Serenity for Tortoise Investors

As long as I can remember, my sister always had a plaque in her bedroom containing the Serenity Prayer. For those of you unfamiliar with this particular prayer, it goes something like this: "God, grant me the serenity to accept the things I can not change, the courage to change the things I can, and the wisdom to know the difference."

The first time I was old enough to actually read and comprehend this statement, I found the message to be profound. I have realized through the years that the first two parts of the prayer are important, but they are meaningless without the wisdom to distinguish between what can be changed and what cannot.

When it comes to preparing for retirement, it's surprisingly simple what is placed in our direct control:

1. The % of our income we save
2. Our portfolio's allocation
3. The costs we incur

If nothing else, these 3 aspects of a retirement plan should be well understood, so let's look briefly at each one individually.

The largest engine to a successful retirement is savings. You could outperform the market for many years, but if you've only saved a small amount, that performance won't mean nearly as much concerning your lifestyle in retirement. In 2007, the Fidelity Research Institute found that the typical working American household is on track to only replace 58% of their working income in retirement. They also found that they would have to start saving 12% of their income today to be able to replace 85% of their working income in retirement. As a society we have gone way too long without saving for the future. It's time to make saving as common in in our lives as buying staples.

The performance of the stock and bond markets in October and November this year has been a wake up call for the very real risks of investing. As an efficient market guy, I recognize the difficulty of trying to time the top and bottom of market cycles.....so I we're left with portfolio allocation as a strategy to manage risk and return. There are multiple empirical studies which state 90%-95% of a portfolio's volatility can be directly attributed to it's allocation. If you're like me and think that volatility is an acceptable measure of risk, then your portfolio allocation is the best way for you to control risk. Having a portfolio allocation containing downside risks you are comfortable with is crucial.....as no one minds the upside.

With investing, there are costs chipping away at your portfolio from every direction. Nothing in life is free, so every investor should expect to pay something, but the size of that something matters a great deal. Investing passively is the best way to keep costs low. Passive investing has very low portfolio turnover compared to active investing. This means that the transaction costs and tax impact of passively invested dollars is far less than that of actively managed dollars.

As tortoise investors, if we focus on the things that are in our control, we'll experience far less anxiety and place ourselves in a much better position to retire with our desired lifestyle.

A Tortoise Investor's Best Defense

It's all about diversification.

Let's assume for a minute that the odds are against you when trying to time the market. The costs to transact and the likelihood that you would mis-time your movements are simply too high. There is substantial empirical evidence to suggest that this is the case. Your best remaining option is to try and devise an investment strategy that relies upon continuous investment over long periods of time. You should allocate your portfolio in a meaningful way with a deep understanding of the potential downside risks involved, having looked at the worst periods available for your allocation. The last month and year could serve as a good proxy.

Thanks to the Capital Asset Pricing Model (CAPM) provided by economist and Nobel Laureate William Sharpe, we know that the most effective way to reduce a portfolio's overall risk while not substantially effecting the expected return is through diversification. In this sense, diversification does not mean holding 30 stocks as opposed to 10....it's more like holding 17,000.

There are two broad categories of risks associated with investing in stocks. Unsystematic risk, which are risks such as a company fails or all the companies in a particular industry sector suffer for one reason or another. The good thing is unsystematic risk can virtually be eliminated through proper diversification. The other broad risk is the systematic risk of the market as a whole. Systematic risk includes macroeconomic conditions affecting all companies in the stock market and cannot be diversified away. Today's credit crisis is an excellent example.

Investors can expect long-run compensation in the form of a risk premium for accepting systematic risk. The same can not be said for investors who accept risks that can ultimately be diversified away.

Below is a cartogram representing the market capitalization, as of the end of 2007, of each country's stock market relative to the world's total market value:



A well diversified portfolio would have some exposure to each of these markets. As it's impossible to predict which of these markets is likely to perform well in any given time period, one would benefit from investing in all available. The stock portion of our portfolios usually contain 60% U.S. stocks, 30% Developed Nation non-U.S. stocks and 10% Developing Nation non-U.S. stocks. This stock portion may be as little as 20% or as high 80% of the overall portfolio, depending on the risk tolerance and needs of the investor.

Regardless, each of our portfolios has some exposure to stocks, but that exposure is as diversified as possible, leaving only the systematic risk of the market behind.

Sticking to a Tortoise Plan

Today I made a contribution to my IRA and invested it my tortoise investment strategy. That's right, I made the decision to increase my investment in the stock market. Some of the readers of this post might think it foolish to put more in the market right now. So, why did I make this contribution? Because it came up on my calendar to make the transfer as part of my long-term savings plan, and I see no reason to change it. In fact, I see this current economic crisis as an opportunity.

Warren Buffet has many famous quotes, but one of my favorite is: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." You'd be hard pressed to find a time when the average investor was more fearful than now. I wonder if this is the mentality driving Berkshire Hathaway's recent decisions to invest in GE and Goldman Sachs, both struggling companies.

Though I try to check both the emotions of fear angreed at the door when I make investment decisions, I see this contribution to my IRA today purchasing more shares than I was able to purchase with the same contribution last Spring. Assuming I will be hanging onto these shares for decades to come, I'm happy to purchase them at today's fear laden prices.

Don't get me wrong, it's been painful watching the value of my retirement accounts decline over the last year and months and especially the last few weeks. It's been even more painful watching the value of my client's accounts decline. But as a tortoise investor, I also have the ingrained expectation that troubling economic conditions are bound to happen from time to time...knowing I am better off over the decades weathering the storm as opposed to trying to time the top and bottom of each boom and bust.

I've realized lately that expectation is everything when it comes to making sound investment decisions. It's like 2 doctors each giving you a shot. The first says, 'this might hurt a bit'; and the second says, 'this won't hurt a bit'. The fact is you are going to feel some degree of pain, perhaps not as much as expected with the first doctor and certainly more than expected with the second doctor.

The Day the Market Went Down Quite a Bit

Today seems like a day that will go down in infamy. From a statistical standpoint, these types of days are indeed extremely rare. Stock prices dwindled across the global marketplace. The S&P 500 was down 0ver 106 points or -8.77%, which is the second largest 1-day drop in value (behind October 19th, 1987) since 1950. Can anyone remember the day that has just been pushed down to 3rd place?

I think we already have a fair amount of insight into some of the root causes of this current economic downturn, and it has everything to do with many groups of people miscalculating risk. Government agencies were slow to raise concern about the lack of regulation and oversight on the Credit Default Swap (CDS) market. It is their job to make sure there are rules of the road and that they are adhered to, so we don't have a situation where markets could potentially collapse. Many investment banks are now going under or selling at a fraction of their recent value because they were stuck with toxic securities on their books. They were unable or unwilling to accurately ascertain the risks of these securities if (and as it turns out, when) the market for them evaporated. And there are hundreds of thousands of American people who did not adequately assess the risks of getting into sub-prime home loans. They didn't envision what would happen if their property values decreased, their variable rates went up and their cost of living went up faster than their paycheck.

This is not to point fingers. I'm just pointing out the common thread that this most recent economic downturn is a result of a gross underestimation of risk at virtually every level. Too many people had their eye on the potential rewards, that the consequences of the risks being taken essentially became invisible.

The good thing is that tortoise investors don't put themselves in a position to be sent to the poor house over night. They also know that accumulating wealth for a successful retirement doesn't happen over night either.

One can look at today and think the sky is falling and that the losses are unrecoverable, but that's really a short-term knee-jerk reaction. I'm not trying to make light of the situation....it's certainly been painful, but I am trying to put it into perspective.

Tortoise investors make decisions based on decades of data, not short periods of high volatility. They realize that they are going to be invested in the market continuously over long periods of time. Looking all the way back to 1927, there is not one 20-year period where the annualized returns of the U.S. Total Stock Market Index were negative. Even the 20-year period starting in 1929 had an annualized return of 3%, and the 30-year period starting in 1929 had an anualized return of 7.7%.....and obviously those periods contain the worst span of performance we have seen yet.

There are two important take-aways from this post: 1. Know the risks you take. Really try to understand the potential downside of any investment. 2. Tortoise investors don't sweat the short-term. It's not that they don't care, it's just that they know better.

The Yellow Jersey

I recently had a discussion about investing with a relative of mine. He is very well educated and has taken the time to learn about different investment strategies in his quest for market beating returns. He is most definately a hare investor and we have had many battles about the best approach concerning investing.

During this last discussion he said to me that any strategy worth it's salt should be able to be the S&P 500 any given year. My response to him was that investing is like the Tour de France in that it doesn't matter who wins any given stage....all that matters is who is wearing the yellow jersey at the end.

I think my hare relative was trying to point out that the passive strategy I subscribe to did not perform as well as the S&P 500 in 2007. The S&P 500 was up 5.5% in 2007 and a 100% equity passive strategy was down -0.8% (when Madden Funds maximum fee is applied) for the same year. OK, so my hare relative has a point when it comes to 2007, but the tortoise investor should not be troubled by a down year or two or three. If each of us only got to invest for one year in our lives, I might be really worried about a passive approach, but with any luck, each of us will have many more years to invest. I am planning on investing for the next 60 years....if I am fortunate enough to make it to age 90.

If we take the long view, the S&P 500 had an annualized return of 11.0% from 1973-2007. Over the same time period a 100% equity passive strategy had an annualized return of 13.8%. Some of you might be thinking, what's the big deal about a measily 2.8% per year. Well, if you had invested $10,000 in the S&P 500 at the beginning of 1973 you would have had $385,749 by the end of 2007. If you had invested the $10,000 in the 100% equity passive strategy over the same time period, you would have had $922,527 or a measily 139% better. The power of compounding never ceases to amaze me.

For all you tortoises out there, be confident that you'll get to sport that yellow jersey over the long-run. Hares might like to poke and prod during periods that favor them, but just smile and know that this is a very long race that as a whole will favor you.

Save Like a Tortoise

Q: Who wants to be financially independent? A: Who doesn't?

Becoming truly financially independent means you have accumulated enough wealth to maintain your lifestyle utilizing only the growth of your investments. Many studies suggest a moderate annual withdrawal rate for a retiree is 5% of the portfolio. So as a rule of thumb, if you live on $100,000 a year, your financially independent breakpoint is when you have amassed $2,000,000 or more in invested assets.

OK, so how do you obtain such wealth? Well, there are two ways this is accomplished. The first is something extraordinary happens for you. You are extremely talented and have a really high paying job; you win the lottery; your wealthy grandmother just passed away and left you everything, or you were the first person to have hot coffee burn you and the cup didn't have a warning telling you that coffee is hot. Cha-ching! The second way is for the remaining 99.5% of us. The answer is save like a tortoise.

Let's take a 30 year old making $100,000 a year and growing at 4% year over their career. They have nothing, meaning $0, saved for retirement so far. Today they start to save 10% of their income and split it up among their 401k and IRA. Their employer has a typical match of 3% of their pay. So, starting now they have the equivalent of 13% of their income being saved for retirement. This person has taken the time to educate themselves on Modern Portfolio Theory and Efficient Markets, so they construct a passively managed, globally diversified portfolio with 80% in stocks and 20% in bonds. This is an aggressive strategy, but this tortoise investor has confidence in the long-run and knows that 35 year's time is on their side. From 1973 thru 2007 this type of investment strategy produced an annualized return of 13.6%. Once you take out any advisor fees, custody & transaction costs, and a reduction in return for performance that is unlikely to repeat, it is reasonable to assume this tortoise investor will receive an annual return of 10.6% given the riskiness of their portfolio.

Given all of these assumptions, this 30 year old investor starting at $0 would retire at 65 with almost $6.6 million in the bank. To put this into perspective, we reduce this amount for inflation, 3.1% a year, and it would be the equivalent of just under $2.4 million in today's dollars. This person would have the option to retire financially independent at age 63 if they so desire, or they can wait until 65 and retire knowing that they'll have more than enough.

The key here is to start early. If this same investor started at 40 instead of 30, they wouldn't become financially independent until age 73 at a 13% savings rate. To retire at 65 with enough, they would have to save upwards of 20% of their income.

Each of the assumptions above are linear. Obviously, life does not work in a straight line, but this type of analysis can be a helpful guide and should be updated once a year to reflect the changes in your circumstances.

One wrinkle in your plan an investor might not expect is a large increase in income later in their career. Let's say an investor goes from making $100,000 a year to $150,000 a year at age 50. This investor should not get used to a $150,000 lifestyle....they haven't prepared for it the last 20 years. This investor will still experience a bump in lifestyle due to the pay increase, but it will be muted a bit by the lower income they have spent the last two decades preparing to replace.

Today is a wonderful time for the educated and disciplined. Each of us have more control on our retirement future than the generations before us. We've been provided 80 years of in-depth market history, computers to help make sense of all the data, portable tax-advantaged vehicles to invest and grow our wealth.

We have all the tools we need. But do we have the self-control and patience required to save like a tortoise?

Why You Should Want Your Advisor to Do Nearly Nothing

OK, your financial advisor should definitely do more than nearly nothing when servicing you. They should make sure you are invested using a strategy that is grounded in the fundamentals of proper asset allocation. They should help you accurately assess your ability to tolerate risk. They should educate you so you understand why you have made the decisions you have made. They should help you devise a written plan for saving during the accumulation period and managed withdrawals during retirement. They should hold your hand during periods when the market is volatile, guiding you away from making poor investment decisions driven by fear. Essentially, they should serve as the calm, confident, objective and impartial financial expert, making sure you have the best odds of achieving your retirement income dreams.

But when it comes to making buy and sell decisions for your investments, you want your financial advisor to largely leave it alone and only make adjustments when necessary. I'll use an analogy to explain why....

Your retirement portfolio is essentially the vehicle that will carry you through your retirement and provide your legacy to children or favorite cause, so let's compare it to a car. Let's say that you start with an extremely efficient well-oiled car that actually appreciates in value over time....basically this is where you would begin with a retirement portfolio invested using Modern Portfolio Theory. Imagine every time you visited a mechanic he had the next hot component or a major 'fix' for you to consider. Every change costs money and over time made your car less efficient, but there was a small outside chance these changes and 'fixes' would help the car appreciate faster than if the mechanic had just left it alone.

Your best chance of having the well appreciated car at the lowest cost is to have a mechanic that recommends only the periodic servicing and maintenance necessary to restore the car to it's original efficient well-oiled condition. Of course, the mechanic in this scenario represents the type of financial advisor you should be seeking.

There are two major reasons why advisors might not want to go down the road of minimizing adjustments to a portfolio. One, they may be compensated by the stocks or funds you buy in the form of a commission. So, they are paid to sell you something they deem suitable. If you make no changes, they get less pay. Two, they want to appear busy, appear to be 'earning' your money. Their afraid you might be thinking: "My portfolio hasn't changed in a while and I'm down 5% in the last six months. Shouldn't my advisor be doing something about that? What am I paying him for anyway?" The answer to that second question should be, you are paying them to prevent you from making a bad investment decision. It's easier for the advisor to say, "ok, you're down right now and this is what I'm going to do about it.", than it is for the advisor to say "ok, you're down right now and this is what you're not going to do about it."

To go back to the car analogy, imagine your efficient well-oiled car goes a little slower up large hills than other cars. You go to the mechanic to ask what you should do about it. The mechanic suggests you can change the fuel injection and add turbo boosters to increase the power....it will only cost you $2,000. You decide to do it and you are happy to climb hills with much more power than before, but you soon realize that you went from 45 miles per gallon to 15. Now you've added a continuous additional cost for the marginal benefit of climbing hills with greater power.

You call your mechanic to ask why he didn't stress the decrease in efficiency, but he's out of the shop enjoying a nice lunch on you.

M&M Theory

The day I first started learning about Modern Portfolio Theory and the Efficient Market Hypothesis I was sitting across the desk from Joe Madden, the President of Madden Funds Management, exploring the possibility of joining the Madden team. The pleasantries were behind us and we were now ready for a more substantive discussion. Joe contemplated for a moment, searching for the best way to unveil the fundamentals of their strategy to me. I'll never forget the four words he chose to start the conversation: "Brendan, markets are efficient."

Now, I have a background in statistics. I've studied and taught the subject. I had also used statistics in my professional career up to this moment, so his statement had a particular resonance with me. It took some time for me to more fully grasp the nuances of the strategy, but it was at that moment I realized I had been examining investing through an incorrect lens. This new lens made much more sense. Since then, I've been looking for ways to demonstrate why I believe the market is efficient, or at least highly efficient.

The answer: M&M Theory

At a previous employer, I was lucky enough to work under a truly gifted manager. One of his talents was building highly functioning teams. On the first morning of a 5-day sales training session, this manager began by placing a large glass bottle full of M&M's on the table in front of a staff of about 60 people. He asked each of us to make a guess sometime during the first 4 days as to how many M&M's were in the bottle. There were obviously hundreds.....

I think I was the only one who took a scientific approach to the problem. Apparently M&M's have a well designed shape in which they are able to occupy a great deal of the volume, leaving very little empty space. It has to do with the variety of possible orientations in which they can be situated. I found a university study on the Internet that examined the number of M&M's per unit of volume. The study came complete with an equation for me to use......all I needed was a value for volume. Fortunately, the bottle in question had the volume figure on the bottom, so I was able to confidently make my guess: 789

On the 5th day of the sales training it was revealed that the actual number of M&M's in the bottle was 782. I was happy with the result, but there was another closer guess. One of my colleagues had guessed 787. I asked him about it and he said he was just lucky and that he had simply guessed.

As I was an analyst for the business, my manager asked me to take all 60 guesses and calculate the average. The average was 784. Not only was the average of all the guesses only 2 away from the correct answer, it was closer than any individual guess. The point of the exercise was to demonstrate that as a group we were smarter than any one of us individually.

You might now be asking yourself, "What does this have to do with investing?"

In this example, the bottle of M&M's represents the true value of a company stock and the 60 people guessing represents the broad market of stock investors.

Let's take into consideration how the price of a single stock is determined. Imagine all the public information widely available and free flowing to investors this day in age. It's immense. Investors as a group take all the available information and begin to trade depending upon their evaluation of the value of a stock. In the first 3 months of 2008, The New York Stock Exchange reported 654.4 million trades across the 2,805 listed companies. This breaks down to about 3,762 trades per listed company per trading day. It is the buy/sell decisions of the investors on both sides of these trades that determine the price of a stock at any given moment.

It's important to note that for every seller there must be a buyer and visa versa. There is an equilibrium reached between the two groups. When new information becomes available (i.e. a new earnings report) this new information is quickly incorporated into the stock price as it again achieves equilibrium. So if a stock is valued at $10 dollars a share today, that value was determined by the investor group as a whole.....like the average guess of M&M's in the bottle, except on a much grander scale.

Hare investors are of the mindset that if they do enough research they will be able to capitalize on stock 'mispricings'. Essentially they believe that the market has inefficiencies that they would be able to use to their advantage. They may look at the stock valued at $10 a share and say, "I think it's really worth $12 a share." So they buy the stock. What they are really saying is, "I'm smarter than the thousands of other investors who have already collectively made their opinion known that the stock is correctly valued at $10 a share.

Tortoise investors believe that the market is highly efficient and that they would be better served working with the market as opposed to digging around to find situations where the market got it wrong.

Think of it this way, if you had to make the decision to guess every day for the next 30 years as to how many hundreds of M&M's were in a bottle where the number changed daily or alternatively accept the average guess of a large number of participants everyday for the next 30 years, which would you choose?

Switching Lanes

In the opening scene of the movie "Office Space" the protagonist Peter is stuck in traffic on his way to work. He watches the cars in the lane next to him move forward as his lane remains at a standstill, so he quickly changes lanes just in time for the free flowing lane to come to a complete stop. He then watches the lane he just left start to move. Again, his frustration gets the better of him and he decides to change lanes quickly back to his original lane....of course just in time for that lane to stop moving again. To punctuate the situation, he notices an elderly woman using a walker and moving at a relatively slow pace, pass him on the side of the road. The point is, he would have been better off staying in his original lane the whole time.

About 5 months ago a friend asked me to help him allocate his 401k. Like most 401k's he had about 15 mutual funds to choose from and I examined each of them with him. Now, I am a subscriber to Modern Portfolio Theory and the Efficient Market Hypothesis, so I had some rhyme and reason behind which funds I selected. I favored the funds with the lowest expenses and tilted the portfolio toward small cap and value funds. I helped him setup automatic rebalancing every quarter, and told him that he would probably only need to reexamine his allocation about once a year.

After 3 months, my friend called me and told me that he had just sold two of the funds I had helped him select. We were in the middle of a down market and he saw that these two funds were down the most since he had put his allocation together with me. He said, "I had to stop the bleeding." This thinking sounds logical, but essentially my friend was behaving the same way as Peter in the traffic jam example above.

The problem was the difference in our perspectives. My friend was focused on the poor performance of his portfolio over the last few months, where I was focused on the expected performance of the asset classes in his portfolio over the next 30 years. Even though he had no intention of making any withdrawals from his 401k anytime soon, he felt like he had to do something.

What my friend needed to understand is that there are going to be times when different asset classes in his portfolio are down, and those are not the times to sell off those asset classes. Instead those are the times where he could actually buy more shares per dollar than he would have before. For example, let's say that you invest $100 a month into your 401k, and you allocate 10% of your portfolio to a fund that is selling for $1 a share. That means every month you buy 10 shares. Let's say that the fund falls in price to $0.5 a share. Now your $10 dollars a month will 20 shares while the price is down. If you take the long-term view that the $0.5 price per share is temporary, you should take advantage of the low price while it lasts and accumulate as many more shares than if the price had remained the same.

Switching lanes based on recent performance, whether the recent performance is up or down, is a method of selling low and buying high. Not the best strategy for growing wealth over time, but this is the mentality of many hare investors.

Staying in your lane, taking advantage of times asset classes are down and periodically rebalancing is a method to systematically buy low and sell high. This requires discipline, patience and forward thinking....very much a trait of tortoise investors.

Does the Tortoise Investor Really Win the Race?

Aesop's fable concerning the race between the tortoise and the hare had always sounded unrealistic to me. How could the hare lose, really? This begs the question: In the case of long-term investing, is it true that the tortoise investor will win the race? The empirical data overwhelmingly suggests the answer is, Yes, most of the time. The masses want to dismiss the fable with regard to investing. The tortoise is slow and conservative and boring and the hare is quick and nimble and more exciting, essentially exchanging a smart and safer strategy for one that is speculative and more risky. To examine some of the reasons why the tortoise wins, first we must define attributes of a tortoise investor versus a hare investor.

Most investors today are hares whether they know it or not, simply by the investment options they choose to accept in their portfolio. A hare investor's objective is to beat the market, like it is some invisible adversary. Hares believe the market is relatively inefficient, creating opportunities to capitalize on security mispricings. The tortoise investor believes the market is a friend and highly efficient, meaning information is free flowing and widely dispersed, so security mispricings are rare and difficult if not impossible to capitalize upon. Tortoises strive to efficiently and reliably accept the returns the market provides.

Hare investors are more likely to move in and out of the market depending on the most recent forecast. Some hares use sophisticated computer models to look at different market cycles and trends to make buy and sell decisions, but many hares succumb to emotions such as fear and greed when making buy and sell decisions. Tortoise investors think the recent past is a poor predictor of future results and buy and hold investments for the long-run, transacting as little as possible. They are more likely to make decisions free from the emotions of fear and greed, relying more on future investment performance over the next decades as opposed to the performance of the recent past.

The biggest reason the tortoise wins is due to costs. It simply costs much more to try and beat the market than it does to accept market returns. A March 9, 2008 article in the New York Times written by Mark Hulbert entitled "Can You Beat the Market? It’s a $100 Billion Question" cites a study conducted by Kenneth French, a finance professor at Dartmouth, which concluded that in 2007 American hares spent over $100 billion in the effort to produce market beating returns.

Many former hare investors have caught on to the idea that a tortoise strategy will ultimately provide the best chances for winning results. In the same article above, Professor French calculates the proportion of the aggregate market cap invested in index funds (a tortoise strategy) has more than doubled to 17.9% from 1986 to 2006.

If you are a hare investor or think you may be a hare investor, you might want to reconsider the odds against you when racing against us tortoises.