Inflation is a complicated concept.  It’s simply not easy to understand but if you choose to ignore it, your money will slowly and stealthily go from your pocket to someone else’s.  Thus the subtitle of this tale is How Does Inflation Affect My Investment.  As a teenager growing up in the 70’s I would hear the newscasters talk about inflation and price controls yet could never tell if it was a good or bad thing.  Interest rates were going up as were house prices and income.

This had to be a good thing I thought but little did I know.  What I learned later in life as I studied inflation is that like most things, inflation is a double-edged sword.  There are winners and there are losers.  It is good for some and bad for others.  As you read this tale focus on the two main concepts about inflation.  Learn what it is and what it means to an investment portfolio.  In A Preservation Tale, I will walk you through some ways that in the past worked to protect your capital from inflation.   Hopefully you will learn a logical framework so that you can possibly be positioned on the “gain” side of the equation instead of the “pain” side.

WHAT IS INFLATION?

So what is inflation?  Type the word inflation into your favorite search engine and you will probably get directed to Wikipedia.  There, you will read that inflation is “A rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects an erosion of purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.  A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.”  If you are like me and read the above definition you are thinking blah, blah, blah, blah, blah.  So since the objective of Financial Tales is to keep things simple, let’s just translate this to what it means to an investor.

I like to think of inflation in terms of what can $100 buy in the future if I don’t invest it today.  If I make 0% rate of return on my $100 bill because I take it and put it under my mattress or bury it in the ground or keep it in a safety deposit box and a few years later I want to know what it can buy this is what inflation means to the investor or consumer.  What that $100 can buy is called purchasing power and purchasing power is directly proportional to the rate of inflation.  The following table shows what $100 un-invested can buy at different inflation rates over different time periods.  I call it my Mattress Investing table because it teaches us you can’t put money under your mattress unless you want to guarantee that you will slowly erode the value of your money.

MATTRESS INVESTING

(The Loss of Purchasing Power Associated with Not Investing $100.00)

How should an investor read this table?  Investors should understand that if they keep their money in a mattress for 15 years and the inflation rate over the 15 year period is 5% per year their $100 can only buy $46.33 worth of “Stuff.”  If inflation were to average 7% for 30 years their $100 could only buy $11.34 worth of “Stuff.”    I know it’s silly to think that anyone would keep their money in a mattress but the reason I use the table above is because it illustrates the important concept about inflation which is loss of purchasing power.  Inflation in and of itself is meaningless.  What matters to people is what inflation causes which is the loss of purchasing power.  As an example, when I get in my car to drive I have a rudimentary notion of how the engine functions.  People that know me know I’m not mechanically inclined.  I do however know how the steering wheel works.  To an investor, inflation is the engine while purchasing power is the steering wheel.  You can be completely oblivious to how an engine works and still be an excellent driver.  So if you are so inclined you can spend a disproportionate amount of time studying how the engine works or the nuances of inflation or you can learn how to drive and invest your money to combat the loss of purchasing power.  How to invest your money to combat inflation is discussed in A Preservation Tale.  I’ll give you a little hint—I am not a Gold Bug but if you put a $100 gold coin under your mattress instead of a $100 bill you have a much better chance of preserving purchasing power during inflationary times.

READING THE MATTRESS INVESTING TABLE

So once again, how should an investor read the Mattress Investing table?  Let’s focus on the 3% inflation rate since that has been a good approximation for so many decades.  What this table shows is that if the inflation rate is 3% and you keep your $100 under your mattress, in 5 years it will only buy $85.87 worth of “Stuff.”  I like to use the technical term “Stuff” to describe purchasing power.  To investors, the intended use of a $100 bill is to be able to buy “Stuff.”  In and of itself the $100 bill is worthless.  Its only value is the amount of “Stuff” it can buy.  In this case it can only buy $85.87 worth of “Stuff” so the Mattress Investor has lost $14.13 of “Stuff” by keeping it in his mattress or not investing it.  When you hear the term Loss of Purchasing Power it means “Stuff” you can’t buy.  This leads directly to what I consider the minimum objective for investors and one of my maxims.  The purpose of investing should be to at a minimum maintain your purchasing power.  I believe you should invest so that you don’t lose your “Stuff.”

So let’s put our knowledge to the test.  If the inflation rate is 3% over the 5 years how much money would you have to make to breakeven or maintain your purchasing power?  This is where things get tricky.  At first glance you might answer that you need to make $14.13 to maintain your purchasing power.  But you would be wrong.  While you would have $114.13 at the end of 5 years it could only buy you $98.00 worth of “Stuff.”  The best way to think about this problem is to divide your $114.13 into two pieces, the original $100 and what you’ve earned over the 5 year period or $14.13.  When you do this you quickly learn that the $100 has lost 14.13% of its value and can only buy $85.87 worth of “Stuff” and the $14.13 has also lost 14.13% of its value and can only buy $12.13 of “Stuff.”  When you add $85.87 and $12.13 you get $98 so your $114.13 can only buy $98.00 of “Stuff.”

Let’s test our knowledge further.  At what rate of return over the 5 years period would you have to invest your $100 in order to have it still buy $100 worth of “Stuff” or maintain its purchasing power?  If you answered 3% you would be wrong.  At 3% you would have $115.93.  If you break it into two pieces like I suggest your original $100 is worth $85.87 and your $15.93 is worth $13.68.  Together this is only $99.55.  The correct answer is you would need to have $116.46 in order to maintain purchasing power.  For the math inclined, the $116.46 can be calculated by dividing 1 by .008587 and this translates to a compounded annual growth rate of 3.09%.    So please commit the following to memory since it’s all you ever need to know about inflation–You need to make a higher rate of return on your investments than the inflation rate in order to maintain purchasing power.

I would bet if you interviewed 100 investment advisors that only a handful would have this knowledge.  The majority would say if the inflation rate is 3% you need to make a 3% return in order to maintain purchasing power.  They would be wrong but so what, they’re sticking to it.  You however don’t have the luxury of misunderstanding this concept.  Always remember-it’s your money and you are responsible for it.  If you read A Purchasing Power Tale, which I recommend be read right after this tale, I provide a table that shows the rates of return an investor needs to make in order to preserve purchasing power.

WHAT CAN WE LEARN?

So what can we learn from this tale that puts money in our pocket?  Who wins and who losses from inflation?  By now it should be clear that at any inflation rate greater than 0% you must make more than 0% on your money in order to maintain purchasing power.  Yet when guaranteed interest rates are not accommodative, like they are today and have often been in the past, the investor must invest in non-guaranteed investments to maintain purchasing power.  For investors that have read tales such as this one this presents a quandary.  They can intelligently ask themselves, if I want a guarantee and guaranteed rates are so low that I can’t preserve purchasing power then I must accept a loss of purchasing power.  However, if I want an opportunity to maintain purchasing power I must assume risk.  This is the never-ending portfolio management question that is forever on every investor’s mind and will be at every stage of their life.  While most investors answer this question by forgoing guaranteed returns in order to not just maintain purchasing power but to potentially increase purchasing power, others do not.  There are investors that choose to avoid risk at all cost and are knowingly watching their purchasing power erode slowly in some guaranteed interest environments.  Unfortunately, the sad circumstance for most risk-averse investors is they behave as they do out of ignorance or fear and not based on knowledge.  Many are willing to invest their money in bank CDs, money market funds and government bonds at below required levels just to keep it guaranteed.  The only guarantee they’re getting during most periods is the guarantee of a loss in purchasing power.  When and if there is increased inflation these are the people that will also suffer the most.

Who benefits then when we experience an increase in the inflation rate?  The answer is simple.  Those that own “Stuff” benefit and those that owe on “Stuff” at a fixed interest rate benefit even more.  Many are familiar with Shakespeare’s quote “Neither a borrower nor a lender be.”  Whenever I hear this piece of advice all I can think is that The Bard of Avon had never experienced inflation.  If he had he might have written, though surely more elegantly–you should be a borrower and not a lender during inflationary times.  So what can we expect and what should we do with our money to win the preservation of purchasing power game?  To find out some techniques that work or at least have worked, I suggest you read A Preservation Tale.  If you must provide income from your investments you should read A Distributive Tale or else you might run the risk of running out of money prematurely.

Lastly, I have included a paragraph from a 1977 article written by Warren Buffett for Fortune Magazine on inflation.  Inflation was a big deal back then though we tend to dismiss it today since it’s been so low for so long.  But I thought the paragraph would be appropriate since it is easy to understand writing and he has a unique way of thinking about inflation as a tax.  If you think of it the same way you will quickly understand that inflation is a consumer of your capital.  We as a society take to the streets if there is so much as a hint of our elected officials raising our taxes.  Yet we have no problem when we willingly or out of ignorance tax ourselves by investing in below inflation rate guaranteed investments.  The following is taken straight from the article.

WHAT WIDOWS DON’T NOTICE

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn’t seem to notice that 6 percent inflation is the economic equivalent.

If you have $1 what do you do with it? How about $1000 or $10,000 or more? You only have two choices; you can either spend it or save it. If you save it you can put it in your pocket, you can bury it in the back yard, put it under a mattress or you can invest it. So when choosing between whether to invest money vs save money, you need to be sure you do what's best for you: Because most people correctly recognize that anything other than investing it means they will lose the ability to preserve purchasing power due to inflation they choose to invest it.

HOW TO INVEST YOUR MONEY

If you invest it you must decide how to invest it. This means you will invest it in something. This something is called an asset and they come in many forms but in my opinion there are only three “Core Asset Classes.” So, what are the core asset classes? They are stocks, short-term investment grade bonds and longer-term investment grade bonds. We are familiar with stocks but maybe not so familiar with bonds. Short-term investment grade bonds are commonly referred to as cash and have maturities of 1 year or less. Most people recognize them as money market funds. Longer-term investment grade bonds are commonly referred to as bonds and mature in more than 1 year. With these three building blocks of stocks, cash and bonds an investor can work wonders.

Asset classes that do not fall into one of these two categories I consider non-core. In the hands of the most sophisticated of investors these non-core asset classes can add value to a portfolio. However, seeing these types of non-core assets in real portfolios over the last 30 years tells me that for the vast majority of investors they are counterproductive. The reason of course is that people don’t know how to use them correctly. In the wrong hands, these non-core assets do more harm than good. Some examples of non-core asset classes include real estate, commodities, natural resources, currencies, high yield bonds and options. This tale focuses on the big three core classes. I think investors have their hands plenty full just dealing with these three.

THE ASSET ALLOCATION DECISION

In A Tale of Diversification we learned that the most crucial decision an investor must make is determining if they want to even have a diversified portfolio of stocks as well as a diversified portfolio of bonds or some combination of the two. If the decision, which I highly encourage, is to diversify using stocks and bonds then the next critical question is how much should I have in a diversified portfolio of stocks and how much in a diversified portfolio of bonds. This is the asset allocation decision. Investing is just another term for allocating your capital. It is the second most important decision about investing after the will I or will I not choose to diversify.

Let’s look at some examples. If Investor A chooses to put all their money in a single stock such as General Electric, he has made two decisions. He has chosen to not diversify and he has chosen to allocate 100% of his money to stocks since General Electric is a stock. If Investor B chooses to put all their money in an exchange-traded fund such as SPY, he has also made two decisions. He has chosen to diversify and he has chosen to allocate 100% of his money to stocks. The reason Investor B is diversified and Investor A is not is because by investing in SPY, Investor B has chosen to invest in a diversified portfolio of stocks while Investor A has invested in only one stock. Nevertheless they are both 100% allocated to the stock market. The same reasoning we used for stocks can be used for bond investing. This leads to the logical conclusion that “You can’t make an investment decision without making an asset allocation decision.” Investing and asset allocation are one and the same. Asset allocation is nothing more than the slicing and the dicing of your money. Asset allocation is the percentage of your money that is allocated to different asset classes so that it adds up to 100%..

CONSTRUCTING A PORTFOLIO

Let’s construct a simple portfolio with our three core asset classes. If you allocate 60% of your money to stock investments, 30% to bond investments and 10% to cash investments you have created an asset allocation that includes all three. A portfolio like this might be called a 60/30/10 portfolio to reflect the individual pieces. This is a good way to look at any portfolio. If the 60% stock piece is invested in a diversified portfolio of stocks and the 30 piece is invested in a diversified portfolio of bonds and the cash piece is safe and plays the role that cash is designed to play in a portfolio then the investor with a 60/30/10 can expect to make rates of return that are within historical parameters while taking risks that are also within historical parameters. But what if the investor chooses not to diversify?

Lets look at an example of an asset allocation where the investor has a 60/40/0 portfolio that is dangerous and misses the objective of asset allocation. I stumbled upon an investor in my travels that said he had a 60/40 portfolio. I was impressed with his ability to recognize and quantify his holdings. Most people can’t or don’t know the importance of asset allocation. This guy knew however somewhere along the way he missed the point about diversification. I asked him to explain and he said that he had 60% of his money in a small stock I had never heard of and the other 40% in a bond I had never heard of either. This guy knew the lingo, did in fact have a 60/40/0 asset allocation, but he didn’t have a firm grasp of the implications behind the term asset allocation. Implicit in the term asset allocation amongst academicians and professional investors is the notion that a portfolio is diversified. Since this fellow lacked diversification because he only owned one stock and one bond, he was missing the benefit of diversification. He was right but he was wrong. Most importantly, his expected returns and potential losses were not the same as the investor that chose to asset allocate while employing diversification as well.

Now that we know the 3 “Core Asset Classes” we can learn a bit more. When people speak of asset allocation they might say they have a 40/60 or 50/50 or 60/40 or 75/25 or 90/10 portfolio. In every case the first part is the portfolio allocation to stocks and the second part is the allocation to bonds and cash. Bonds and cash are typically lumped together and is something you should be aware of but not how you should look at your portfolio since cash and bonds have different return and risk characteristics. Nevertheless this is the way asset allocation has evolved when people talk about portfolios. This lumping together effectively leaves us with just 2 “Core Asset Classes” which are commonly referred to as simply stocks and bonds. So when I met the investor that said he had a 60/40 portfolio I immediately assumed he had a diversified portfolio that had 60% allocated or invested in stocks and 40% allocated or invested in bonds. Had he told me he had a 75/25 portfolio I would have assumed he had 75% invested in stocks and 25% invested in bonds. Learn this lingo because it’s universal.

Pay attention to the rest of this tale because if the only thing you learn from this tale is what follows, you will know more than most everyone you meet.

BUILDING A DIVERSIFIED PORTFOLIO

Let’s build a diversified portfolio with just the stock and bond “Core Asset Classes.” We need to give them some characteristics. In the stock class we will use the S&P 500 as a representation of the stock market and in the bond class we will use the Barclay’s Aggregate as a representation of the bond market. With just these two you can build a diversified portfolio because with these two investments you are effectively investing in hundreds of stocks and bonds. Let’s pick an actual investment that we can utilize. Let’s pick the exchange traded fund SPY for the stock market and AGG for the bond market. Let’s examine some characteristics of each of these. For this example, SPY should make the investor about 10% annually and AGG should make about 5% over the long run based on historical returns. In addition at times SPY might make as much as 50% or lose as much as 50% in a year. AGG is much tamer and might make as much as 20% or lose as much as 10% in a year. Let’s look at the table below and see what this means to an investor.

This table is what I consider a highly realistic portrayal of what a person can expect to make in any 1 year because the assumptions I made for the characteristics of SPY and AGG reflect their approximate historical nature. We can see that when the investor told me he had a 60/40 portfolio I immediately was able to characterize him as a person that would reasonably expect to make 8% over the long run, but that he would have at least 1 year where he made as much as 38% that year and others where he lose as much as 34%. Thus asset allocation, though it doesn’t say it in its’ name, means that once you choose an asset allocation you are targeting a return as well as a risk level for your portfolio. Stocks provide a higher long-term return but with more risk than bonds. Conversely, bonds will give you a lower long-term return but with less risk than stocks.

Here comes the part that will put money in your pocket if you can execute it properly. Rest assured it is not psychologically easy to do but if you do it you will make approximately an additional 1% per year compared to what the table above suggests. What is it? It’s called rebalancing between stocks and bonds. If you don’t know what rebalancing is I suggest you read A Rebalancing Tale. Let me say one last time that if the only two investments you ever made were in SPY and AGG and if your asset allocation is not skewed to overly aggressive or conservative, then the proper rebalancing formula or algorithm will put about an extra 1% per year in your pocket. For example, pick an asset allocation that’s not overly aggressive or conservative such as a 60/40 allocation and every time that the stock allocation reaches either 10% higher or lower you rebalance back to 60/40. My research as well as that of many others shows that this adds almost 1% rate of return to your portfolio. In practice this means that if the portfolio composition reaches 66% stocks, 10% higher than the initial 60%, at any time from the last rebalancing you would sell 6% of SPY and buy AGG to get back to 60/40. Conversely, if the portfolio composition reaches 54% stocks at any time from the last rebalancing you would sell 6% of AGG and buy SPY to get back to 60/40.

WHY DOESN'T EVERYONE DO THIS?

What makes this difficult? Why doesn’t everyone do this? The answer is human behavior and why I consider the reconditioning or reprogramming of our evolutionary tendency to make poor investment decisions one if not the most important aspect of successful investing. Let me give you an example to help you understand. The subtitle of this tale is “Everyone’s Got A Plan.” I often use subtitles to help you remember the moral of a tale. In this case I use it to help you understand the psychological difficulty of rebalancing. It is not easy to do because while it may seem simple to think that you will act in a rational manner when the time comes to rebalance, rest assured, most people are ill equipped because they’ve been taken out of their game plan. Let me draw a similarity between boxing and rebalancing. There was a time when Mike Tyson was the greatest heavyweight boxer on the planet. In a post fight interview after a decisive win by knockout the still undefeated champ is told by the announcer that his next opponent has a plan to defeat Mike in their upcoming bout. Mike looks him right in the eye and says “Everyone’s got a plan, till I hit them.” It’s the same with rebalancing. Everyone’s got a plan until the market hits them. It’s easy in theory to project how you will behave, but when you get hit by losses and fear grips your psyche it is hard to execute. You’ve been hit and your plan goes out the window.

As of this writing, February of 2009, most investors are in a state of fear. They are unwilling to buy stocks or take risk. They have lost money and all they see or experience is the recent past. They are seeking safety. They are avoiding pain and in portfolios, pain means stocks. Yet, many of the 60/40 models I look at have signaled the purchase of stocks from the sale of bonds multiple times from the market high of October 2007. If and only if an investor can overcome this fear can they take advantage of rebalancing between stocks and bonds. It is easier said than done. One last note on rebalancing. Psychologically rebalancing is asymmetrical. What I mean by this is that it is much easier to sell stocks when they reach 66% of your portfolio than to buy them when they reach 54% of your portfolio. Fear is a much harder emotion to overcome than greed.

THE REAL BENEFITS OF ASSET ALLOCATION

You may have read studies that discuss the benefits of asset allocation. They are very confusing to most because they make conclusions that very few people understand. They say things like “90% or 93% of the return that a portfolio generates is based on asset allocation.” It’s silly. We know that 100% of the return that a portfolio generates is based on asset allocation. What these experts are trying to say is something else. They are trying to say that the most important decision that a person makes is the amount they allocate to stocks vs. bonds. I agree. There is a world of difference between allocating 100% to stocks vs. 100% to bonds. Just look at the table for proof.

We learned that by choosing a 60/40 portfolio of SPY and AGG you will make about 8% per year. We also learned that rebalancing between the two when they get too far away from their original allocation increases that return by 1% so that you can now make 9% per year. Rebalancing effectively converts a 60/40 portfolio to an 80/20 portfolio while maintaining the risk of a 60/40 portfolio. Rebalancing is a tool you should use. Finally, examine the all-stock allocation. It can’t rebalance because it is always fully invested in stocks so it can’t get the 1% boost from rebalancing. Rebalancing between stocks and bonds is after diversification the single most important thing that the average investor can do to make money. Do it if you can. If you can’t, hire someone that will do it for you.

If diversification is the Wall Street version of a free lunch, then rebalancing must surely be the equivalent of a free breakfast. I highly encourage people to fully participate in both breakfast and lunch. Unfortunately, there are no free dinners on Wall Street.

People say diversification is the only free lunch on Wall Street. By this they mean that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected return. This is a powerful mathematical concept. What is diversification? It means that for every stock that you buy and add to your all-stock portfolio you have a good likelihood that it will add return as well as reduce risk or some combination of the two. In any event adding more stocks to an all-stock portfolio is a good thing. As a student of finance and as a financial practitioner I completely embrace the claim diversification makes and you should as well.

In this tale, I want you to eliminate everything except stocks from the diversification discussion. My focus on diversification will be limited to that of an all-stock portfolio. Of course everyone knows that a portfolio gains diversification when asset classes other than stocks are added to it, but in this tale I am trying to isolate the effect of the stock component of your portfolio only. It is critical. Furthermore, I consider the addition of asset classes such as bonds, cash, real estate, or commodities to an all-stock portfolio as more of an asset allocation decision than a diversification decision. The two concepts of diversification and asset allocation are so intertwined that it is difficult to know where one ends and the other begins. However, they are very different. Investment diversification is a mathematically precise derivation and asset allocation is a theory. Diversification is robust while asset allocation is untested.

Incidentally, I don’t espouse the use of real estate or commodities in my asset allocation models. I think it’s a form of self-delusion to think that these two asset classes will protect the investor during turbulent times. My research indicates that when markets are turbulent, this means when they are going down, that there is no safe shelter other than cash or bonds. As we see the events of 2008 play out we can witness that the asset allocation theory where practitioners have included real estate and commodities in their portfolios did not work out. It might work for the next 50 years but it did not in 2008 and it won’t the next time there is major turbulence. Nevertheless, I will explore the subject of asset allocation in An Asset Allocation Tale.

IS THERE A LIMIT TO THE BENEFITS OF ADDING STOCKS TO A PORTFOLIO?

The answer is yes. There is a limit or point of diminishing return where adding another stock does very little to either increase return or reduce risk. When you reach this point you theoretically have a diversified portfolio. Because there are so many ways to construct a diversified portfolio of stocks and because Americans have a compulsive need to measure things they had to create a stock market benchmark or measuring stick. The first and to this day still most recognizable benchmark or index is the Dow Jones Industrial Average, or DOW. Since then we have progressed to bigger and more encompassing indices or benchmarks such as the S&P 500, Russell and others. Ironically another American trait is to overdo a good thing and soon we will be to the point where there will be more benchmarks than individual stocks that make up these benchmarks. But for purposes of this tale let’s say that the S&P 500 is the best measure of performance for the stock market.

We know that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected return. You do this by adding stocks to your portfolio. We also know that when you construct what you think is a diversified portfolio of stocks you will measure it against a diversified portfolio of stocks called the S&P 500. The question then becomes is there a way to construct a diversified portfolio of stocks that has better characteristics than the S&P 500? Can we build a portfolio that makes us more money with less risk, or more money with equal risk or maybe less money but substantially less risk? These are the questions that everyone asks. It’s good to ask these questions because it shows that you are thinking but once you delve deeper into the concept of diversification you will learn that the answer in most cases is no. If you have a diversified portfolio of stocks then by definition it will behave like the stock market, which in this case is represented by the S&P 500. This means that if you own a diversified stock portfolio by definition you own a basket of stocks that acts like the entire universe of stocks.

So at first we were happy to hear that diversification is Wall Street’s version of a free lunch but now we’re not so sure we want to accept the invitation. Diversification sounds wonderful but it’s misleading. It’s incomplete because it doesn’t take people’s behavior into consideration. Diversification is a double-edged sword. What’s the problem with diversification? Diversification doesn’t allow for spectacular returns and many people want spectacular returns because, you guessed it, they think they are spectacular.

To make spectacular returns you must concentrate, overweight or trade your portfolio. A concentrated, over-weighted or traded portfolio is the antithesis of diversification.   It means putting all or a substantial portion of your money in the best performing investment opportunities that you envision. This is the way that most great fortunes are made. These fortune builders put all or most of their eggs in one basket by starting a business or investing in a small company that grows to a large company. This is an all-or-nothing strategy however and when they are wrong they end up on the Nothing end of the rate of return spectrum instead of the All. We only hear about the Alls but rest assured that the Nothings far exceed the Alls. Diversification assures that you will be somewhere in between All-or-Nothing.

TO DIVERSIFY OR NOT TO DIVERSIFY

This brings us to the critical issue about diversification and one that is seldom discussed in the financial literature. The question to diversify or not is the question that every investor faces. It is unavoidable. This tale is not about telling you how to diversify a stock portfolio, you can do that in 1 minute by picking up the phone or punching in a buy order for a mutual fund or exchange traded fund that buys the S&P 500. Diversification in America today is easy. The choice is not. This tale focuses on the question to diversify or not? That is the central question of diversification, not the how to. Because you must choose to diversify, you are the integral component of your portfolio. How you behave matters.

Lets look at where we are as of this writing with regards to stockmutual fund investing. We see that approximately 20% of the assets that are invested in the United States are invested in low cost index funds or exchange-traded funds. These types of investments that just buy the S&P500 or other well known indices are called passive investments because they don’t require an expensive portfolio manager or what I call a Hired Asset Manager or HAM. People that choose to invest this way are called passive investors. Where’s the other 80% invested? The remaining money is invested in active investments that require the skill, expertise and expense of an active manager or HAM.  People that invest this way are called active investors and the HAMs are called active managers. Unfortunately, the two terms alone, passive and active, are enough to see where this takes us. Do you want to be passive or active? Given this choice I would vote active. After all isn’t active better than passive? Don’t we all want this? Aren’t we taught this from birth? The correct answer is passive however. There is no evidence that active management outperforms passive management over the long run.

This 80/20 dichotomy is perplexing. How can it be even after 20-30 years of academic research that preaches the futility of active management that more people choose active management over passive management? Certainly the terms active and passive have something to do with it. If I were running an index fund company I would work on changing how my indices are branded. I would rephrase the question is active better than passive to is a “Favorite” more likely to make you money than a “Long Shot?” Would investors change their answers? What if I were to say that there are two ways to invest in stocks. If you bet on the “Favorite” every time you will over time make the same or more money than 95% of the people that bet on the “Long Shot.” If the question were phrased this way you wouldn’t see 20% of the people investing in the “Favorite” and 80% investing in the “Long Shot” as we do today. The percentages might in fact be reversed. This is a better way to think of diversification. If you are passive, if you bet on the “Favorite”, if you diversify you will more than likely be far better off than if you don’t. Yet we can observe that people don’t invest this way.

Why don’t we see this type of rational behavior when we examine the facts? One reason is people are sold active investments because they are in the best interest of the salesman, sales driven advisor or SAD. A second is lack of education. This tale educates you. The last reason and perhaps most misunderstood is because of human behavior. In cultures such as America’s where people think they are special it is difficult for someone to say that they must be satisfied with average results. It seems un-American to think that as an investor you will be average. Research in the field of Behavioral Finance shows that over-confidence or entitlement plays a major role in the poor returns that most people experience. People reject diversification and choose active management because even after I or someone else tells them the realities they still think it’s the other guy that is going to lose, not them.

WHAT WE HAVE LEARNED

Let’s extend the definition of diversification to include what we’ve learned. We can now say that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected rate of return, that you will outperform or equal at least 95% of your fellow investors, that you will never make extraordinary returns but that you will make about the same returns as others that choose to diversify. Let’s focus on the phrases expected rate of return and the same return as others that choose to diversify. As you diversify your portfolio your returns will resemble the returns of S&P 500. In fact it may be exactly the S&P 500, which is available for purchase in its entirety. This means that for the 20% of investors that own passive investments today, if the expected rate of return for the stock market is 10-12% per year on average, they will make these returns.

Choosing diversification makes you average amongst other investors that choose diversification as well. It presents a paradox however. How can a group of people that choose to be average make higher rates of return than those that don’t. Are they smarter? Are they more educated? Are they more self-aware? Do they know something we don’t know? We know from decades of stock market research that when one chooses to be average, when one diversifies, actual long-term performance translates to way above average performance since most individual investors as well as active professional portfolio managers never come close to achieving long-term returns of 10-12%. In people’s quest to be above average they fall below average and in many cases way below average. It’s of note that in any given year, about 80% of active, professional, highly compensated portfolio managers fail to outperform those that simply invest in the S&P 500. Active management is a losing game for individual investors as a whole. It can be won as many have proven but overall it’s a bad bet because even when you win you win by so little that it’s not worth it.

So is diversification a free lunch? The answer is yes if you want it to be because all are welcome. Diversification welcomes the entire spectrum of investors from expert to novice. It’s a bet on the “Favorite.” In a very democratic fashion, diversification doesn’t discriminate; it offers the novice the same expected rate of return as the expert. The novice will never get better investment odds anywhere else. Let’s be clear, it is not the goal of investing. The goal of investing is to increase the purchasing power of your money. Diversification is a technique that you would use to achieve your goal and one that most people should use and that I recommend. It is a portfolio state but before it can be a portfolio state it must be a state of mind. A diversified portfolio doesn’t happen by chance. It is not a random event. It is a conscious decision that an investor makes and makes every day since it is also so easy to reject diversification after you have started down the path.. However, be certain that you will never achieve extraordinary returns with a diversified portfolio. To achieve extraordinary returns you must by definition choose to not diversify. The choice is yours. Choose wisely. Recognize that throughout history anyone that has ever achieved extraordinary returns did not do it by diversifying.

SOMETHING TO PONDER

Let me try to influence your choice. Let me give you a thought to ponder. One of the largest and most successful money management firms in the world is Fidelity Investments. People that know baseball will know that Yankee Stadium was called “The House that Ruth Built.” I call Fidelity Investments “The House that Peter Lynch Built.” Peter Lynch is the legendary investor that managed the Fidelity Magellan fund and racked up the best mutual fund performance of his generation. He was the Babe Ruth of mutual fund managers. He has been retired for almost fifteen years and my question to Fidelity and others is, where is the next Peter Lynch? When the payoff for the firm that finds, creates or nurtures the next Peter Lynch can be counted in the billions it begs the question where is the next Peter Lynch? I can’t find him and either can Fidelity and others.

Clearly these firms have resources that an individual investor doesn’t have and yet they have met failure after failure in their pursuit of a superstar money manager. These large money management firms have infinite resources devoted to discovering the next great money manager, yet they can’t. Once again, despite all their resources they can’t find another star money manager to take them to the next level of profitability. With that in mind, I find it difficult to believe that if they can’t when they have billions of dollars of profits as an incentive, that the individual investor picking active managers from their living room can achieve spectacular results. It’s laughable. I also find it laughable to think that if Fidelity and the rest of the mutual fund establishment can’t find these managers that people buy into the concept that a SAD at a full service brokerage firm such as a Merrill Lynch or Smith Barney or Wachovia can find private money mangers for the individual investor. I think the choice for most people is simple—–insist that either you or your advisor construct a diversified portfolio of low cost index funds and focus on designing an asset allocation model that accommodates your risk threshold for a large portion of your portfolio.

In December of 2006, my two oldest children came home from college for their winter break. My son was a senior and my daughter was a sophomore. For those parents out there who don’t know this yet, college-age children are not early-risers. However, for some strange reason, one morning the entire family was up early, and my wife and I were having our homemade lattes. We use a very old-fashioned and inexpensive espresso maker, and we heat up the milk ourselves. We don’t think much about it. As the morning progressed, I notice that both my seemingly intelligent son and daughter were also drinking lattes. However, they weren’t drinking the homemade kind my wife and I were drinking, but the fancy expensive kind that you get from Starbucks and other upscale and expensive coffee houses.

I was a little bit miffed at the situation to say the least. I clearly saw their upscale coffee expenditure as an unnecessary extravagance. I’ve always preached the old refrain of a “penny saved is a penny earned,” and yet right in front of me was empirical evidence that I had not proven my point. In order to procure their precious nectar, one or both of my children had to get in a car, drive, spend money on gas and auto depreciation, risk injury or worse, and finally pay an exorbitant price for a latte they could have easily made at home for a lot less effort, and that in my opinion tastes much better.

I didn’t say anything, but I went into my home office and did some math. I ran a quick spreadsheet with some very conservative assumptions and came back with some startling information to share with my children. I wanted to illustrate the refrain of a “penny saved is a penny earned” in a practical and everyday sense. The overpriced lattes gave me the perfect avenue. I developed a model where a 22 year old chooses to eliminate the daily store-bought latte and instead makes it at home until age 65. I assumed the daily savings at $1.70, with an interest rate of 8% invested once a year.

I then gave my latte-loving children a quiz. I asked them to estimate the difference in cost between the lattes they drank and the ones my wife and I drank. I then asked them to estimate how much they would save over the next 43 years if they prepared their lattes at home vs. enriching their coffee house of choice. Let’s just say their estimates were significantly below mine. They had underestimated the power of compounding over 43 years, as most people do. They were guilty of a common financial sin. When I showed them the results, they were surprised. So what’s the savings? I estimate a person saves $212,686 over 43 years by making lattes at home vs. buying them. It just takes $1.70 per day at an 8% interest rate for 43 years to save more than $200,000.

This tale illustrates two things. The first is the power of compound interest. The second is the importance of counting pennies in our everyday life. I am sure that for those that truly understand this tale, they can come up with creative ways of stretching the dollar and putting themselves on the road to financial success.

A few days later, my latte-drinking children each received their own $14.95 espresso maker as Christmas presents. Inside was a note labeled the “The $200,000 Espresso Maker. Love, Santa.”

 

This is the third of a multi-part series of Tactical Investing Tales that deal with how to view investing and how to look at risk when comparing stocks to bonds. Also, this tale discusses the risk associated with margin & borrowing, & US and European Banks.

A Transformative Tale

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