Money Management and the Economy

Wednesday, October 22, 2008

Confusing Volatility and Risk

You aren't smarter than the market. It really is that simple.

The recent stock market crash has reminded many people that there is risk associated with buying stock. But that is really the wrong lesson for people to learn at this point. What the crash has shown is that the stock market is volatile, it will go up and down. But how much risk that creates depends on your investment horizon. If you plan to hold on to your stock for another ten years, then the recent crash has few consequences. The price in the current uncertain market says very little about the price you will get ten years from now when you sell the stock.

In fact, the stock markets' hourly gyrations have very little import for most investors, regardless of their investment horizon. Volatility is relative. Monthly fluctuations have consequences for short term investors. The decline in market prices since July reminds us why we shouldn't own stock that we will need to sell in a couple months for our immediate living expenses. On the other hand, even the decline in prices over the past year has very little meaning if your investment horizon is 30 years out. But the ups and downs over the last decade do have consequences.

In fact, if you have been buying stock over the past 10-15 years, if you sell now the chances are pretty good that you will have lost money. And that is real "risk", not simply volatility. And that risk continues to exist. Its possible that the money you are "saving" by buying stock may not be there at all. The boom and bust of the dot com bubble followed by the boom and bust of the real estate bubble make it clear that projecting the likely real value of that stock portfolio ten years from now is uncertain at best. While the argument that the market will go up "in the long run" is probably still accurate, we should remember that adage "in the long run, we are all dead".

What is important is to recognize that the current market value of our stock portfolio is not the same as money in the bank. That current market value is an estimate of our stock's value. Its very accurate in telling you how much money you will get if you sell today. But it becomes less and less accurate the longer it will be before you sell. If you are planning to start selling stock in 30 years as you near retirement, then today's market price is pretty meaningless in determining how much money you will get for it. In fact, given market volatility, it is almost guaranteed that if you get a range of different prices if you sell over a period of time. And the recent market makes it clear those could be dramatically different prices.

So your financial management software adds your bank balances to yesterday's market value of your stock and gives you a very precise amount that you have "saved", right down to the penny. Then you plan for your retirement or other financial decisions based on that number. The recent market has reminded us is that precise number is really a very rough estimate. Just think of it this way, "I have this much saved - plus or minus 40%".

Its also important to understand that while money saved in the bank is not as volatile as the market. There is still risk associated with it. The risk that inflation will be higher than the interest paid on your savings and the money you have in retirement will buy less than it does today.

Volatility of the market creates greater risk the shorter your investment horizon. The risk of inflation is greater the longer your investment horizon. This is why as you get closer to actually needing money, it makes sense to sell stock and put the money in savings.

Thursday, September 25, 2008

Inanities in a crisis

You aren't smarter than the market. It really is that simple.

The media is filled with plain silly inanities these days as everyone is focused on the crisis du jour on wall street. Here is one that grabbed my eye:

"The Depression itself was a dynamic sequence. It wouldn't have happened if the Fed hadn't insanely tightened credit in response to the stock market crash, rather than the correct policy of easing interest rates."

First, that monetary policy lead to the depression is a highly controversial explanation favored by money-supply ideologues. But the Fed did not have a policy of "tightened credit". They simply couldn't expand the money supply by printing dollars because, at the time, each dollar had to be backed by gold bars at Fort Knox.

Where the government did act to make the problem worse was cutting federal spending in response to reductions in tax revenue. Essentially the folks in charge ran government like a business, cutting expenses in response to reduced revenues, instead of using their almost unlimited borrowing power to stimulate the economy by keeping right on spending.

Finally, this ignores the central cause of the depression. People couldn't afford to buy the products they were producing. When the market crashed, as every speculative bubble will, businesses had enormous inventories of unsold goods. Think about what would happen today if every industry had the same oversupply that the housing market has. The housing market is in a depression now. That was the state of everything going into the great depression.

Of course blaming the great depression on low wages, cuts in government spending and market speculation are not messages that are very welcome in today's business environment. So we hear inanities about monetary policy that just coincidentally seem to justify the government stepping in to bail out the speculators when bubbles pop.

But that is just one example of what is turning into a propaganda fiesta with the media whacking pinata's and spewing out some businesses message. A recent NYT story described falling real estate prices and sales as "necessary" in order for the market to clear out the inventory of homes. Now you might ask how falling sales will help clear out the excess inventory. The answer is that it obviously doesn't. In fact, falling prices combined with falling sales indicates the opposite, the problem is getting worse and we are a long way from the bottom. Even with lower prices, the number of customers for homes continues to decline and the supply of homes available continues to grow. Of course that is not a good message if you are trying to get people to open their wallets and buy an overpriced house. Thus, whack! and the real estate industry's message comes flying out of the media's pinata.

Sunday, August 10, 2008

Don't Buy a House Now

You aren't smarter than the market. It really is that simple.

There have been several articles lately that I suspect are part of a determined effort by the real estate industry to get people back into the housing market. The basic pitch is that higher interest rates will eat up any savings you get from waiting for lower prices. Even the New York Times has gotten in on this action.

The calculation always goes something like this. Say you have a house for 500,000 and you make a $100,000 down payment today with a $400,000 mortage at 6.5%. Now compare that to a year from now if housing prices fall by 10%, you would make a down payment of $90,000 and borrow only $360,000, but at a higher interest rate. If the interest rate is high enough, you will end up with higher payments and paying more total for the house than if you purchased it now.

There are two problems with that calculation. The first is that isn't really how people buy houses. People decide how much they can afford and then find the best house in their price range. So the actual comparison is if I can afford the payments on the $500,000 home today, what will I be able to get for that money a year from now. If you assume prices will fall 10%, then a house selling for $555,555 today will sell for $500,000 a year from now. Of course, whether you can afford it will depend on the interest rate - that was the point of the above exercise.

So what can you afford to borrow at different interest rates?
Your monthly payment at 6.5% on $400,000 loan is $2528:
at 7% you can borrow $380,000
at 7.5% you can borrow $361,000
at 7.8% you can borrow $350,000
at 7.97% you can borrow $345,000

So if you assume that you can get a 5% return on your $100,000 down payment, you will still be able to afford that house priced at $500,000 if it drops to $450,000 a year from now and interest rates don't go beyond 7.97%.

This brings us to the second problem with the calculation. Interest rates help determine the price of houses. If interest rates approach 8% a year from now, then housing prices are very likely going to drop a lot more than 10%. In fact, if you look at the example above as the typical buyer for a $500,000 home today, an increase to 8% interest, by itself, will force the price of that house down by more than 10%.

At this point, interest rates have not even been a significant factor in the plunge in housing prices. The housing bubble pushed prices well beyond their fundamental value when compared to the cost of renting and family income. And housing remains overpriced by those measures in most markets. If interest rates go up, that will only add to the market correction.

Finally, going back to the example above. If you plan to buy a house to live in for a few years, then the current fluctuations in price won't matter very much. But if you can wait a year and buy a house that is worth 10% more than the house you can buy today, you will be way ahead. Not only will you get more for it when you sell it, but you will have had the benefit of living in a nicer house for as long as you owned it.

Tuesday, July 29, 2008

Walking Away from Your Mortgage

You aren't smarter than the market. It really is that simple.

The BBC has a story about how home owners who find themselves under water, owning more on their house than it is worth, are simply walking away. In most states, they have no obligation beyond what the bank gets from foreclosure. The result is that people who can still afford the payment are making a business decision to simply let the bank take the loss.

Housing prices are continuing to fall. There are some predictions that the ultimate floor on prices may be less than 50% of a home's peak value during the bubble. That means even people who bought with hefty down payments may find themselves owing more than they own. In addition, the premium for owning your own home over the cost of renting went up with the bubble and still hasn't come down again. So in many places, most people who own could rent some place similar for less money.

So does walking away make sense? If you look at it as purely a financial decision, it probably does. You will take a hit to your credit record. But unless you plan to borrow again in the next five years that may not matter very much. You are probably better off investing the money you save from renting than continuing to make payments on a asset which is declining in value.

On the other hand. A house is a place to live, not an investment. So whether to bail out is more a life decision than a financial one. Do you like where you live? Can you find a place you like as well. Will your kids need to change schools? In other words, how much is your current house worth to you? If it was worth the payments when you bought it, then it is likely still worth that to you now. If you plan to live in your house until the mortgage is paid off, it probably doesn't matter very much what the current market value is.

But many people chose a house for its investment value as much as a place to live. They didn't buy the house because they wanted to retire there, they bought it with the expectation that they would sell it and move up in a few years. If you are one of those people, don't stay trapped. The sooner you bail out, the more money you will save and the quicker you will recover financially.

One thing from the BBC article I would like to highlight:

"This is becoming a tsunami of voluntary defaults," Professor Roubini says.

"The losses for the financial system from people walking away could be of the order of one trillion dollars when the entire capital of the US banking system is only $1.3 trillion.

"You could have most of the US banking system wiped out, so this is a total disaster."

That is a stark warning. But, in capitalist America, that is the way the system works. Better that they take the loss than that you do. When they loaned you the money secured by the house you were buying, the lenders understood that they were sharing the risk you took in buying that house.

Thursday, June 26, 2008

Economics as Ideology

You aren't smarter than the market. It really is that simple.

This is a quote from a CNN Money online report on the debate over whether we are faced with inflation:

'president of the Federal Reserve Bank of Cleveland and a voting member this year of the Federal Open Market Committee, explained in a speech last month.

"As consumers spend more money for higher-priced petroleum and agricultural goods," she continued, "they eventually have less money to spend on other goods and services. Other relative prices must then fall."''

Well yes, prices are falllng "relative" to oil and food. But this is a clearly a statement of ideology rather than evidence based science. And it is clearly wrong. As people have less to spend, they buy less and producers produce less and lay off employees who now have less to spend, creating stagflation. From that same article:

"Automakers Ford (F, Fortune 500) and General Motors (GM, Fortune 500) have slashed their production schedules as well, as consumers stopped buying the fuel-guzzling sport utility vehicles that were once a huge source of profits for Detroit. The loss of high-paying pilot and autoworker jobs will only add to existing weak wage and job trends."

The only prices that seems to actually be falling as preciptiously as gas and food is the price of people's houses. But that is hardly a response to inflation. To the contrary, inflation may be what finally stops the bleeding in real estate by pushing up incomes to a level that makes the inflated price people paid for their homes a few years ago affordable.

This discussion, however, reveals the real role of economists, whether Marxist or Capitalist which is to express an ideological explanation for the privilege of their preferred group. For Marxist economists that is workers, for Capitalist economists it is managers. You can see it in the popular economic theory that inflation isn't a problem as long as employees can't demand higher wages to pay them. Essentially higher prices aren't a problem as long as the money goes into the money managers pockets. It becomes a problem when it encourages employees to demand a bigger share of the pie. But then who pays economists? Who funds economics departments? The answer is those who manage most of the resources. And they get paid to justify the privileges that group enjoys as the natural law of science, rather than a choice we make as a society.

Monday, April 14, 2008

Don't buy a house, Sell if you can

You aren't smarter than the market. It really is that simple.

Remember the adage, "buy low, sell high"? That applies to the real estate market too. This may be obvious to most people, but apparently not to the financial advice industry. Buying a house right now is a very high risk investment. In fact owning a home is a high risk investment, if you think your home is an investment.

Of course, most people don't own their home as an investment, they own a home to live in.  But the cost of owning one's own home the last couple years has been very high in most markets.  And unlike past situations where real estate prices fell, this one preceeded the onset of a broader economic slowdown rather than resulting from it. A weakening economy should push prices even lower in the short term. 

Long term, the situation could be worse. The market fundamentals such as rents, household income and historic rates of appreciation all indicate the current market is still overpriced even with its low interest rates. If interest rates go back up to more normal levels, or when they go up, housing prices are going to take another hit. People buy houses based on how large a payment they can afford. That is what helped create the current housing mess. And when interest rates go up, the price of the house they can afford goes down.

It may well be a decade or more before housing prices get back to where they are now, muchless the peak of a couple years ago. And in real terms, when correcting for inflation, it may take much longer than that.

Inflation is actually one of the positive indicators for people who own a home or are thinking of buying one. Because as the cost of other goods and services go up, the relative cost of housing should go up as well. That changes the market fundamentals by creating higher family incomes and higher rents. On the other hand, inflation also drives up interest rates.

So buying a home is a risky investment. But worse, for most people it is a highly leveraged risky investment. While "no money down" is largely a thing of the past, we are a long way from requiring the traditional 20% down to get into a home. If you put 5% down on a house and it loses 10% in value the first year, you have lost your entire "investment" and now owe the bank more than you have in the house. Fortunately, unlike with securities, banks do not make margin calls and demand you invest more. While people have benefited from that leveraging in a boom market, they are going to suffer as prices continue to fall.

What this means is that if you have found your dream home and realistically intend to live in it for 30 years, then buying a house may make sense. Your housing costs are protected from inflation and you get the benefits of owning the home you live in. In fact, current low interest rates make buying attractive for someone planning to hold onto their house and pay off the mortgage over the next 30 years.

But if you don't know that you will be staying in the house you buy or are thinking about moving out of one you already own, look for a good rental situation instead. Finding a good landlord may be easier than finding a house worth the price. If you intend to use your house as your primary retirement savings you might want to consider selling it and getting that money invested in something more stable. Your money will be safer in the stock market. If you want to speculate, try pork bellies.

Wednesday, March 26, 2008

Stop Saving for Retirement

You aren't smarter than the market. It really is that simple.

No matter how often the financial services industry repeats the message, it is still a lie. Young people should not be saving for retirement. You have an entire life to live before worrying about what you will do when you have had bypass surgery and no longer have the energy to even go to the grocery store. While the financial services industry needs you, you don't need them.

That doesn't mean you shouldn't be saving money. You should be saving for your wedding and honeymoon, to buy a house, to send your kids to college, to take that dream vacation or to buy a new IPOD. Of course, you can also just borrow money to do those things and pay it off later. For most young people that is more realistic and, frankly, a better idea. You are likely to earn more as you get older and it will be easier to pay off the debt you took on than to save the money now to buy stuff.

Of course, what you buy matters. A house is a pretty good investment. It gives you a place to stay and it will likely go up in value along with all the other houses keeping your housing costs affordable. By some measures your wedding is a good investment assuming it is a once-in-a-life experience. Your college education? A great investment that will more than pay for itself. The latest new Ipod? Well no, because you can almost guarantee you will "need" to buy a new one in six months if you want the latest technology. When you consider credit purchases, think about how long the item you buy might last. The longer it will last, the more sense it makes to buy it on credit. If you are using credit to afford groceries or takeout food, then you need to create a new household budget or find another job.

I have a vacuum cleaner I bought on credit almost 30 years ago that still cleans just fine. I have a cast iron skillet that I still use, bought on credit when I was out on my own for the first time. When I bought it, it was a week's food budget. Today I can spend enough on groceries for a single meal to buy a new one. And that is the fundamental point. As you get older, you will have more money and you will still be getting lasting benefits from the purchases you made on credit when you were younger. Even the money I spent wining and dining my wife is still paying off.

So yes, you will be much more comfortable at 70 if you start saving your money now for retirement. And if you measure your success by how much your estate will be worth, then go for it. But for most of us, money is a means to an end, not an end in itself. You are going to earn a lot of money over your lifetime - spend some of it now to make that lifetime more pleasant, interesting and valuable.

And if you really want a more comfortable retirement, brush your teeth and floss every day.

Monday, March 24, 2008

Your Social Security is more Secure than your Securities

You aren't smarter than the market. It really is that simple.

Allen Sloan over at Fortune Magazine is making the case that Social Security will run out of money in 10 years. His are the crocodile tears of the very people who have looted social security, using the excess social security taxes to provide themselves and their rich cronies with tax breaks. He makes clear his new-found concern for social security is really an excuse to further raid the treasury with his suggestion for a solution: "We can still buy time by investing current cash surpluses in non-Treasury assets." I.e. we should use social security taxes to buy some of his rich buddies' fancy financial products.

To understand how this really works you need to start with social security taxes. The original idea was that the taxes paid by current workers would pay the current benefits for people who were retired. In turn, the next generation of workers would pay the retirement of the next generation of retirees.

The critics like to describe this as a "ponzi " or pyramid scheme, but it isn't. It ought to be clear to anyone that once they retire they will be supported by the people still in the work force. The question is how those people will get paid. Whether its personal savings or social security that money will have to be taken out of the economy - which is another way of saying that those still producing will have to pay the bill. Far from a scheme, that is simply the way life works. People are born, join the work force, retire and die.

In the early 1990's there was a recognition that there was an element of a pyramid being created by the country's demographics. More people were entering the workforce than leaving it for retirement and the resources available to pay social security benefits was greater than would be sustainable when the baby boomers retired and those numbers reversed. The result was the "Social Security Trust Fund" where current workers paid more social security taxes than was necessary to pay current retiree benefits.

The extra money from Social Security taxes was put into treasury bills. The same treasury bills the government uses to borrow money from anyone else. Like the T-bills Mr. Sloan and his friends buy to avoid taxes and that, presumably, the government will have to pay him and his friends a higher return on to borrow the money they are currently borrowing from the Social Security trust fund.

The problem is not how the trust fund is invested. Its that many of the conservative critics don't want to have to pay off the loans the government took out to provide tax breaks to their rich friends. Social security taxes are incredibly regressive. They tax low income wage earners at a higher rate than those making over $100,000. Every year we pay more social security taxes than are needed to pay current retirees and the government borrows that money instead of raising the more progressive income tax. As that surplus is disappearing the government has two options, raise taxes or borrow more money from elsewhere.

Where Mr. Sloan is fundamentally wrong is suggesting the problem is ten years off. It is happening now. Each year the surplus available from social security taxes is declining and the government is having to borrow more from other sources, reduce spending or raise taxes. That process will continue into the foreseeable future. Putting social security trust funds into non-government securities will just speed it up. Of course, Mr. Sloan and his financial services friends will make a hefty profit from fast tracking the social security deficit.

But the larger problem is that the social security issue is an example of a much more fundamental shift. Over the next 50 years, fewer workers are going to have to produce the goods and services used by a large number of people who aren't in the work force. Social security is only one institution which is going to be effected by that reality, so is every business. Global markets may be able to absorb some of the production, but for the United States that will require continuing to transfer huge amounts of wealth overseas in the form of loans and/or capital.

And if you want to find a ponzi scheme look no further than the dot-com "bubble" or the real estate "bubble" or dozens of other unsustainable investments. The money "lost" in these bubbles was found by the people who got rich off them, just like any other pyramid scheme. But don't let anyone convince you to base your retirement on those investments whether its your 401-K or the social security trust fund.

Monday, February 18, 2008

The recession is coming! The recession is coming!

You aren't smarter than the market. It really is that simple.

So you think we are headed for a recession and the market is going in the tank. You aren't alone. There are plenty of other investors out there with the same idea. And your opinions are already reflected in the current market price of stocks. While you could turn out to be right, it is equally or more likely you are wrong. Guessing what will happen next in the stock market is not an investment strategy, its a gambling strategy. The only advantage it has over Vegas is that the investment analysts and financiers usually take a smaller amount off the top than the casinos do.

So what should you do? The answer depends on whether you are a buyer or a seller. And that has nothing to do with what you think the market is going to do. It is a question of where you are in the investment cycle. If you are adding to your investments then you are a buyer. If you are at a point where you are moving money out of the stock market, you are a seller.

While most people are buyers, there are circumstances where you might be seller. One is that, as you get closer to retirement or other use of your investments, you want to shift your investment mix from heavily in stock to a less risky mix with less stock and more bonds. There are two ways to do this. One is to add new money to your bond investments. The other is to sell some of your stock and put the proceeds into bonds. A second reason you might be selling is that your stock did better than your bonds the past year and you need to sell some stock and move it into bonds to rebalance to your targeted investment mix. The third reason would be that you are retired and are selling stock to pay living expenses or you need to cash out your investment for some other purpose.

If you are a buyer, the answer of what to do now is straight-forward. Buy stock. Use dollar cost-averaging to avoid getting caught spending all your money now when you might be able to buy more shares at a lower prices later in the year. By averaging out costs over the year you will protect yourself from buying high in what is a volatile market.

If you are a seller, you actually have an apparently more complicated decision to make. But because we simple minded investors don't like complicated answers, there is a simple one. Or rather two simple ones.

If you want to change to a less risky investment mix because you are getting closer to retirement, or other use of the money, you should do it over time. Just as you cost average purchases, you should cost average sales. That means figuring out how much you will need to sell to achieve your new investment mix. Then divide that amount into 12 equal installments. Then sell stock worth that much on a monthly schedule. By cost-averaging you will guarantee that you aren't selling all that stock at rock-bottom prices. You will sell at roughly the average price for the year.

Correction: On reflection, this is not correct. In fact cost averaging your stock sales means that you will sell more shares when the price is down and fewer shares when the price is up to generate the same amount of money. This will actually result in your getting less than the average price for your shares. You should decide how many shares you will need to sell. Then divide the shares into equal installments. Whatever disparities the different selling prices create will get fixed when you do your annual rebalance.

If, on the other hand, you are selling in order to rebalance your investment mix, you should continue to do this all at once on an annual basis. The point of rebalancing is to sell high. You are selling because the class of assets you are selling did better than the other classes of assets in your portfolio. Think about it as taking your profits (or cutting your losses if all your assets went down).

The one thing you should not do is change your investment mix because you are nervous about where you think the market will go. Managing risk based on your expectations about the market is the same as any other attempt to time the market in stock. Its likely that you will end up with that more conservative investment mix just about the time the market decides to take off. You will have sold low and now be faced with buying high to restore the mix you initially had. Your investment mix should be based on your long term goals, not your current nervousness. You are not smarter than the market. So don't try to be.

Tuesday, February 5, 2008

Media Investment Advice

CNN's Walter Upgreave today made clear why taking investment advice from the media is a bad idea. In his column today he takes a contrary view of "dollar cost averaging". The dead giveaway is this line:

"But while dollar-cost averaging has risen to the level of accepted truth in many circles, it isn’t the magic bullet it’s made out to be. Indeed, some of the claims are simply an illusion."

Put another way, his job is to provide something interesting for us to read and repeating conventional wisdom won't get you many readers. But there is a reason why dollar cost averaging is conventional wisdom and Upgreave is doing a huge disservice by encouraging people to ignore it. Sometimes conventional wisdom is wrong, but, if you really understand the role of investment mix or dollar cost averaging in risk management, you realize that Upgreave's argument has no merit. Here is the nut of his argument:

"Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy."

There are several reasons this is flat out wrong. The first, is that by investing all your money in a lump sum you are increasing your risk well beyond what you intended by a 60-40 investment mix. This is because you are taking on the risk of daily/weekly/monthly fluctuations in the market compared to a similar investment dollar-cost averaged. In essence, he is encouraging you to make a short term investment in the stock market.

One way to look at this is to take your lump sum and divide into four installments. That is what you do with dollar cost averaging. The next question is what should you do with the money in the mean time until you need it? Upgreave is, in essence, suggesting you invest it in stock and bonds using the same 60-40 mix that you had settled on for your long term investment strategy. But the 60-40 mix that is appropriate for money you will not need for at least 10 years, is not appropriate for money you will spend on stock three month from now.

To get an idea of how this works take a couple scenarios this year:

Lets assume you got a tax refund of $1200 on June 1st, 2007 and invested it in Vanguard's Balanced Index fund which gives you that 60-40 mix. The fund's shares were at 22.54 that day so you would have purchased 53.24 shares. Three months later, on September 4th that same $1200 would have bought 54.15 shares. By December 4th is would buy 53.98 shares.

At the end of 2007 those 53.24 shares were worth $1172. The 54.15 shares were worth $1192. and the 53.98 shares were worth $1188. By February 4th, 2008 that $1200 would buy 56 shares. Those same shares would have cost $1262 in June.

Having saved your money in a conservative cash account, you would be buying low. Having spent all your money in June - you would still own just 53.24 shares.

But why stop now? What happens when shares have reached $40 per share? That investment from June is worth 2121, if the investment was made in September it is worth 2166. The December investment is worth 2159. The February investment is worth 2240. If you invested the money in four installments, you made $50 more than you would have if you had invested int all in May and those net losses will continue to grow right along with the price of your shares.

Of course, the opposite could have happened. The market might have gone up. On average, that is more likely to happen. But if you don't cost average, you aren't playing the averages. You are timing the market whether deliberately or not. You may happen to get lucky and buy when the market is low. If you are very unlucky, and buy when the market is high. But avoiding that kind of high risk, is exactly the reason for having a relatively conservative 60-40 mix of stocks and bonds to begin with.

There is no doubt that leaving your money in cash is more conservative than investing it in the market. Bonds are more conservative than stocks. That is a the reason why investment horizon is important in determining your mix of cash, stocks and bonds. In the long run, stocks, on average, will give you the best returns. But, as the saying goes, in the long run we are all dead.

Thursday, January 24, 2008

You are NOT smarter than the market

You are not smarter than the market. Accepting this basic fact is the first step toward successful investing. That is counterintuitive to some people. There are lots of people out there who want to "beat the market". They hire financial advisers who claim that they will help them accomplish this allusive goal. There are also people out there who want to win the lottery, they buy lottery tickets. In both cases, you hear a lot about the "winners". What you don't hear is that there are a lot more losers and the odds are you will be one of them.

Now, financial advisers will argue that what they do is not really gambling because they can control the outcome. They claim that by being "smarter" they give you a leg up on the typical investor. That isn't really true because the market price of stocks in not set by the "typical investor". Prices are set by the collective wisdom of market professionals, many of whom manage billions of dollars each. Your financial adviser is one of them, albeit not likely one of the billion dollar managers. And, on average, they collectively lose money for their clients.

We know that they lose money for their clients because for every stock sold, there is a buyer and a transaction cost. So while the financial advisers will have made money, that money came out of some poor dumb investor's pocket. Don't be the that dumb investor. Take a deep breath and admit you aren't smarter than the market.

The positive side of this is you don't need to be smarter than the market. Because the market,in general, is pretty smart and you will make money if you can just match it rather than beat it. So your goal as an investor is to match the market, not beat it.

Of course, people go to Vegas because they like to gamble. They want to win, but many of them accept losing as part of the excitement. Just don't gamble with your house payment, the kids college tuition or your retirement funds. If you have extra money and want to play in the stock market, go for it.

But you won't find much help or wisdom here for doing that. Except to understand is you win, it proves you were lucky, not that you were smart.