minimum investment ETF prices change in real time, MF prices change daily ETFs have significant tax advantages over MFs –, 11

12 More info on ETFs Several sites are available to provide info on ETFs –,,, etc. Using these sites, one finds that the largest ETF in some of the asset classes above is – Large cap domestic: SPY – Med cap value domestic: IWS – Small cap growth domestic: IWO – Investment grade US Corporate bonds: LQD – EAFE: EFA – Emerging Equities: VWO – REIT: VNQ – Commodities: DBC (DBA for less oil focus) There’s the start of a sample portfolio for you. 12

13 MFs, ETFs Some MFs and ETFs specialize in areas other than asset classes, for example – High dividend stocks – Specific assets, e.g. gold, or Brazilian stocks – Hedge funds – Target retirement dates – Merger Arbitrage – Israel stocks 13

14 More terminology: Active, Passive Active vs. Passive Exchange Traded Funds and Mutual Funds – Active: Experts pick what they consider to be the “best” holdings, often in a single asset class – Passive: Nonexperts pick a representative sample of holdings in an asset class – There are active and passive Mutual Funds and ETFs You might think active funds perform better – You are in for a surprise! 14

15 Index Funds An index is defined by an organization, describing “a representative sample of holdings in a single asset class” A passive fund holding stocks representing an index is called an index fund. – Essentially all passive funds are index funds Most ETFs are index funds, most MFs are active funds – For historical reasons Many books and people say “ETF” when they mean “Index Fund” 15

16 What is an Index It is not clear how to define an index in an asset class – especially in asset classes as complex as commodities So indexes are typically defined by major organizations – The definition of an index can be multiple paragraphs Examples: Dow Jones Industrial Average, S&P 500, S&P 400, etc – Dow Jones Industrial Average: created by by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow and statistician Edward Jones. It is now owned by the CME Group. Consists of 30 stocks.Wall Street JournalDow Jones & CompanyCharles DowCME Group – S&P 500: Essentially the 500 largest US stocks. This represents 2/3 of the capitalization of all domestic stocks. – S&P 400: 400 midcap domestic stocks, covering 7% of domestic stocks. – Wilshire 5000: 6700 stocks, essentially all domestic stocks Index funds identify themselves as following a specific index 16

17 Management Fees MFs and ETFs each have an annual management fee – Why do active funds typically have much higher management fees? Hint: “experts” – On the next slide you will see some management fees of some of the most popular ETFs. Notice how low they are. Fees of active MFs can be close to 1%; professional fees are typically over 1%. – The table is From Malkiel, “A Random Walk Down Wall Street”, © 1973-2011, pg. 400 Over 1.5 million copies sold 17

18 ETF Management Fees 18

19 Active vs. Index Funds An active fund is managed by one or a few humans using their judgement. Each active fund must continually be creative, nimble, better than the rest. Every active fund has a horror story about a period when it went bad. Will you be lucky enough to avoid the horror story when it is time to cash out? 19

20 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 20

21 Cold, Hard Facts One aspect of the Efficient Markets Hypothesis: Most active funds underperform their benchmark indexes. The table on the next page is from Malkiel, pg 292. 21

22 22

23 More Efficient Markets Hypothesis Even the Winners Are Losers: Another Table from Malkiel, pg 181 23

24 More “Winners Are Losers” Evidence According to a Wall Street Journal article: “Heading into 2008, 14 stock and balanced mutual funds had beaten the S&P 500 for nine years in a row … just one of those has stayed ahead” in 2009. – Of course, the important measure is cumulative return. – If we have time, we’ll look at that at the end. 24

25 Double Whammy So when you buy an active mutual fund you get a double whammy You are paying a higher management fee And your manager is typically underperforming the MF’s benchmark index. You are losing money twice over. Paying a front end fee? Triple whammy. 25

26 Do it yourself? Do you buy individual stocks and bonds? Think you can beat the MF experts? They do investing full time They are trained and chosen especially for this craft And they underperform the indexes 26

27 The good news Indexes, which outperform the experts, are available to each of you, and cheaply, through indexed ETFs and MFs. See the previous sample portfolio. 27

28 I know this great stock… A standard practice among investors who buy individual stocks is to buy stocks that have shown terrific performance recently. But the cold, hard truth is that investing in poorly performing stocks, so-called “value” stocks, is a wiser strategy. The tables on the next slide are from Bernstein, pages 40 and 41. 28

29 Don’t buy great stocks! 29

30 Active MFs are profit centers Bernstein, pg 139. 30

31 Timing the Market You can’t. From Goldie and Murray, “The Investment Answer”, 2011 31

32 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 32

33 Some Anecdotes “October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February.” Mark Twain, Pudd’nhead Wilson “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” Mark Twain, Following the Equator “How could I have been so mistaken as to have trusted the experts?” JFK, after the Bay of Pigs fiasco 33

34 More Anecdotes “It’s far more profitable to sell advice than to take it”, Steve Forbes, publisher of Forbes magazine “In 30 years in this business, I do not know anybody who has done it [Market timing] successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely, not only not to add value to your investment program, but to be counterproductive.”, John Bogle, founder of the Vanguard Group. Remember this guy hires many many successful fund managers. 34

35 But I’ve always beaten the Market! Peters and Waterman, in In Search of Excellence, report that a random sample of male adults were asked to rank themselves in terms of their ability to get along with others. One hundred percent ranked themselves in the top half of the population. Twenty five percent ranked themselves in the top one percent. Even in athletic ability, an area where self-deception would seem more difficult, over 60% of male subjects ranked themselves in the top quartile. Only 6% ranked themselves below average. 35

36 I beat the market, ctd. An October NYT article by Nobel Prize winner Daniel Kahneman makes these points: – Investors, who trade more, are less successful. – Men tend to trade more, and lose more, than women. – We tend to ignore evidence of our failures. – dont-blink-the-hazards-of-confidence.html dont-blink-the-hazards-of-confidence.html 36

37 What about those MF Ads? Here are some tricks they use – Create 10 mutual funds. Close those that underperform their benchmark indexes, then advertise the ones that are left, if any. – Given an MF, claim it was a number one performer for a short period, or compared to a small set, say of funds with asset values between $250 and $500 million. 37

38 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 38

39 Modern Portfolio Theory We don’t have time to go into this. It’s explained in Malkiel, pages 202-213. It says, basically, that a portfolio containing widely diversified asset classes yields higher returns and lower risks than one containing fewer or similar asset classes. 39

40 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 40

41 Rebalancing You should decide on a percentage allocation of your portfolio into asset classes based on your personal risk tolerance. Every 6 months to 2 years you should buy and/or sell assets to recapture this allocation. Rebalancing can reduce risk and increase returns. 41

42 Rebalancing Example, Malkiel Pg 370 42

43 Outline Introduction Terminology Data Anecdotes Modern Portfolio Theory Rebalancing The Bottom Line 43

44 From This We Learn? Don’t buy individual stocks or bonds, or active mutual funds. Instead, buy index ETFs or index mutual funds. Buy index funds with low management fees. Buy index funds in a widely diversified set of asset classes. Rebalance Don’t try to time the market. Buy and hold. 44

45 Questions? The remaining slides are to be used only if there is time. They cover: The most popular mutual funds For those that are no-load and actively managed, comparisons with corresponding index funds Modern Portfolio Theory 45

46 Most Popular Mutual Funds 46

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51 Modern Portfolio Theory Umbrella Manufacturer Resort Owner Rainy Weather +50 -$25 Sunny Weather -$25 +50 51

52 MPT: Example Assume half of days are rainy, half are sunny If you own one share of Umbrella Manufacturer – Average profit is (50-25)/2 = 12.5 – But your investment has high risk = high variance Same results if you own one share of Resort. What if you diversify and own one share of each? – Rainy day: profit is (50-25)/2 = $12.5 – Same for sunny day 52

53 MPT: Results In our example, you initially owned just one stock, a profitable but risky investment. Then you diversified. You got the same expected return But with no risk This worked because the two stocks had a covariance of -1. 53

54 MPT in the real world Real asset classes don’t have negative covariance. – However, their covariance is often significantly less than one – See slide 10 above However, diversifying over asset classes with covariance less than one will reduce risk. Bottom line: Owning a diversified portfolio will reduce your risk while preserving your profit. 54

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