ITA Wealth Management

Where does one begin if you are a new investor with an interest in participating in the stock market? The number one move is to follow the “Golden Rule of Investing.” Invest as much as you can as early as you can. That may seem obvious, but it is extremely important if one is preparing for retirement.

Here are a few next steps.

• After saving a few thousand dollars, open up an account with a discount broker. TDAmeritrade is an example of such a broker.
• Be sure you can access the account over the Internet so you can buy and sell equities without going through a broker.
• Lay out a long-term goal as to what you want the portfolio to look like when it is growing to over $100,000.
• If the plan is to make small monthly payments, use an index fund such as VTSMX. VTSMX is Vanguard’s Total Market Index fund.
• Keep feeding an index fund such as the VTSMX until you have well over $10,000 invested. Then begin to fill out your asset classes according to your plan.
• When you can put something close to $1,500 in an ETF, begin with VOE (mid-cap value) or VBR (small-cap value). Hold commissions to under 1%.
• Once dollars are working in all the value asset classes, begin to populate REITs, international (developed countries), emerging markets.
• Keep feeding VTSMX on a monthly basis and when you have sufficient funds, sell some shares and begin to fill in blend or core asset classes such as VB, VO, and VV.

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Mark Hulbert attempts to answer the question, “Can You Beat The Market?” Hulbert uses a working paper by Kenneth French as the basis for this article. Check out Hulbert’s full article using the link below.

http://www.financialexpress.com/news/Can-you-beat-the-market-Its-a-100-billion-question/285039/
Photograph: Big Deschutes River near Sunriver, Oregon

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David Swensen, at the very end of the introduction to his book, “Unconventional Success,” proposes a solution to the interested investor. “The investment management world includes a very small number of not-for-profit money management firms, allowing investors the opportunity to invest with organizations devoted exclusively to fulfilling fiduciary obligations. Moreover, the market contains a number of attractively structured, passively managed investment alternatives, affording investors the opportunity to create equity-oriented, broadly diversified portfolios. In spite of the massive failure of the mutual-fund industry, investors willing to take an unconventional approach to portfolio management enjoy the opportunity to achieve financial success.”

One of those organization “fulfilling fiduciary obligations” is Vanguard. This is why we are using the Vanguard ETFs to populate the AA-Mosaic Portfolio. If we were in a 401 (k) plan and saving $100 a month, we would be using Vanguard index funds. Since we invest sufficiently large sums with each purchase, we are using ETFs as the commissions are a small percentage of the purchase.

We are also taking a passive approach to investing. Trading is a negative to building wealth. The AA-Mosaic Portfolio is certainly equity oriented and it is broadly diversified. We are following all of Swensen’s recommendations, as stated above.

Photograph: Rim of Crater Lake, OR

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If you missed David Swensen on NPR this morning, you can catch it using this link. Near the top of the page, click on “Listen Now.”

http://www.npr.org/templates/story/story.php?storyId=6203264

Examine the asset allocation pie chart on the NPR page. Notice Swensen advocates a more conservative breakdown of assets compared to the AA-Mosaic Portfolio. As he points out in the interview, there is no one perfect allocation that fits all investors.

Here is an addition reference with specific index funds and ETFs identified to match Swensen’s asset allocation recommendations.

Photograph: End of pew in the RAF Chapel, London, England

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Yesterday I wrote a post, “Slaying the Goats.”  Expanding on the point of cost, Evensky raises the question, “Why has this active premium cost hurdle received so little attention?”  It is no surprise he also supplies the answer and here it is.

“The answer is that investors (and investment professionals) have short memories and recent market returns have been historically high.  During the last 10 years or so, market returns have compounded at around 15 percent.  At this rate the hurdle drops by almost 40 percent.  John Bogle of Vanguard, making a similar observation in a Vanguard publication (The Vanguard Group, Selecting Equity Mutual Funds Conference Paper (Chicago: June 14, 1991), 1-14), notes that assuming an active management cost of 2 percent, it “eats up” only 1/8 of the returns of the 1980s and 1990s, but almost 20 percent of the long-term historical equity returns.”

Photograph:  North side of Mt. Hood, near Portland, Oregon

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Active investors point to Warren Buffett, Peter Lynch, and a few other master investors as examples of how an individual can outperform their benchmark. An appropriate reply is - “Why don’t we see more Warren Buffett’s?” We rarely see this question asked. I consider Buffett et. al. to be “seven sigma” managers and they are rare. We hear so much about them because they are so unusual.

Active investors look at Warren Buffett and think to themselves, if he can do it, so can I. Unfortunately, there is such a thing as the Bell Curve and for all investors, it is skewed slightly against them due to commissions, bid/ask slippage, and other fees. In addition, if one examines returns for mutual fund managers, as the years pile up, their performances tend to lock in a permanent position behind an appropriate benchmark. On the other hand, there will always be some manager who will outperform the benchmark. The trick is to select these money manager in advance of their track record before it comes to the attention of the masses. There is no evidence to indicate investors can actually identify today who that manager will be or who will be the next Warren Buffett.

Another set of active investors are not seeking managers. Instead, they are managing their own money. Again, these investors face the same laws of probability and those are, the majority of private investors will lag the market in any given year and this problem will compound over long periods.

Just another comment.  While we read of Buffett’s outstanding performance, we really have no idea how this performance compares to the benchmark.  We assume new money has been added to Berkshire Hathaway over the years.  Do we know if the benchmark “received like cash” for investment?  In other words, is the Internal Rate of Return (IRR) calculated properly for the benchmark?  If not, then we really do not have a clue as to how well the stock performed relative to a broad market index.

Some of these questions will be raised on later posts.

Photograph: English security - London

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What headway are you making with your Investment Policy? As you develop your investment program, here are a few questions to consider.

• What investments do I have at this time?

1. What percentage is in stocks, bonds, and cash?

• What are my cash flow needs?

1. Do I require income or is it possible to keep my investments in place for five or more years?

• What is my tolerance for risk?

1. If you are not sure how to answer this question, I suggest you take the Risk Capacity questionnaire available at this web site.

• What asset classes do I want to include in my portfolio?
• What percentage of my total holdings are committed to each asset class?
• What constraints or limits do I want to place on each asset class.

1. In other words, what upper and lower percentage limits will I permit for each asset class. We use +/- 30% for the AA-Mosaic Portfolio.

Consider the above questions as you develop your Investment Policy. It is very important to have a plan of action.

Photograph: American tourist with London bobbies.

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Photograph: Crater Lake Lodge

The reason for take the passive investing route to portfolio management is none other than playing the probability game. Let me quote again from David Swensen’s “Unconventional Success” book. “Security selection may provide substantial excess returns for skilled investors, but those excess returns come directly from the pockets of other players who suffer poor relative returns. When aggregating the returns for all actively managed portfolios, the combined results inevitably mimic the market, less a discount equal to the amount paid to play the game. For the investment community as a whole, security selection plays a return-reducing role in investment performance.” Swensen is simply stating what William Sharpe proved in “The Arithmetic of Active Management” paper.

If you are one of those individuals who know you can outperform the broad market by active management over the next 20-years, then by all means, keep selecting those stocks. However, the laws of probability are working against you. For this reason, we are taking the passive investing route.

Here is a short piece on Swensen and more of his advice.  I too prefer to listen to David Swensen rather than Jim Cramer.

http://www.informationarbitrage.com/2007/06/why_i_love_dale.html

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Photograph: London, England

Yesterday, I was having coffee with a friend and we were discussing Blog writing and how we try to make the information interesting and understandable.  This fellow writes on an entirely different topic, but the motivations are similar.  In both cases, we are interested in helping our readers.  In our discussion, we both agreed that it is necessary from time to time to go back to the beginning and reexplain some of the basic principles.  There are a number of reasons for this.  1) The reader may not be ready to accept or understand the idea when first explained.  2) The explanation is likely stated in a different way in later posts and the reader picks it up when written differently. 3) Repetition is the “Mother of all learning.” 4) New readers come on board and need to be introduced to the language and ideas without going back and reading all historical posts.  Whatever the reason, reviewing the basic principles from time to time is useful.  This is one of those entries.

As the title to this post suggests, one needs to know the first steps in constructing a portfolio.  Here are some suggestions to follow.

• Develop a plan for the portfolio.  Why are you investing?  For most investors it is related to providing for retirement.
• Do you want to increase your wealth as fast as possible by taking on additional risk or are you a patient person willing to pursue wealth building gradually?
• Understand the importance of diversification.
• Think through how many asset classes you would like to include in your portfolio.  Think beyond stocks, bonds, and cash.  When one reads about asset allocation, too many writers and researchers limit the asset allocation topic to only a few areas.  I recommend a minimum of six to eight asset classes and a maximum of 12 to 20.  The numbers will vary depending on how one defines an asset class.
• After deciding on the number of asset classes, the most difficult decision an investor needs to make is what percentage of the total portfolio is allocated to each asset class.  This is a personal decision and no answer fits all investors.  Mark Hebner’s book, “Index Investing: The 12-Step Program for Active Investors” is the very best book I know of that will help investors make this personal asset allocation decision.
• Understand the importance of value investing.  Search for Value on this Blog and you will come up with useful material.
• Understand the importance of investing in small-cap asset classes.
• Study the Exchange Traded Funds (ETF) choices and make sure to look at Vanguard’s ETFs and Barclay’s iShare ETFs.  Keep expenses as low as possible.
• Know the difference between mainstream ETFs and boutique ETFs.  Remain leery of the latter.
• Know what it means to rebalance a portfolio.  Again, a search for Rebalance will bring up useful material.

Above all, please ask questions in the Comment section and I will attempt to answer your questions or find someone who can answer them.

Lowell Herr

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To launch the Investment Policy, one needs to have money to invest in the market. If you missed earlier posts, do a search for “The Golden Rule of Investing.” Begin populating the asset classes you determined you want in the portfolio. I would first invest in value ETFs and small-cap ETFs. Then move on to international markets and don’t forget to include emerging markets. Even though it may seem too early, I would invest some dollars in the ICF iShare or Vanguard’s VNQ REITs.

If you are reluctant to jump into the market, search “Goofus and Gallant” and read that material carefully.

Photograph: Red Lion pub - London, England

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