Monday morning investment quarterbacking

Bill Nygren, portfolio manager at the Oakmark Funds, has some interesting commentary in his fourth quarter (2013) report:

Investing shares a lot of similarities with sports. Good decisions often lead to bad outcomes and vice-versa. [Note that I'm skipping his introduction about sports, since that doesn't interest me.] ...

One of the most important contributors to successful long-term investing is asset allocation. Investors evaluate the tradeoff between higher returns on riskier assets, such as stocks, and lower returns on more stable assets, such as U.S. Treasury bonds. In constructing a portfolio, they try to balance their desire for maximum returns with their ability to withstand volatility. Long-term data clearly demonstrates that stocks, though more volatile than bonds, have rewarded investors with higher returns. Statistics compiled by Ibbotson Associates show that since 1926, stocks have produced an average annual return of 10% while U.S. Treasury bonds have returned less than 6%. Long-term investors in stocks have been well rewarded for accepting the risk of short-term loss. Obviously, if one could avoid owning stocks in the negative years, one’s return would be even higher (and one’s risk would be lower) than if one used a buy-and-hold approach. With this in mind, many investors attempt to time their investments in stocks. But almost every study has concluded that trying to time the market is futile for most investors.

And yet, despite all of the evidence that stocks are the highest returning asset class over the long term and despite all of the evidence that almost nobody can time the market, the financial media usually treats bears as being more thoughtful than bulls. This is a pet peeve of mine because I believe it is a disservice to individual investors. Much like with Monday morning quarterbacking, investors need to consider the probabilities. Since the stock market has to either go up or go down, you might think this is a 50/50 proposition. However, the S&P 500 Index has had 24 down years since 1926; in other words, in 88 years, only 27% of the years have produced a loss. The probability of a down year has been about the same as the probability of an eight-point underdog winning a football game. It happens, but it isn’t a bet you’d make unless you got good odds. In short, history shows a much higher burden of proof is on the people who predict that the market will fall, rather than on those who predict it will go higher.

When we look back on the S&P 500 gaining over 30% in 2013, it will seem like owning stocks was an easy call. The market had been moving higher in preceding years, valuations weren’t demanding, and the economic recovery was still quite young. But the bears argued that it was foolish to invest after stocks reached a new high in March. They argued that slowing growth in China threatened our economic recovery and that it was too risky to invest when our government was so dysfunctional that it shut itself down. Additionally, they predicted that the Fed tapering would bring a screeching halt to the positive returns. As Gilda Radner’s Saturday Night Live character Roseanne Roseannadanna said 35 years ago, “It just goes to show you, it's always something--if it ain't one thing, it's another." There has always been something for investors to fear, not just last year but every year, yet the market has averaged a 10% annual gain and has gone up in 73% of the years since 1926.

Let me start by saying that there's one thing I don't like about his comments. He seems to be defining "risk" as "volatility." The fact is, when you're an investor, there are all sorts of different risks. But for someone like me, volatility is almost completely immaterial.

Unless I'll be forced to sell when the stock market is down (and I think I've taken prudent steps to counter that possibility) or I'll panic during a market crash (and given that I got through the 2008 economic collapse just fine), why should volatility concern me?

Sure, I'm human, and I hate to see my investments decrease in value - especially since they normally go down a lot faster than they go up (though not nearly as often). But volatility isn't a big risk for me,... and I've got some very volatile holdings.

However, there are two points he made which I really liked. First, good decisions don't always lead to good outcomes, especially in the short term. And bad decisions can make you money,... sometimes.

It's always valuable to look back at the decisions you've made and see what the outcome was. But just because an investment decreased in value, that doesn't mean your decision was wrong - not given what you knew at the time. You have to look at it more closely than that.

Now, sure, you might always be tempted to say that you were right, that it was just the stupid market that was wrong. But sometimes, that's true. More generally, you can make all the right decisions and still be disappointed in the outcome. That's because you can't predict everything (and you should certainly know that).

This past year, the stock market has boomed. If you were in the market at all, you probably felt like a genius. But that's probably not the case. And you're not going to learn to make better decisions if you don't recognize that.

Yes, look at the past. Look at the recent past and look at the long-term. Look at how your decisions have turned out. But also remember why you made those decisions and look at whether your reasoning was valid, however the results ended up.

If I bought a lottery ticket and actually won the lottery, would that mean that buying lottery tickets was a good idea? Sure, it worked out for me that time, and I'd be very happy with the result. But if you look at the odds, it was still a bad decision. (Note that I've never actually won the lottery - or even bought a lottery ticket.)

It can be the same way with investing. You can have good results without making a good decision. But I wouldn't bet on it happening regularly. Likewise, just because you lost money, that doesn't mean your reasoning wasn't sound. It could be that your reasoning wasn't sound, and I'd examine that possibility very carefully. If you keep losing money, I suggest that you've probably overlooked something. But it doesn't have to be that you made the wrong decision.

The second part of this is to remember that the stock market goes up over time. Maybe that will end someday, I don't know. (If it does, we'll probably have bigger things to worry about than our stock market portfolios.) But so far, the stock market - over the long term - has been the closest you can get to a sure thing. If you stay invested long enough, you'll make money.

My holdings generally go down a lot faster than they go up, but they go up far more often. This past year has been especially great, unusually great, and the past five years (despite a down year in 2011) has been absolutely incredible. Of course, that's because the economic collapse at the end of the Bush Administration was so severe that we were at a very low level five years ago. I really don't expect another investment opportunity like that in my lifetime.

But what about this year? What about 2014? I have no idea. A down market wouldn't surprise me in the slightest, but an up market wouldn't really surprise me, either. (Another year like 2013 would surprise me, but look at the late 1990s if you don't think that can happen.)

The thing is, if you bet that the stock market will go down, you might make money. You might even make a lot of money. If you're right. But the odds are against you, because the long-term direction of the stock market is up. That's gambling, not investing.

I'm not a gambler, because I don't like to make bets where the odds are against me. If you buy a lottery ticket, you might win big, but it's a lousy bet. If you go to a casino, you might come out ahead, but it's a lousy bet. Casinos don't make vast sums of money because your odds of winning are good. Just the reverse, in fact.

But your odds are good if you invest in the stock market and avoid making stupid mistakes. (Many small investors do make stupid mistakes, of course. I've done it myself. I probably still do. But that's not what this post is about.) But long-term investors have the odds on their side, which is the exact opposite of gambling.

(I might also point out that investors have the government firmly on their side, too, since most investors are wealthy. Investors pay far lower taxes than people who work for a living, and there are an abundance of ways to avoid taxes altogether. Most of those government policies help the wealthy more than you and me, but we can still take advantage of them.)

At any rate, the stock market will go down someday. And the fact that 2013 was such a boom year (following a great year in 2012, too) probably makes it more likely that 2014 will be down, just because prices are higher now. But will last week be the start of a bear market? I have no idea.

I'm definitely cautious (well, as cautious as I get, which isn't very). I've made a few minor adjustments to my portfolio. But as they say, markets climb a wall of worry. The time to get scared is when that stops, when everyone seems to think that the market will continue going up. Except for those times of "irrational exuberance," I'd just consider such worries as little more than noise.

Over the long term, the odds are in your favor. In the short term, well, who knows? Not me. And not anyone else, either. (You can guess and get it right. But what does that really tell you?)  Bears have the odds against them. They can still make money, just like you can still make money in a casino, but it's not easy. (Besides, successful bears tend to focus their picks on individual stocks, not the market as a whole.)

Maybe it's a personality quirk, but I don't like gambling. I positively hate the idea of betting against the odds. That's a sucker's game, and I don't want to feel like a sucker. So I don't gamble. I risk my money, yes. I take on a lot of risk - more than most people would feel comfortable with. But I always want the odds on my side.

Bridgeway Funds semi-annual report

I don't often blog about investing, but I was reading the latest semi-annual report from the Bridgeway Funds, and a few things caught my attention - this graph, for example:

(click to embiggen)

The top line graphs the price per book value (one of many valuation metrics) of the U.S. stock market, going back to 1972. The bottom line is the price/book of just high yield dividend-paying stocks.

The point of this was to demonstrate that high yield stocks have generally been valued less than the market as a whole, but how that has changed recently:

On the basis of one measure of valuation, “price to book value”, they are the most expensive, relative to other stocks, we have seen at any time in our data history going back to 1972. On this measure, the price of these stocks has already been bid up on a relative basis. For the first time in at least four decades, high yield large cap stocks are actually more expensive than the broader market. Buyer beware.

That's interesting enough, for some of us, so I'll elaborate (and if you're not interested in this kind of thing, you might as well stop reading now).

Stocks which pay a high yield in dividends might be, for example, government-regulated utilities which make a reliable profit (since they can raise rates to cover costs), but will never make an excessive profit (because regulators won't let them gouge their customers too much).

Others might just be large companies in mature industries. They make a good profit, but there's usually not much growth potential, so the company is not valued as highly as other companies.

These days, most companies don't pay out much in dividends, because they want to use that money to grow. You see, a bigger company benefits the people who run it (and the people who make these decisions), and wealthy investors don't need the cash and don't want to pay taxes on a distribution.

Now, if you're a retiree on a fixed income, you probably want a steady stream of cash. But unless you own enough stock that you don't actually need the money yourself, you're not going to have much influence in any of this. Technically-speaking, you might 'own' part of a company, but you don't control it.

So most retired investors tend to own a lot of bonds. Besides, they're normally safer than stock (safer and less volatile). But after the worst economic collapse since the Great Depression, bonds yield hardly anything at all, and cash is even worse. So retirees have been searching for higher yield (and taking on more risk in doing so, though some of them may not realize that).

This is just basic supply and demand. More people are searching for yield, so they've bid up the price on these high yield dividend-paying stocks. Now, they're very expensive, compared to other stocks, by historical standards.

Please note: this doesn't necessarily mean they're too expensive. It doesn't necessarily mean that you shouldn't buy them. It doesn't even mean they won't hold up better if the market crashes. It's just, well,... buyer beware. It's seldom a good investment if you pay too much for it. (How much is too much? I have no idea.)

But take a look at that graph again, this time at the general market (the top line). Look at the late 1990's. Look at that peak in 2000 and at what happened afterwards. Trying to pick the short-term moves of the stock market is a fool's game,... but why wouldn't everyone have been worried about valuations like that?

For the most part, though, it was just the reverse. That was a time of irrational exuberance. The stock market was screaming upward and it would never drop again! Supposedly. (And suppose you saw how expensive it was and got out in 1997 or 1998. The market continued to scream upward after that, for another couple of years, anyway. And everyone but you would be making money.)

That graph even understates it, because some parts of the market were still dirt cheap back then. At work, they switched our 401-k plan at the very peak of the market, dumping the boring old funds they'd had previously and loading up on the go-go growth funds which had been climbing ever higher.

I remember going to a meeting of plan participants and asking for just one small-cap value fund in our investment plan, just one. But the 'experts' who were providing this plan to us (not our HR department, but the investment professionals they'd hired) explained that "no one" wanted to invest in small-cap value funds anymore.

Within a few months, the collapse came. Note that this wasn't like 2008, where everything dropped. No, this collapse was focused on those particular go-go growth stocks, and especially on tiny internet stocks with massive valuations and no revenue. Those small-cap value stocks I'd wanted did extremely well then.

But just for an idea of how things went with the more speculative investments, here are the results of the NASDAQ Telecommunications Index: Up 103% in 1999, Down 54% in 2000, Down 49% in 2001, Down 54% in 2002. I knew a guy who'd bought at the peak, when our company 401-k was switched into this kind of stuff, and finally got out at the bottom, three years later, just as the market was ready to turn around again.

Last I heard from him, he was wondering about finally getting back into the market again. This was not long before the 2008 crash. After all, everyone else had been making money for four or five years by then...

Anyway, there are many things I like about the Bridgeway Funds (including their rule that the CEO can't be paid more than 7 times as much as their lowest-paid full-time worker - compared to the more typical corporation where the CEO might get 300 or 400 times as much as the average worker), but this post is too long, already.

I do, however, want to point out how much fun it is to look back at the annual returns of their funds, since this report also indicates whether they did better or worse than their primary benchmark (which varies, depending on the fund). Take the Ultra-Small Company Fund, which was the first fund I bought from them, many years ago.

This fund invests in very, very small companies, and it's... unbelievably volatile (it dropped 46% in 2008, which was actually a little better than its category). The first years I owned it, it just blew the lights out. I didn't have much money in it back then, but it was certainly an incredible fund. Then came that crash I've been talking about at the end of the 1990s.

In 2000, the S&P 500 dropped 10% and the NASDAQ, which contained more of those high-flying growth stocks, dropped 39%. The Bridgeway Ultra-Small Company Fund gained almost 5%, beating its benchmark. (Remember how I said that not everything had dropped?)

2001 was a little different, though. Thanks largely to the 9/11 attacks, the overall market was down again, and this time, the Ultra-Small Company Fund did worse than its benchmark index. However, it still went up 34%. Yes, if I remember correctly, the average small-cap value fund was up almost 40% that year. And this is when those growth stocks were still crashing.

In 2002, the Ultra-Small Company Fund again beat its benchmark, with a gain of 4%. But the overall market did very badly that year. For most indexes, it was the worst of three very bad years. So what would you do then? You win the prize if you said, "Buy!" because 2003 was a very good year indeed!

True, my fund failed to outperform its benchmark, but with a gain of almost 89% that year, it's hard to complain much about that!

Note that this fund hasn't done as well recently (although it had a good year last year). But you can't buy it, anyway, since it's closed to new investors. Indeed, even current investors can't add to their holdings, since Bridgeway wants to keep this fund very small. (At the bottom of the market, in early 2009, I was able to put a bit more money into it, but that opportunity didn't last long.)

In fact, that's why I'm mentioning it here. You see, I don't want to give investment advice, even by implication. I'm not qualified to give investment advice, so please don't think that any of this is a suggestion of what you should be doing. I just think this stuff is interesting, so I wanted to talk about it. That's all.

Well, there's lots more I could say, but I think we've all had enough, haven't we? :)

Dow reaches all-time high

(The Maddow Blog)

The Dow Jones industrial average, a stock market metric, has just reached a new all-time high. Good news - for me, certainly, and hopefully for the whole country.

But I think it's kind of funny, too. That first arrow indicates when Barack Obama first took office in 2009. Under George W. Bush, our economy had cratered, ending in the worst economic collapse since the Great Depression.

Only our social safety net, which we largely put in place after the Great Depression and which Republicans have been working hard to dismantle, kept this from being even worse than that earlier collapse. Only the remaining regulations on banks, which Republicans had also been working hard to dismantle, kept our economy afloat.

Well, Obama's stimulus measures helped, too, but that barely offset the wholesale cuts at other levels of government. Overall, we didn't do much government stimulus - not nearly enough - since state and local governments slashed payrolls, making the problem even worse. But, of course, we also bailed out big banks (that started under Bush) and kept our automotive industry from collapse (that was Obama, against the opposition of Republicans).

But this worked. Obama quickly halted the collapse, and ever since, we've been slowly climbing out of that hole Bush dug for us.

The overall economy doesn't look nearly this healthy, though. The stock market is a leading economic indicator, and employment is a lagging indicator. And everything Obama has done has been in the face of fierce resistance from Republicans who see improvement as a political danger.

They were desperate to keep us in recession, so they'd have an easier time defeating Obama in 2012. Well, that failed, though they've caused a lot of misery along the way. And now? Well, they seem to be stuck in opposition. No matter what Obama does - even adopting a Republican health care plan, even nominating a conservative Republican as Secretary of Defense - gets a knee-jerk response of instant opposition.

But there are a couple of things which are particularly funny about this. Before I get to that, though, let me quote from Steve Benen:

To reiterate a point from a few months ago, the New York Times recently found that over the last half-century, the president who's overseen the strongest performance on Wall Street was Bill Clinton, and the second best, by a wide margin, is Barack Obama.

And as we discussed in October, the real fun begins when we reminisce about what Obama's Republican critics were saying in early 2009. Indeed, the Wall Street Journal ran an entire editorial in early March 2009 arguing that the weak Dow Jones was a direct result of investors evaluating "Mr. Obama's agenda and his approach to governance."

Karl Rove and Lou Dobbs made the same case. So did Rush Limbaugh, Sean Hannity, and Fred Barnes. For a short while, it was one of Mitt Romney's favorite talking points, too. Even John Boehner got in on the larger attack.

I don't think a strong stock market is necessarily proof of a robust economy, but the right shouldn't try to have it both ways. If a bear market in 2009 is, in the minds of conservatives, clear proof that Obama's agenda is misguided and dangerous, then soaring Wall Street indexes shouldn't be dismissed by those same detractors as politically irrelevant.

First, I remember those right-wing critics in March, 2009. And I remember thinking that they'd been wrong about everything during the Bush administration. Seriously, I don't think that's an exaggeration. Did they get anything right then? If so, I can't imagine what it might have been.

So I figured it would be smarter to bet on the exact opposite happening, and, for that reason and others, I took every bit of cash I could scrape up (not much, after the Bush years) and invested it in the stock market. See that low point in the chart? Yup, Obama's critics weren't just wrong, they were spectacularly wrong.

The stock market will go down eventually. After all, that's what the stock market does. If you don't expect ups and downs, you have no business investing at all.

And note that the right-wing has been working very hard to make that happen. They've done everything up to deliberately damaging America's credit rating to collapse our economy again. And they will undoubtedly point to any drop as evidence backing up their own position. But just look at that chart.

And the second thing is,... well, you know how the wealthiest people in America have been screaming about Obama? Well, guess who owns almost all of the stock in this country? (Refer to my earlier post, if necessary.)

Yes, the wealthy have been making out like bandits ever since Barack Obama took office. And the wealthier you are, the more stock you own, so those billionaires who've been the most unhappy are the same people who've been doing the best. Do you wonder why their tax bills have gone up? It's because they've been making lots and lots more money!

If you're a schoolteacher, a fireman, a policeman, you might have lost your job in government cutbacks. If you're making almost nothing, your hours might have been cut because greedy CEOs - who enjoy a lavish health insurance benefit themselves - don't want to offer health insurance to you. If you're lucky enough to still have a job, you might be facing drastic cuts in hours and pay because of the sequester.

But if you're rich, you're doing great. If you get most of your income from investments (as I do, admittedly, though I'm far from rich), you've been making money hand over fist, plus you pay a lower tax rate than working people, too! (I'm just embarrassed at how little I pay in income taxes, thanks to tax shelters and low rates on capital gains and dividends.)

The stock market tends to be a leading indicator, which is why so many people lost their jobs in 2009 - after Barack Obama took over - even though the stock market crashed in 2008. Employment generally lags, because companies usually don't want to fire people unless it's necessary, and they really don't want to hire new people until they're sure they'll need them (and can't offshore to cheaper workers overseas).

So this is a good sign for the general economy. However, it's far from determinant. And Republicans in Congress are still trying to throw a monkey wrench into the works. This sequestration is bad for a weak economy, and if Congressional Republicans get crazy enough to shut down the government (again), we could end up right back in a deep recession, before we've even climbed very far out of the last one!

But when you hear the wealthy whine about paying more taxes, and when you hear their Republican stooges echo that complaint, think about that graph, above. Remember who owns most of America and who's been making money hand over fist throughout this administration - indeed, for the past thirty years or more.

Given all that, do you feel a lot of sympathy for millionaires and billionaires? I don't.

Even the pros don't like stocks right now

(INKCINCT Cartoons)

Worried about the stock market? You're not alone. From CNBC:

Wall Street strategists are the most negative they've been on stocks since the bull market began more than three years ago.

The consensus view of U.S. equity strategists from major banks is for investors to allocate just 52 percent of their portfolio to stocks and the rest to fixed income, commodities or cash, according to a Bloomberg survey.

This is the lowest allocation for stocks since the nearly 50 percent level that the survey reached back in March 2009.

Well, we've been hearing a lot of bad news lately, from China to Greece. In America, banks seem to be up to their old tricks, with JP Morgan behaving more like a hedge fund than an FDIC-insured bank. And clearly, Republicans are still determined to sabotage the economic recovery, no matter what it takes.

This is also, typically, a bad time of year for stocks. "Sell in May and go away" is the old adage. And according to this article, the S&P 500 is already near a three-month low. Scary, huh?

But note the last time the pros were this negative - March, 2009. That was one of the best times ever to invest in stocks. I've been worried, but this article actually seems like good news to me. (Note that the pros rarely get too negative, because they make money from other people investing in the market. You have to look at this in relative terms.)

As Warren Buffett says, you have to be greedy when other people are fearful, and fearful when other people are greedy. When no one likes stocks, prices tend to be low and there's a lot of money sitting on the sidelines, available for investment. When everyone loves stocks, prices tend to be high, with little extra money available to push them higher.

Well, I have no idea where the market is going from here - and neither does anyone else. I can't be overly optimistic, but I'm very glad to hear there's this much negativity.

We've been in a bull market since the last time stock market strategists were this negative, just a few weeks after Barack Obama took office. (Just think of how much Wall Street would hate him if they hadn't been making money hand over fist all this time!) Bull markets don't last forever, but this is a very good sign.

I don't give investment advice, and I don't know how I'd advise you if I did. But if you only invest in the stock market when everything looks wonderful, you'll be pretty much guaranteed to pay too much for what you get.

Of course, it's a whole lot easier to go along with the crowd. Then, if you're wrong, you won't be alone. If you lose money, everyone else will be losing money, too. No doubt that's comforting.

My investment plan, pt. 3

This is the conclusion (here are Part 1 and Part 2) and the reason why I wanted to write this investment plan post in the first place.

Even before I retired, I'd been keeping notes on my investments, and afterwards, I've continued, every year or two, to review what has happened and record my current thinking. To me, this is a great learning tool, and I thought it particularly interesting to review at the end of last year.

Our memories are malleable. You may think you remember your worries and your expectations of a few years ago, but your memory is probably not completely accurate. Re-reading what you wrote years ago is likely to make you cringe, but it can be useful.

We have to remember our mistakes if we ever hope to learn from them. And even when you made the right decision, it's helpful to remember how difficult it was, how fearful you might have been, how uncertain you almost certainly were. Well, that's my opinion, anyway.

After I retired, I reorganized my investments - consolidating some of them, rolling over my 401-k and deferred compensation plans into an IRA, and moving my holdings to a fund supermarket. (When I was working, I invested directly with individual mutual fund companies, but retirement meant that I needed a simpler system to move money around.)

So this note was written almost a year and a half from when I retired, but only a year or so from when I got all that settled:

Nov. 1, 2007

So far, so good. The market has done far better than I expected this past year, even including the increasing volatility. I really don't expect this to last (I'm getting increasingly pessimistic), but my net worth has increased by xxx over the past year. Can't beat that! My biggest fund, xxx, has been my top performer, but even xxx has continued to do well. Oakmark Select is the only real dog this year, though I still have faith in the manager (xxx Real Estate has been weak, but that was entirely expected).

[Note that I'm censoring all of the financial details, and even the names of funds which did well for me. But I'll leave the ones which did really poorly, since I don't suppose you'll take that for a recommendation. :) ]

I spent more than xxx in the past 12 months, including taxes. That's considerably more than I'd expected, especially considering there were no big-ticket items this past year. I spent almost xxx on xxx, which had not been budgeted. This might slow down in future years, but it seems that this is an expensive hobby. Considering how well the stock market has done, income taxes (more than xxx) might tend to average less. But I'd rather make more and pay the taxes. Nothing else really stands out, but it feels like I've been spending money like water. It's hard to cut back, when you get away from pinching pennies. We'll see what happens when the stock market turns down.

My financial plan below still looks good, though I'm more concerned these days about the risk of a real meltdown, unexpected or otherwise (black swans, fat tails on the probability distribution, or however you want to put it). Bush has really been a disaster to our country, and it won't get better any time soon. I took my taxable dividends in cash last December, so I've been keeping almost xxx in my Internet savings account (interest rate has dropped to 4.75%). Though the market has gone up, I can't really feel that this was a mistake, and indeed I plan to do the same this year (hoping like crazy that the market stays high that long). Is that timing the market? Or just being prudent? I'm expecting huge mutual fund distributions again this year.

OK, this is exactly as I wrote it, emphasis and all, in 2007 (except where I excised the details, of course). I also added an addendum to my investment plan then, but that's not what I want to talk about here.

I was lucky. The first year and a half after I retired went really, really well. But note that I was already starting to stray from my investment plan, at least a bit. I'd told myself that I wasn't going to try to time the market, but only to take advantage of any irrational behavior.

But I was taking cash out of the market, not because of "irrational exuberance" - although prices had increased considerably - but because of my general pessimism. At least, that's how it seems to me as I read this now.

As it turned out, that was a very good thing. But was it a wise thing to do? I wasn't sure then, and I'm not sure now.

My next note was less than three months later:

Jan 28, 2008

Stocks have dropped considerably (though I suspect there's plenty more to come), so how do I feel about my plan at the start of a bear market? First, it's tough to see my net worth evaporate like this, even though I expected it. It's not easy, and it's never going to be easy. When I was working, I could at least figure that I was buying cheaper stocks during a downturn, but I don't have that consolation now. All I've got is my conviction in my strategy - a thin reed, indeed.

After taking dividends in cash again in December, I'm holding a lot more cash than usual (about xxx, not counting xxx in I-Bonds). The interest rate has dropped to 4.3%. I've still got the vast majority of my money in stock mutual funds, so if the market goes right back up (the least likely scenario, I'd say), then I'll be quite happy. If the market continues to drop, I'll be very glad to have cash (wishing I had more), though it will be difficult to know when to invest it again. And if the market goes sideways, I'll probably make as much income holding cash (though, admittedly, the tax treatment isn't as favorable). Some of America's best money managers hold cash for opportunity purchases, but I'm not sure I'm willing, or able, to give it that much attention. We'll see. So far, taking my dividends in cash hasn't been a bad move. And actually selling funds would really be trying to time the market.

My net worth increased by about xxx in 2007 - not bad, though down considerably from October. But I've dropped another xxx since then, wiping out most of my gains since I retired (though I've paid living expenses out of that, too). My mutual funds are down more than xxx in the past four weeks,... Most of my investments are quite volatile, and they've shown it. And as I say, I suspect we haven't seen the half of it yet.

For now, I'm sticking with my original plan, though I should make a few observations. My 'diversified' portfolio hasn't made the slightest difference, with stocks everywhere crashing at once (as I should have expected). And my hedges were far too small to have any impact. (Note, too, that Morningstar's Risk Analyzer is completely bogus. Just before this, it was showing a gain as my 25% risk chance in a down market.)

Going forward, I should feel more comfortable holding cash. You just never know. But I'd like to put more money in xxx, in particular, and really, nearly all of my funds still have my full confidence. Over the long term, I'm sure they'll do better than average. Nevertheless, I'm expecting this year to be bleak, indeed.

Heh, heh. I hadn't seen anything yet. The year was going to be far, far bleaker than I expected!

But I did expect that this was just the start of a bear market, and I was prepared for further losses (just, maybe, not such big losses). I was glad to be holding extra cash, and I was beginning to consider that as a deliberate policy.

But note the problem with timing the market, that you have to be right twice, once when you sell and then when you buy back in again. And if you're selling in a taxable account, you'll probably have to pay taxes on your gains (certainly if you're buying low and selling high). So you have to be very right to make it all worthwhile.

If I thought January was bad, how about October?

Oct 12, 2008

OK, things have become REALLY nasty. I've lost massive amounts of money - more than I made in most years - in each of the past two weeks. My portfolio has dropped to xxx, which means that I've lost nearly xxx,... so far. Except for xxx, which has been almost fully hedged, my mutual funds have lost between 21% and 55% YTD. Quicken shows a -38% average! And that doesn't include what I lost at the end of last year!

As I noted in January, everything has dropped at once. Value funds have been particularly bad this time, since banks are failing. (Washington Mutual, among others, went completely bankrupt, and 15% of Oakmark Select was in that stock, at one time.) xxx was a nice hedge (it's down only 4% YTD), but I didn't have enough in that fund to matter much. And xxx has done what it was supposed to,... but it's still down 21% YTD. My extra cash is the only thing that's saved me.

So,... now what? This has been worse than even I expected, and I have no idea how much longer the market will drop. The whole financial system is melting down, and there's panic everywhere. Well, I can understand that. But it's time to start buying more, I think. I'm transferring xxx to xxx, and I'll try to do that a couple more times over the next few months. (But I've got to live on something, so I'd better not be too eager.)

It's also a good time to move funds around, since I don't have to worry about taxable gains! Actually, I'm still happy enough with my selection of funds, though some have performed much worse than the market lately. But I think it makes sense to concentrate my picks. Spreading my investments around too much will tend to give me average performance, and I'd like to beat that. Of course, as we've seen this year, I will be risking underperformance, too. But I can't think that my managers have lost their abilities, even if they've made some big mistakes this year.

Bottom line: as bad as things look, companies are cheaper now than they've been in years. True, the near future looks horrible, and prices may continue to drop (and companies even go bankrupt), but that's why the prices are low. And at this point, what choice do I have?

PS. Note that deflation might be more likely than inflation right now. Yeah, energy prices are still very high (though much less than they were), but we're looking at a severe recession, if not a depression. And also note that my foreign holdings have crashed even worse than the domestic stuff, though they've both been disasters.

This was shortly after Lehman Brothers went bankrupt, and everyone seemed to be panicking (for good reason, no doubt). As I noted above, for two weeks in a row, I'd lost more money in the stock market than I'd made in most years. I'd known my portfolio was risky, but still, that was a shock.

But still, as Warren Buffett has said, be fearful when others are greedy, and be greedy when others are fearful. I had absolutely no idea if the stock market would keep falling, but with most people trying to sell, the price of stock looked cheap to me.

And I had my plan. I had enough in cash and other secure holdings to live for several years, at least. I was lucky enough to have some additional cash, and if I wasn't going to invest it then, when would I? Well, it sounds reasonable now, but it's harder when there's blood in the streets.

Mar 31, 2009

As planned, I transferred xxx on Oct 13, 2008, and another xxx ten days later, as the market continued to crash. I also sold three funds ... to concentrate on my favorite picks. (Note that all three funds had some taxable gains, but I expected to pay no taxes on long-term gains in 2008.)

I added to my holdings in xxx, but I put the bulk of the money into Fairholme, making it one of my largest funds. [Fairholme has been a disaster this past year, so I don't have to censor that one, I think!] It had done quite well YTD and over the long haul, and I didn't want to get too concentrated in my top holdings. In my roll-over IRA, I sold xxx (my holdings were too small to matter much), and added to xxx. Again, just concentrating my picks.

Without trying to "time" the market, I rather thought that things were oversold, and I expected that forced selling might abate at the end of the year. Well, the market turned around almost immediately and had a solid advance by the first of January. (Barack Obama was elected president, too, which probably helped.) In November and December, I took my dividends (no removing cash this year!) and another xxx in cash (getting mighty low now) and added to my holdings in xxx.

[Sorry, but my notes are full of details of individual funds - so I could remember exactly what I was doing - and I really don't want to share that. So I'm cutting a lot here.]

No big surprise, but the market turned south again almost immediately at the start of the year (so much for my idea about forced selling) and dropped back to the October lows - or even lower - by early March. I was really running short of cash, but I took the last of it and bought more of xxx. (This means that I'll have to sell [some of my emergency stash] to live on this year, since my bank accounts are completely depleted.)  I also sold xxx, my most conservative fund and one which has weathered the crash better than anything but xxx, in all of my accounts, and bought more xxx. I like the balanced fund, but I figured it was time to be really aggressive.

I made my last purchase March 9, and the market has boomed in the three weeks since then - up more than 20% (it had dropped more than 25% in the first two months of the year - this is a volatile market). It could easily be a bear market rally, of course, just like at the end of 2008. I hope not, but it wouldn't surprise me one bit. I can't ever hope to time the market in the short run. I doubt if anyone can, not reliably. And really, I've done surprisingly well (relatively-speaking) the last few months, generally buying at the very bottom. I've got no cash left at all, just xxx. That's about xxx years worth of living expenses (I'm cutting my spending to the bone), but it's probably not wise to invest any more money in stocks. Since I'm happy enough with what I've got (though Fairholme has done rather poorly since I bought more - just reverting to the mean, no doubt), I'll simply be sitting tight and seeing what happens now.

Currently, my biggest holdings (top down, 11% to 8% of my portfolio) are xxx. So I'm positioned VERY aggressively right now, even more than I have been. And I'm much more concentrated, with 64% of my portfolio in just these seven funds. We'll see.

I expect that the incredible volatility will continue this year, and we might even set new lows, but I think that the worst is behind us. I don't expect much, though - certainly not a quick recovery. But I should be able to live for about xxx years without taking anything out of the market, and I really do expect to be in better shape by then. The near-term danger is the backlash against "bailouts" and deficit spending. Well, most people are economic illiterates, if not [oh, that really wasn't a nice thing to say!].

I cut a lot of this, but I hope it gets the general idea across. I continued to buy as the market (for the most part) dropped, until I reached the point where I had nothing left to invest. I still had my emergency stash, of course. I expected that I could still survive until the market recovered, but I was about as aggressive as I could possibly get.

I had no idea that early March would be the market bottom, and certainly not that the market would scream upwards from there. That was pure luck. I was simply positioning myself more and more aggressively as stocks got cheaper and cheaper. If you're going to buy low and sell high, you've got to buy when no one else wants stocks.

Yet, it's easy to forget now (I think all Republicans have forgotten it), but when Barack Obama took office, the economic collapse seemed to have no bottom. And the stock market collapse, likewise. There was no telling just how far we'd drop or how bad things would get. It's not easy to buy at a time like that.

I'm not trying to pat myself on the back here, but just to point out that I was following my investment plan. And I had enough confidence in that plan to continue to follow it, even when things looked bleak. Maybe that was foolish. I mean, yes, it worked this time, but will it work the next time? There's just no way to know.

I was lucky. I was very, very lucky. I can't count on that luck the next time. So what I really need to ask myself is if my investment plan still makes sense. That's always what I need to ask myself, year after year. I can never stop asking it.

It was almost two years before I added another note (well, I did say that I was bad at consistency), and that was just recently:

Dec 31, 2011

OK, it's been a long time since I updated this. Briefly, my previous investments, in October, 2008 and March, 2009, were among the best investment decisions I've ever made. March was the absolute bottom of the market crash. At that point, my net worth had dropped in half. Well, I've always known I was taking a risk. But within a year and a half, I'd made it all back up and then some. It's been a wild ride!

I've been much less successful this year, so I've dropped back nearly to the net worth I had when I retired five and a half years ago. (Considering everything, that's not so bad, though.) The S&P 500 ended the year about even, but my holdings have done far worse than that. Partly, that's because I'm well-diversified globally, and international stocks have recently done much worse than American companies. And partly, it's because I'm still heavily overweight in small-cap - and especially micro-cap - stocks, mostly the result of xxx being so astoundingly successful for years.

But my biggest problem was owning so much of the Fairholme Fund, which really blew up this year. It ended the year down 32%, far and away my worst performing mutual fund. And it was one of my biggest holdings, too. Adding money to that in 2008 seems to have been a big mistake (admittedly, it did well until 2011). Well, that's nothing new. I'm used to making big mistakes. In fact, I've come to expect it. I seem to do OK anyway, or I have so far. One of the problems with concentrating my holdings is that when one blows up, it really, really hurts. Of course, when one does well, it makes a big difference, too. That's the same trade-off I accept when I invest in volatile funds. They tend to go down even faster than they go up - just, hopefully, not as often.

The combination - concentrated investing in volatile funds - requires an iron stomach. But, so far, I don't see any reason to change my investment plan significantly. I would never recommend it to anyone else, but it seems to work for me. On the other hand, my holdings are even more volatile now than they were when I retired. I took on more risk at the bottom of the stock market crash, and I still haven't managed to revisit that.

Going forward, I'm very pessimistic. I have no idea what the stock market is going to do, but I'm pessimistic for my nation. We don't seem to have learned anything from the mistakes of the Bush administration. But I have no idea what that means for my investments. I can't be optimistic, but I'm going to stick to my plan. In general, I think that stocks are relatively cheap right now, but not screaming buys. Given that Republicans are deliberately trying to sabotage our economy for their own political advantage, we could see another huge collapse in 2012. There is that risk. So holding a little extra cash might be prudent.

But interest rates are at record lows, so cash is making nothing right now. And bonds would seem to be extremely risky. Everyone is scared of the volatility in the stock market, so they're buying Treasuries like crazy. Following the herd is almost always a recipe for disaster. But I'm not sure if anything looks really cheap, either. Maybe I'll punt.

So that's it. As usual, I don't have a clue what's going to happen next. I don't see any especially good places to invest, but bonds and cash are paying nothing. I couldn't give you any advice if I wanted to, because I just don't know.

But what I do know is that following an investment plan has worked for me, so far. And being able to go back and read my notes (I've got notes from further back than this, and I keep excerpts from what other people are saying, too) has been very interesting - to me, at least - and valuable, too, I think.

My investment plan, pt. 2

As I noted in Part 1, I wrote down a detailed investment plan before quitting my job at age 55. Well, I've known a lot of people who retired early and ended up looking for work again remarkably soon.

Sometimes, that was because they were bored with retirement. (Honestly, I can't understand that at all. Retiring early was one of the best moves I've ever made, and I seem to be busier now than before I retired. But people are different.)

For most, though, it was because they'd ended up in financial difficulties - often enough, in just a year or two. And so they went back to work, but in jobs that paid a lot less than the one they'd just quit. I didn't want that to happen to me!

But I'm wary of sharing the details of my own investment plan, because I don't want to give you financial advice, even by implication. For one thing, I'm not qualified to give you such advice. And if you're in the habit of taking investment advice from your neighbor or some random guy on the internet,... well, good luck with that!

Besides, I wouldn't recommend my own plan to anyone else. I'm certain that no reputable financial adviser would recommend it to anyone! After five and a half years, I'm still convinced that it works for me. But my situation is not yours.

Let me just leave it at that. I'm a very private person, and although I'm sure I end up sharing far too many personal details in this blog, I'm not actually comfortable with that.

But let me just say that I'm not wealthy. I could only retire at all because my expenses are low. But I was looking at years without Social Security or Medicare (indeed, retiring early will drop my eventual Social Security payments drastically), and certainly no pension. So it was a pretty significant step to quit my job and decide to live on my investments.

Now, I didn't actually expect the worst economic collapse since the Great Depression. You have to expect bear markets, but frankly, the reality exceeded my worst projections. Given all that, I can't be too unhappy at the results. I'm just slightly ahead of where I was when I retired, but that's after paying all of my living expenses for almost six years. Therefore,... so far, so good.

My written goal on my financial plan was very simple: "To survive without depleting my savings." (Remember, I said that my plan was far simpler than yours would need to be.)  My expectation: "That I can live on my earnings while growing my financial assets (after inflation)."

What I needed to know first was the amount of money I would need for living expenses each year, on average. Well, I've kept my financial records on Quicken for many years (and I've avoided paying cash, wherever possible, so I could tell where my money went).

It was easy enough to average my expenditures over the previous decade, even adding a little extra for inflation, but I needed to look into it a bit deeper than that. For one thing, I could subtract from that the amount I was adding to my investments each month, and I could subtract most of the amount I paid on income taxes, too. (If I did better than expected, paying extra taxes would not be a problem!)

My health insurance costs would increase dramatically, though. And I had to expect occasional big expenditures on home repair and car purchases. I thought I was being very conservative, but I've actually been spending more than I expected. However, I wasn't too far off, I guess.

From Quicken, I knew my net worth, of course. My house isn't a big part of that, but it still needed to be subtracted from the equation. (I wasn't going to get a mortgage just to invest that amount in the stock market.) But I was left with a very rough idea of what percentage return I would need, on average, just to survive.

As you might imagine, it wasn't that simple. First, in order to survive for long, that percentage return needed to be after inflation. When you're working, you can usually count on your pay increasing every year, to at least cover inflation, So it's easy to overlook that. But once you were retired for ten or twenty years, you'd probably be shocked at how inflation adds up. (I'm shocked already at the increased cost of food and health insurance.)

And all these were just averages, too. This past year, I've had some major home expenses. With any luck, it will be a few years before something like that happens again, but I still had to pay them now. And that money is no longer available for investments.

The stock market, of course, is notoriously volatile. That was obvious even before the recent crash. Volatility isn't a problem, unless you need to sell before the market recovers again. And that could take years. On the other hand, if you avoid volatile investments, you'll be lucky to even match the inflation rate (very lucky, right now), let alone make something above that.

My point is that there's a lot to think about. And you cannot reliably predict the future. No one can. As I said, I don't want to tell you the details of my own solution (really, I'm not giving investment advice here), but I will say that it's mostly stock investments (in mutual funds, for reasons I noted previously), with a large emergency stash, so I don't have to sell when those investments are down.

Anyway, after I set out my requirements in that investment plan, and looked at the risks, I decided how I wanted to apportion my money - how much I needed to keep in cash, for immediate expenses; how much I needed for an emergency stash, and where I'd keep it; how much I needed in more conservative investments, in case even that emergency stash wasn't enough; and how much I could truly think of as entirely a long-term investment.

In my case, the vast majority of it was in the latter category. Well, it had to be that way. I really didn't have any choice, because you pretty well need to accept volatility in order to get a return that's above inflation. Again, that's just an average return, and it might be a very long-term average, too. It doesn't help much if the stock market recovers after you've already gone bankrupt.

On the other hand, if you keep too much in "safe" investments, you won't make anything. Indeed, you'll probably lose money, after inflation.

Younger people, working people, don't have to worry about this. (I know, they have other things to worry about.) If the market crashes, they'll just be buying stock at a much cheaper price. Indeed, for a young person with a secure job, a stock market crash might be the best thing to happen. (But note that "secure job" part again.) When the stock market drops, that's when you want to put more into it. (Unfortunately, that's just when it's the hardest to do.)

But if you don't have a job, you won't have that income to be buying cheap stock during crashes. And sorry, but I don't think that anyone can reliably predict the direction of the stock market. Some people do get lucky, true. If you have a roomful of monkeys throwing darts at stock listings, a few of them, just by the laws of statistics, are going to look like investing geniuses. But they probably won't do so well the next time they throw those darts!

On the other hand, it's not impossible to recognize the extremes of either irrational exuberance or panic. It's just likely to be very, very hard to act as a contrarian at such times. When everyone you know is talking about how much money they're making from tech stocks, can you avoid the temptation to jump in, yourself?

What if it continues for two or three years, with everyone but you making money? How will you feel then? As... someone said, the market can stay irrational for longer than you can stay solvent.

When the whole country is panicking and there seems to be no bottom to the stock market crash, can you decide that stocks are just too cheap to pass up? Even knowing that they'll likely get cheaper, because you have no idea where the bottom is, either? "Buy cheap and sell high" is a nice slogan, but investors usually do just the reverse.

There's a good reason for that. It's hard to be a contrarian. And contrarians are often wrong. In fact, they're almost always wrong, at least at first. So how long can you stand to be "wrong" before deciding that, yes, you really were wrong? As it turns out, most people are contrarians right up until the worst possible time to change their mind.

And no, I'm not going to tell you what an investment genius I am. I'm just as human as everyone else. When everyone else gets afraid, so do I. When everyone else is irrationally exuberant, I feel great about my investments, too. It feels good to make money and it feels bad to lose it. It doesn't make any difference how much of a contrarian you want to be, you'll still feel those emotions.


Sorry, I get carried away. This post has not gone where I expected it to go. I thought I'd write more about my actual plan - if not the details, then at least some of the general advice I gave myself (like "Diversify - but remain skeptical of the latest fad"). But those things look more like obvious platitudes, now.

I thought maybe I'd talk about different risks - volatility (or market risk), inflation, deflation, recession, stagflation, terrorism - and my predictions of what they'd mean to different kinds of investments. There are risks in everything. Even government-secured investments have a great deal of risk (inflation risk, in their case). If something looks risk-free, think again. You can't eliminate risk, but you can try to manage it.

But much of that gets into the details of my plan - how I planned to manage those risks, as much as possible. And the details are just what I don't want to give. Seriously, my investment plan won't work for you. It might not even work for me, not for long. I just don't know. But I do know that I'm not qualified to give advice.

Yeah, this probably wasn't what you expected. Heck, even I'm bored by it.  :)   But I think you might enjoy Part 3 a little more. I'm going to look back at what I wrote in my notes, every year or two, and see how things actually turned out during the past five and a half years.

Well, it's been a wild ride, so you might find it interesting. I hope so.

___
Note: Here's Part 3.

My investment plan

The beginning of a new year - actually, the end of an old year - is a good time to review your financial plan. You do have a financial plan, right?

Of course you do! Sorry, I guess I lost my head there for a moment.

Well, my financial plan is a lot simpler than yours, I'm sure. I own my own house, I have no dependents, I don't need to finance an education (my own or anyone else's), and I don't even have to worry about losing my job, since I don't have one.

I do need insurance, of course, to guard against any (hopefully, rare) catastrophic events. But other than that, my financial plan is basically an investment plan. So that's what I'm going to talk about,... assuming that any readers are still with me at this point.

I didn't have a detailed investment plan until I started planning to retire - I mean, seriously thinking of quitting my job. My goal was always to retire when I turned 55 - that was about five and a half years ago - but I wanted to be absolutely sure before handing in my resignation.

But honestly, a written plan would have made a lot of sense long before then. I see that now. A written plan, especially in a computer file, so you can easily review and revise it as time goes by (and keep track of those revisions), would have been really valuable earlier in my life. Oh, well. That's not the only mistake I've ever made!

I actually started investing in the stock market - in stocks - in the late 1970s, if I remember correctly. I had a full-service broker, which was mostly all there were back then (Charles Schwab began in 1975, but I didn't know that), and costs were very high, especially for a small investor like me.

My idea at the time was that, since I had little money to invest, I needed to make a killing. Otherwise, any kind of tame return wouldn't make any difference to my life at all. Well, that was the first of my investment mistakes, though far from the last.

I did very well at first. I was enthusiastic, and I regularly spent some time at the public library doing research. (These days, you can do that from the computer, but back then, it required a trip to the reference department to look through paper documents.)

So at first, I did great. Maybe that was just luck, maybe not. But I have a lot of interests, and my enthusiasms tend to come and go. When I stopped paying a lot of attention, and just started listening to my broker, I lost money like crazy.

I spent years like this. I'd get enthusiastic again, and start doing my own research, and I'd do well. Oh, the stock market would still go up and down, but I'd make money over time. But inevitably, something else would catch my attention, I'd stop paying attention to my stocks, and I'd lose big-time. After ten years, I had relatively little to show for my efforts.

That was my first, and maybe my most important lesson: know yourself.  I find everything interesting, and I don't stick with anything for long. Frankly, it's been remarkable that I've stuck with this blog for almost two years now. You may be different, but if I was going to invest, I needed an investment that could run on autopilot when necessary.

So, about 1990, I started investing in no-load mutual funds. Mutual funds have some disadvantages, but they had some big advantages for me. (Please don't get the idea that I'm offering advice here, except the very basic idea of having a written plan in the first place - which, actually, I haven't really gotten to yet.)

Mutual funds probably weren't any easier to select than stocks, and it was at least as hard to know when to sell them, but I didn't have to watch them very closely. It was useful to check on them once a year or so, and to rebalance my holdings occasionally, but I didn't have to pay close attention. I still did, often enough. But there were other times when I got involved with other interests. (That's still the case.)

And I didn't need a broker to buy no-load mutual funds. I could buy them directly from the fund company with no sales charge. That was nice. Even better was that I could start investing with a ridiculously low amount of money.

At first, I started investing in funds which would waive their normal investment minimum if you set up an automatic investment of $50 a month. Yup, just $50 a month. Clearly, I was no Warren Buffett. :)

At $50 a month, it takes a long time to get anywhere. But in investing, time works for you (just the reverse of borrowing money, I'll point out). And I added to my holdings, sometimes adding new mutual funds, as my income increased.

I made a lot of mistakes. Well, they weren't always my mistakes. Sometimes, a mutual fund just wouldn't do what it claimed it was doing. Mutual funds, too, have investment plans. And I did a lot of research trying to find funds with an investing philosophy that seemed to make sense. Sometimes, I was wrong. But often enough, a fund wouldn't actually follow its own plan.

Well, that's how it seemed to me, anyway. And in those cases, I'm not sure if you can call it my mistake. That's something I've learned from my investment plan, too. Sometimes, you can do all the right things and still lose money. Of course, I did plenty of wrong things, myself, over the years. You have to expect that.

Today, I don't own any of those early funds I bought. In some cases, I sold them because I realized I'd made a mistake (and occasionally, it was probably a mistake to sell them). In other cases, I sold them for tax purposes. Investing in mutual funds doesn't get quite the favorable tax treatment as investing directly in stocks, but it's still far, far more favorable than if you actually have to work for a living.

Back then, of course, I did work for a living. And I used that income to invest in mutual funds. And I kept it up for years. That's where my first investment lesson really paid off. You don't actually have to make a killing in the stock market, because your earnings compound over time. You just have to have patience.

At first, especially when I was just investing $50 a month, it seemed like I might just as well blow it on lottery tickets. (No, I was never actually that dumb, not really.) But after awhile, things change. After awhile, you realize that you've started to accumulate a little nest egg.

I remember the first time I made more in my existing investments than I'd added to them during the year. That was a real milestone! Much later, there came a year when I made more on my investments than I'd made from my job. That was another memorable milestone. And it all started with just $50 a month.

OK, this is getting too long, and I haven't even made it past the introduction. Heh, heh. I'd planned to make this a two-part post, but I think it might have to be a three-part post, instead.

I suspect that most of you are horribly bored by this, if you've made it this far, but I'm enjoying the look back, myself. And that's what matters here. :)

But if you have any questions, please ask them in the comments. It might be something I'll get to in parts 2 and 3 (coming up soon, I hope), or it might be something I'm not qualified to answer. But there's a lot to this subject, much more than I'll be able to post here.

___
Note: Here's Part 2.

A tax on dumb people

(Saturday Morning Breakfast Cereal)

As the title of this post shows, I tend to consider lottery tickets as a tax on dumb people (kind of like cigarette taxes, actually). Perhaps it would be less insulting to say "a tax on people who can't do math."

Now, I see nothing wrong in buying an occasional lottery ticket. But I've never bought one myself, simply because I don't want to identify myself as a "dumb person." Nebraska thinks I'm actually dumb enough to buy a lottery ticket? With these odds? They have a pretty low opinion of my intelligence, don't they?

Well, this is why I don't gamble in casinos, either. Gamble when the odds are against me? How dumb do they think I am? Even if I won, I'd know that it was a dumb thing to do.

I do gamble in the stock market, although I call it "investing." Maybe that's dumb, too, but I do it because I think the odds are in my favor. In the long run, over time, the stock market does go up. True, that may change in the future, but I'm just playing the odds here.

When I started investing, I was putting as little as $25 a month into it - less than what some people spend on lottery tickets. I've made some huge mistakes - some my fault, but some not so much - but overall, things have turned out pretty well.

Maybe I haven't won the lottery,... but then, neither have you. :)

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Anxiously awaiting the next bubble

Ed Stein's commentary:

Financial reform actually passed. Another victory for Obama, despite the furious objection of the other party and their Wall Street masters. Much too late, of course, and not strong enough, but at least they’re turning the Titanic slowly away from the deregulatory daze that got us into this mess in the first place. That’s little solace to those of us who have watched our investments dwindle. We could use a little old-fashioned irrational exuberance. Where’s the next bubble going to come from if Wall Street is held accountable? I’m going to have to go back to making money the old-fashioned way, by working for it. And I don’t like it one bit. Let’s have one more round of insanely inflated stock prices. This time I’ll get out when I have enough to retire, and I won’t care when the inevitable bust comes. Then you can regulate all you want. Sound like a plan?

Heh, heh. I thought this was funny, because I'll bet there are a lot of people with the same idea. But irrational exuberance doesn't work that way. When the next bubble comes along, more people will be getting in at the top than will be getting out. That's just the way it works.

Of course, you don't have to be one of them. But tell me, in March of last year, when pretty much no one was optimistic, were you scrambling to put as much cash into the market as you could? That's when you need to invest, you know, when the sky is falling. But it's not easy. And you can't expect to time the market exactly. It's quite likely that you'll invest and then see the market continue to fall. Do you have the courage to accept that?

When Lehman Brothers collapsed in the fall of 2008, panic struck the stock market. Stock prices seemed to be in free fall. But following Warren Buffett's dictum to be greedy when others are fearful, I was a buyer. Prices rose again almost immediately, but in a few months, the market tanked, going even lower for awhile. Again, we were in panic mode, and again, I tried to scrape up some cash for more investments.

I was lucky. There were good reasons to be fearful (there always are), and the market could have continued to drop. Heck, we could easily test those lows again, since we may well be dropping back into recession (not enough stimulus spending and the deliberate attempt of Republicans to sabotage our economy for political purposes). My point is that it's not easy going against the crowd. Good investors make their money when everything seems to be going to hell (and through patient accumulation the rest of the time).

Bad investors, on the other hand, cash out at the bottom and then jump back in when everyone is talking about the easy money to be made in the stock market. Well, they don't call it irrational exuberance for nothing. It's when prices go up - and up and up - that you should start to get worried. But again, that's not how it works.

"This time, yes, give me a bubble and I'll get out at the top." But you probably won't. For one thing, it's seldom easy to tell that we're in a bubble, not ahead of time (hindsight is always 20/20). For another, irrational exuberance can go on for a long, long time. What if you get out and the market continues up for another year, or two? And for a third, seriously, no one can reliably predict such things. Getting out of the market at the top of a bubble is probably not anything you should even attempt.

Don't take financial advice from me. I'm nobody, and I've certainly made my share of mistakes. But here's how I do it. As a general rule, I stay diversified and fully invested (except for an emergency cash reserve). I don't think that anyone can reliably time the market, not in ordinary circumstances. After all, you're competing against the wisdom of crowds.

People are always buying and selling, so no matter what happens, some people will always get it right. But you can't predict that ahead of time. If monkeys were throwing darts to make investment decisions, you'd see the exact same thing. Some of them would look like great investors, at least in the short term. It's simply a product of statistics.

But in times of widespread panic - and also in times of irrational exuberance - the wisdom of crowds breaks down. Crowds turn into mobs. You lose diversity of thought. You lose independence. People tend to follow the mob, because of either fear or greed. You need to take advantage of these occasions, at least to some extent. When it looks like a bubble, I try to take some cash out of the market. I never get out completely. After all, I could be wrong. And I'd have to pay taxes, which means that I'd lose some of my return right off the bat. But when times are really good, it never hurts to accumulate a bit of cash. (The market may continue to rise, sure, but you probably won't make the big money from that point on.)

For the rest of it, I try to underweight what's really been booming and overweight what has lagged the market. During the tech stock mania at the end of the 1990's, I took some profits in the tech sector and invested in small-cap value stocks, which had been lagging badly. When the tech bubble collapsed, small-cap value stocks rose strongly, at least the first year. There were several bad years then, but they were far, far worse for tech stocks than for other parts of the market.

One of the problems with timing the market is that you have to be right twice. You have to get out of the market at the right time, and then you have to get back in the market at the right time. Neither of these are easy, not at all. If the market goes down, you might be tempted to buy again. And you might be right. Or it might be the very beginning of a terrible bear market. It's just really hard - nay, impossible - to tell. But when you need to buy again is when panic strikes. If everyone is running for the hills, that's the time you can find some real buys.

Of course, you have to have the cash in order to buy. One of the problems at market bottoms is that cash can be hard to come by. If you've taken some cash out of the market during the bubble (and resisted the urge to reinvest at the first sign of weakness), that will help. But when times are bad, your job may not be secure. You might just need that cash. None of this is easy. Do not expect to get it perfectly right, and do expect for things to go horribly wrong sometimes. (Note that I recommend keeping an emergency cash reserve at all times. How much depends on your own circumstances, but the volatility of the stock market will hurt you badly if you're forced to sell at a low point.)

This is more than you wanted to hear, no doubt. If you're still with me, are you looking for my current forecast? Frankly, I have no idea. I'm not optimistic, not in today's political climate. As a people, we're apparently not smart enough to learn from experience. We learned during the Great Depression that government stimulus was the best answer to an economic collapse. Since private demand evaporates, with people either losing their jobs or worried about the future (and therefore saving what money they have), government must temporarily step in. This gets people working again, and money going to low and middle income people will get spent, which doubles and triples the effect. (Extra money for the wealthy is almost useless, since they won't spend much of it.)

But Republicans see a political advantage in keeping us in recession. The average voter isn't too bright, and we tend to blame the party in power for bad times. Of course, these bad times were caused by Republican policies, not by Barack Obama. And the deficit - which the Tea Party movement supposedly abhors - is the result of actions taken during the Bush administration: tax cuts for the rich (which were supposed to pay for themselves with a "trickle-down" effect, but didn't), two unnecessary wars (fought on credit, since they were also supposed to "pay for themselves" - needless to say, this was just fantasy, too), the economic collapse itself (due to their mania for deregulation and the bubbles created by those tax cuts for the rich), and the interest payments for all this.

The GOP isn't even bothering to change policies. They're pushing the exact same policies that were proven failures during the Bush years. Hard to believe, isn't it? What's even harder to believe is that we seem to be dumb enough to buy it! I don't care how hard Fox "News" pushes this stuff, it's still incredible. How can we be this dumb? Or is it more a matter of cowardice? We Americans seem to have become hopeless cowards in recent years. Is fear simply making us irrational?

At any rate, I'm not optimistic right now, not at all. But I certainly don't see irrational exuberance in the market, either. For the most part, I'm hearing doom and gloom, and that tends to be a positive indicator. The stock market always "climbs a wall of worry." If people are worried, they don't create bubbles. But that's not to say that they're wrong to worry, either.

In times like these - which is pretty much the normal state of affairs for the stock market - I'm quite willing to admit that I have no idea. Whatever happens, I'll ride it out. Stocks are volatile. I know that, and I'm prepared for it (or I think I am). At the moment, I can't see any part of the market that seems exceptionally cheap, so I don't intend to move things around, either.

Deflation or even a double-dip recession would be bad for stocks but good for long-term government bonds. But bond yields are already so low that it's hardly worth the bet. Inflation (which appears less likely to me) would be bad for bonds, but possibly good for stocks, at least in moderation. Stagnation would be good for no one. But in the short-term, at least, I just don't know.

In the long-term, things don't look good if we don't wise up. Here in America, we've been on the wrong path for decades now. Since the 1970's, we've been ignoring the energy crisis. We've stuck our heads in the sand in regards to global warming (and we'll have to pay for that, eventually). We've let the rich get richer and the poor get poorer. The average worker was better off in the late 1970's than he is today - actually, than he was even before this economic collapse.

We no longer lead the world in education, and we're becoming virulently anti-immigrant (odd for a nation of immigrants, isn't it?). We've stopped creating anything but arcane financial instruments - which have just been shown to be mostly a scam. And the Supreme Court has decided (5 to 4, as usual) that multinational corporations are people, too. If you're extremely wealthy, you're probably happy as a lark. But how long can that last if America slowly disintegrates into bigotry, fear, and superstition?

Yes, I'm pessimistic. But frankly, long-term pessimism doesn't make sense. Pessimistic people never accomplished anything. America used to have that can-do spirit, that sense of optimism that often seemed crazy to other people. How could we be optimistic when the future looked so black? But optimism is necessary for change. No matter how bleak things might seem, we can't lose that. And there is a lot of good in America yet. Turn off Fox "News." Ignore the Tea Party. And kick yourself in the butt, if necessary, to lose that apathy. Vote, damn it! The future is ours to make. So let's make sure that it's a good one.

A wild ride

(Ed Stein)

If you think the ride is wild now, just wait until the GOP succeeds in privatizing Social Security! It's funny how you don't hear them talk about that much these days, not since the market crash. But it will be back soon enough, re-branded by their spin-doctors (since "privatize" doesn't poll well).

Skepticism - science, politics, investing

In my previous post, I stated my strong conviction that it's important to know why we believe what we do, and to recognize what evidence we'd need to convince us that we're wrong. I think about this a great deal, because I know I'm not infallible. I can be wrong. And so I try to examine my firmest beliefs most skeptically, so that I'm clear in my own mind why I still think they're correct.

One book which has been a big help with this is Thomas Gilovich's How We Know What Isn't So: The Fallibility of Human Reason in Everyday Life (1991). Although he shows examples, this isn't about what we know that isn't so, but about how and why we think so. He compares these "cognitive illusions" to optical illusions. Just as optical illusions don't mean that our eyesight is poor, cognitive illusions don't mean that we're stupid. They're just a natural consequence of how our brains are put together. And we are all subject to these kinds of errors.

To a great extent, the scientific method has been developed to compensate for those natural human tendencies. Individual scientists are still human and still prone to such errors (not to mention normal human lapses in ethics and judgment). The scientific method does not stop that (though it does help to minimize the problem). No, instead it's a collaborative effort, always building on previous research, designed so that the majority will weed out errors and determine the truth.

It's not perfect, no doubt, but the scientific method is easily the best way we've ever discovered of separating the truth from wishful thinking. The scientific consensus may be wrong, but that's never the smart way to bet. I'm not a scientist, myself. So, on every scientific issue, I accept - tentatively, as all science is tentative - the consensus of scientists who specialize in that particular field.

Global warming, evolution, the effect of vaccines, the age of the Earth, homeopathy - all of these are questions of science, and all are best answered by scientists following the scientific method. Therefore, I accept the scientific consensus on all of them. (Really, with these issues, it's not even close. The consensus is overwhelming.)

It's harder with political issues, at least when those issues aren't scientific in nature. After all, we all tend to agree with "our side" in such things, and it's very easy to dismiss arguments by our opponents. But our society is based on the marketplace of ideas, that the majority will ultimately pick the best ideas if we can hear and debate them all. Freedom of speech, freedom of the press, freedom of religion - all are part of that.

As a skeptic, I try very hard to listen to what my political opponents have to say. After all, rational conservatives and rational liberals both have valid points to make. And they're not always - or even usually - diametrically in opposition. Often, it's just a matter of priorities, of disagreement on which of two valid points is most important. And compromise can often take both points of view into account, with neither side getting everything they wanted, perhaps, but both seeing progress.

That's why the Republican Party infuriates me so much these days. Currently, the GOP seems to be all about political tactics, and not about policies or issues at all. They've become the party of the end justifies the means. The "end" is simply political power. And since lying has been a very effective political tactic for them, they lie. Repeatedly.

These days, the GOP refuses to bring anything to the marketplace of ideas - either because they don't have any ideas (or none that weren't thoroughly discredited during the Bush years), or because they're not confident they can win a fair debate. And winning, of course, is everything, so they do whatever it takes to win. It's always about tactics. It's always about strategy. It's never about what's right.

In the marketplace of ideas, you're allowed your own opinions, but not your own facts. If you just invent "facts" to push your argument, that's not just cheating, it completely negates the value of the marketplace. It becomes all about propaganda, and nothing about real ideas.

I suppose this is the influence of Fox "News." As David Frum said recently, "Republicans originally thought that Fox worked for us, and now we're discovering that we work for Fox." Fox News used to support the Republican Party. Now, however, the Republican Party seems to exist to support Fox. Certainly, no Republican politician dares to buck them.

Likewise, while Rush Limbaugh has always been an extremist, but formerly on the lunatic fringe of the GOP, now he's become a real power in the party. No Republican dares to say anything even slightly critical of Limbaugh, or he's forced to grovel in apology.

Well, it's hard to feel too sorry for them, because the GOP has become trapped by its own cynical strategy. When the Democrats pushed through Congress the 1964 Civil Rights Act, which outlawed official segregation, Republicans were gleeful. All they needed to do was suck up to white racists and they could take the South (up until then, the most solidly Democratic part of the country). And so they did - and their "Southern Strategy" worked. Now, the South is solidly GOP. Likewise, they decided to "use" religious fundamentalists and right-wing extremists of all types. Hey, the end justifies the means, right?

But they did too good a job attracting the nut-cases. Extremists have now taken control of the whole party, and conservative politicians are terrified that they're not conservative enough for their new overlords. The lunatics have taken control of the asylum. Compromising with Democrats is considered treason, moderation is considered heresy, and no one can be too extreme for the tea-baggers who seem to control the GOP. Well, if you're willing to sleep with dogs, you've got to expect fleas.

Both the right and the left have always had their extremists. But the far-left has absolutely no power in the Democratic Party, none whatsoever. Even the mainstream left is disgruntled these days, since the power in the party is so clearly weighted towards the political center. The far-right, too, used to be mostly a fringe in the GOP, but not anymore. These days, they are the GOP. And if you don't like it, you'd better be careful not to say anything. David Frum is probably not the only conservative to lose a lucrative position for being mildly critical of the lunatics.

At any rate, it's hard these days to listen to rational conservatives, because I can't find any. Most of them have traded their principles for political ambition and joined the far-right crazies (John McCain is a prominent example), and the others are keeping their mouths shut about what they really think. Republican leaders aren't debating, they're just calling names. They're just lying. It's all about what works politically - and about keeping Fox "News," Rush Limbaugh, and the tea-baggers happy.

But I could be wrong. Heh, heh. I get pretty worked up by this, don't I? And I really don't think I'm wrong. But as a skeptic, I must keep that possibility in mind. So I do try to find rational conservatives. I read articles critical of Barack Obama and the Democrats (on the left and on the right). If they've got a point, I want to consider it. But these days, it's really not easy. Conservatives preach only to the choir and to the uninformed. They seem to have abandoned rational argument against anyone who know our own history.

My last example for skeptical thinking - at least, that I plan to discuss now - is investing. I don't gamble, because betting when the odds are against you is a sucker's game. I invest, since the odds are in my favor. That doesn't mean I'm guaranteed to win, certainly not. But the longer you invest, the more likely you are to come out ahead. The reverse is true with gambling.

Nevertheless, it's very easy to fool yourself when investing. In particular, it's easy to think that you're a genius when the market is going up. (At those times, everyone is a genius.) And it's very hard to avoid going along with the herd. Even when you know what you should do, it's very hard to actually do it.

I enjoy the strategy of investing. It's fun. I suspect that's not the way to look at it, but does it really hurt to enjoy what you're doing? I would never claim to be a great investor, and I would never recommend that anyone else follow my strategy. But it works for me.

One thing I do recommend, though, is to write down your plan. Why do you think this is the right way to proceed? What do you expect from it? And why have you chosen the particular investments you've picked? Regularly thereafter, you need to examine your short- and long-term results. Did you make the right decisions? Does your plan still make sense? If not, why not?

Note that losing money is not necessarily evidence that your plan was wrong. No one can reliably forecast the future. The best plan in the world might lose money, at least in the short term. But whether your investments have increased or decreased in value, was your thinking sound?

It might seem strange to include investing in a post about skepticism, but I think it fits. Human nature has a great deal to do with investing (almost as much as with gambling). And to invest successfully, I'm convinced that you have to understand why you're doing what you're doing. You need to have good reasons for your actions, good reasons for your beliefs. And you must accept that you could be wrong.

But you also need the courage of your convictions. You're not wrong just because everyone else says that you are. Don't ignore those people. Listen to them. You could indeed be wrong. But then, make up your own mind. That's never easy. We are social animals, and going along with the herd is natural. Many people would rather be wrong with everyone else than right alone.

Be especially skeptical about things that you want to be true. It is very, very easy to believe what we really want to be true. That's true for all of us. So if we care about being right, those are the things that we need to look at most critically. Make sure that your reasons for belief actually make sense. And don't ever stop questioning yourself.

This post has been kind of a mixed bag, hasn't it? Well, it seems to fit together in my mind, if not so well on the screen here. I'm a skeptic. If I had to use a one-word description of myself, that would probably be it. That doesn't mean I disbelieve everything, not at all. But it does mean that I question everything - and that I need good reasons for my beliefs.

Convince me that I'm wrong and I'll change my mind. But don't count on it being easy. I've thought about these things. I have reasons for my beliefs. I've challenged them myself, and I've tried to be critical. More importantly, I've tried to be rational.