April 2009


As I mentioned a month ago, I tried my first “active” investment by buying a website that makes a small profit. The first month has been interesting as I learned more about how it works, dealt with some surprises, and planned for improvements.

The biggest problem so far is that shortly after buying the website, which is based on monthly transactions, about 30% of them were cancelled. At this point I don’t think this something that could really be known ahead of time but it’s a good reminder that when you make an investment like this you have to discount the value because a lot could change. Since then I’ve had several leads to add new transactions but due to some outdated information and users who can’t be contacted none of them have come through yet. I am confident that in the future the profits will start to increase.

Due to the way it’s set up most of the income can only be transferred to my accounts once a month; since the site came with a balance at the time of the sale I have gotten part of the price back already but the profits for the first month won’t come for a few more weeks. The profits in the first month will be 14% of the real price, and the cashflow for this month has been 16% of the full price. Although the amounts are fairly small that’s a great return to see and the full amount of the investment could be returned in a short time. One of the great things about buying websites is that they often sell for very low multiples of income. This is partly because of the risk that things will change, but a little knowledge can help avoid the ones that aren’t likely to repay the investment.

This cashflow and profit is all the result of past work before I bought the site but I have put in some time to keep things running and plan for future improvements. I’ve started to build up systems that will eventually automate the process, allowing the profits to increase without my direct involvement, and make it possible to bring in more users and increase the value of the transactions. One of my first changes was to start a simple user referral program in place to build on the existing user base and reward them for helping to grow the business. It hasn’t resulted in an increase in revenue yet but I have seen a quick rise in interest.

I haven’t decided what I want to do in the future yet; looking at the rest of the industry I can see that I could grow this into a significant company with enough effort, but for now I’ll try to increase the profits while minimizing my time input. Eventually this could lead to selling the website for a much higher price. It is interesting to work with but if income rises enough I wouldn’t have a problem with selling it to someone who wants to put in the effort to do more with it and investing the profits somewhere else. Whether I keep it or sell it in the end, I need to focus on simple steps to improve the business and developing systems to keep it running without me.

Although there have been several unexpected events this is going well so far. I’m putting all the income in my investment savings account which will allow me to accumulate capital for more investments like this in the future. With the knowledge I get from running this site (and possibly a few others like it) I should have the experience to eventually make larger investments without increasing my risk. At this point the time input probably cancels out the high rate of return but if profits grow in the future this will be my best investment yet.

In my post yesterday I pointed out several things that were wrong in a recent Investopedia article against index investing. While the article doesn’t portray the true risks of index and active funds, it makes several other points about indexes as well that might make them sound bad to an uninformed investor.

One of the later items in the article is about limited strategies. With an index fund you’re forced to follow the whole market instead of choosing a specific investing strategy. In a way this is wrong – an index gives you access to every strategy currently being used (on average)! That being said, this limitation is protection for many investors since the average “strategy” can only hope to match the index if it has no additional fees or taxes.

The mention that you can’t adjust your portfolio if one sector of the market is overvalued or undervalued is true, but most investors are better off not even trying this as it would require a level of research similar to picking individual stocks. With any of these types of strategies there are a few investors who will want to avoid index funds but most people who find the idea appealing wouldn’t be able to keep up with everything they need to know.

The last point about having less satisfaction may also be true – but as Ramit from I Will Teach You To Be Rich says, would you rather be sexy or rich? You could feel more satisfaction from working hard to get a 3% gain trading individual stocks than a passive real return of 6% over 30 years from a simple indexing strategy that you spend less than an hour a month on. I may not get too excited about my investment strategies but that leaves me more time to get excited about what I can do with the profits. It must be hard to feel the “satisfaction of being successful with your money” when you have to keep up with what’s happening every day.

Although this article repeats many commonly-held beliefs, they are mostly wrong. Index funds have inherent risk like all equity investments, which active management can’t avoid. If you want to lower the volatility you can prevent losses but it will cost you lower returns. Many people don’t want to have too much excitement from managing their money – I have some interest in finance but it’s still just as important to end up with something you can use for other purposes. What do you think; are any of the reasons given for avoiding index funds valid or do they just point towards buying more bonds?

There’s an interesting Investopedia article I saw recently that comes out against indexing your investments. While I share many of the questions the author has about modern portfolio theory, I find it hard to share his enthusiasm for active management. One of the interesting things is his first point, that indexing exposes you do to the downside of the market index you choose. While it’s true that this is a common complaint, the problem isn’t the downside. It’s the opposite in fact; the problem is that you might get higher returns than the market average.

Why would that be a bad thing? It’s simple – when people complain that they have to follow the market down with an index, they’re really complaining that it’s more volatile than the long-run trend. While this sometimes causes the market to decline more than it should and become underpriced, it also causes the market to rise more than it should and become overpriced. When this happens it can’t be sustained for ever, which means investors buying into the index at the higher price level lose money while those selling at that time make a profit. There is a potential for a gain if you’re invested before an abnormal increase in prices, but it also causes an eventual decline or stagnation for those who invest later or don’t sell anything on the way up.

To make matters worse, many investors are liable to miss the upside because they chase past performance – only those who bought in at undervalues or fairly priced levels will actually get this upside – and even then they may follow the market back down and lose it all again. Because of these factors, even the desirable idea of getting above-average returns from an index fund doesn’t help many investors. Thinking you can get all the upside without the downside is a lot like planning how you can pick the 10 stocks that will have done the best in a decade – sure it would make you a millionaire from a small initial investment but it’s also IMPOSSIBLE.

The real complaint then is that index funds deviate from the long-run trends in the markets occasionally, with negative effects to investors who aren’t in the market for a long period of time. However that doesn’t mean that you can get the return without the volatility – part of the return from stocks is a reward for potentially not having quick access to your money. In this sense active management has nothing to offer but lower, more steady returns (if not lower and more volatile returns). There are ways to reduce the volatility, such as sticking to an asset allocation planned to give you the right level of risk. Another thing I find myself bringing up a lot recently is that a well-informed investor can adjust their asset allocation based on reasonable estimates of future returns, potentially putting their money in the markets where it has a better chance to grow.

The next point in the article – that you can’t protect yourself against losses because two different strategies would move in opposite directions – is also wrong. You can protect yourself against big downturns while allowing for a small loss, using put options if you just want to avoid a loss or shorting if you’re sure the market will go down. Again everyone would like to avoid the small loss but like any insurance the price to be fully protected would be too high. Careful use of options is another way to reduce the volatility by paying a small amount (a decrease in returns) to avoid losing a much larger amount.

If you had perfect knowledge of the market an index fund would hurt you, but for all regular investors the volatility comes with the asset class rather than the index. You can reduce the volatility at the same time as your returns, or you can pick a more stable asset class with lower returns, but the article fails to bring up a significantly better alternative (something which I find very unlikely). There are a few other complaints about index funds in the article as well – stay tuned for more!

While reading Thicken My Wallet’s interview about stock analysts with two other bloggers, I was reminded of some of the changes in the investment industry over the last century (not that I personally witnessed them!). One of the bigger changes is the effort to ban all trading based on information advantages – to give just one example, this means that communication between company management and analysts is often meaningless because the analysts can’t be told anything that’s not obvious already. This is probably one of the reasons that analysts are all but useless in predicting short-term price moves. But aside from a change in rules helping their reputations, could all investors benefit from encouraging the use of insider information?

The situation is similar to short-selling. Many of the rules proposed to limit or ban short-selling are ridiculous – they would prop up stock prices for a bit but anyone buying those stocks would be overpaying and future returns would be reduced. Some form of up-tick rule or a similar “circuit-breaker” could help avoid targetted attacks on companies, but other than that short-sellers are important in communicating the true value of a company and they make a profit by doing so.

Insider trading is prohibited because it would allow people with an information advantage to make a profit from unsuspecting investors. While this might sound good, it also means that people without this information will continue to trade the stock based on false premises until it’s made public (just like investors in a market without short-sellers). If more insider trading and communication with analysts was allowed that would allow the information to influence the stock price sooner, communicating the changes in the value of the business.

While this may not seem like a big contribution to the market it would help many investors who don’t have time to keep up with the latest information. By making the market slightly more efficient they would be able to learn more from the stock price alone, which might actually follow the fundamentals a bit more closely. The price for this is allowing some players with better access to information to make a profit before the stock price adjusts – but there’s no mechanism that will evenly divide the change between everyone who’s holding or trading the stock. Just like short selling, it’s ok to give some profits to those who expose new information even if it’s done indirectly.

There is some risk that mangement could influence the stock price just to profit from it, but is there any doubt that they spend a lot of time doing this already? Maybe there’s some rule similar to the up-tick rule that could limit the effects of this. This seems to be the main problem with the idea. Of course sometimes all it takes to influence the price of a stock and make a profit from it is a free Yahoo account 🙂

Overall it seems that the biggest loss would be having less grounds to ridicule the efficient market theory. Anyone who invests without extensive research about individual companies – especially index investors – would benefit greatly from having another force to prevent bubbles and excessive declines. Are there any good reasons to limit people from trading a mis-priced stock just because other investors might not be in a similar position to do so?

One of the key facts repeated by the investment industry (although I’m sure some people selling mutual funds say it under their breath) is that past performance doesn’t predict future results. Although there are some time periods that are a bit more predictable, there’s uncertainty at every level from the random day-to-day variations to the long-term trends shaped by the current environment. The reasons vary at different time scales – recently I came across a new reason for long-term uncertainty.

Clearly short-term moves in the next 1-2 years can easily go in any direction. In the 7-10 year range it’s a bit easier to form a guess on what’s likely to happen, but the end result will still be unpredictable. Over 20-100 years people generally expect significant economic growth.

The recent “A Night With The Bears” event highlighted one speaker described his theory about “long waves”, or economic cycles that are about 60 years long. According to this, we would be at the start of a long decline or stagnation. Although there does seem to be more predictability in longer time periods and nothing is immune from cyclical effects, the idea that we’re reliving the past isn’t right either. 

One of the obvious reasons is one-time events. Many people speak of the “post-war” economy that’s developed in North America and Europe in the last 60 years. That particular course of events was most likely heavily influenced by the Great Depression and World War 2, so we’re already on a different course. That’s not the only reason things will turn out differently – there are also fundamental changes in the nature of the markets.

While reading Geroge Soros’ book The Crisis of Global Capitalism, I noticed that one of the points he brings up repeatedly is how the market eceonomy has changed significantly since 1980. I already knew that the last 20-25 years have been an unusual and very long bull market for stocks, which had to result in either a decline or a reduction in future returns since stocks were growing at an unsustainable rate. Add this to some historical studies that show a long-term real return of around 6% from stocks and you can guesss the specific adjustments.

However with the new information from this book it seems that the bull run may have simple explanations, rather than being a random variation that has to return to the mean. According to Soros, the policies of Regan and Thatcher in the early 80s played a big role in opening up markets to free competition and innovation with less regulation. This change may have been a major factor in the rise in stock prices and the eventual speculation and instability.

Although it doesn’t explain everything, being able to put the recent bull market into context has interesting implications. It’s also a great demonstration of why it’s difficult to predict the future. Everyone knows that over the centuries the dominant countries, empires, and cultures change drastically. But there can also be big shifts in a times as short as a decade or two. The specific changes are different each time, making the future highly uncertain.

Current events could result in more regulations and lower returns for some time before market participants figure out the best thing to do in light of recent lessons. Or quick fixes could encourage people to restart an unsustainable bull market, taking stock prices even higher before a change is forced on them. What’s most worrying is that there’s still a possiblity that people as a whole will forget common sense and lessons from the past and take a big step back to policies that restrict economic growth for a long period.

The long-run trend in stock prices may not be affected much when the last 20 years are combined with the next 20, but that’s still a historical fact rather than a fundemental law. In The Black Swan, Nassim Taleb mentions that if you look at a stock chart with the dates removed it’s hard to tell whether it’s for one day or 5 years (you can even turn it upside-down and get the same effect). This illustrates how unpredictable markets are on different levels but if you want to understand what’s actually going on and possibly profit from it you need to know the different reasons.

In the long-term we can make predictions about where current pressures will drive the markets, but we have to remember that the markets we’re talking about are always changing. Trying to predict the future based on the past at any level is likely to be a losing game because the conditions and participants are always changing. Understanding the past is a great way to keep up with future developments though.

This is a guest post written by Rob Bennett, who blogs at A Rich Life. Although I can’t spend enough time on businesses that I’m not involved in to be a real “active” investor, I do follow major financial developments for my own enjoyment and this might be enough to tell when certain asset classes aren’t as good of an investment as they were in the past. Read on for Rob’s take on this!

Millions of middle-class workers are today wondering what happened to their retirement accounts. Investing in stocks wasn’t supposed to cause us to lose most of our life savings. There were studies showing that Passive Investing worked, weren’t there? There was historical data showing that, if we had to suffer through down markets, we would get the money back, no?

No. The historical data has never said any such thing. I’ve checked.

And, no, there are no studies giving any reasonable person cause to believe that Passive Investing (electing not to change your stock allocation even when prices go to insanely dangerous levels) could ever work in the real world. There are 30 years of studies showing just the opposite.

Given the extent of the losses we have suffered, there’s a temptation to conclude that we have all been taken in by a giant con. I don’t think that’s quite right either. I view that explanation as being too cynical.

It was all a great mistake. That’s the reality.

For many years, investors speculated about what was going to happen in the market over the next year or two and changed their stock allocations accordingly. That’s short-term timing.

There was research done in the 1960s and 1970s showing that short-term timing
does not work. This was breakthrough stuff. Lots of people got excited. A new model of understanding stock investing was developed. Passive Investing was born.
It wasn’t until the 1980s that we learned that we had jumped to a hasty conclusion in believing that not only short-term timing but also long-term timing do not work. The new research shows that 10-year stock returns are highly predictable and that long-term timing is REQUIRED for the long-term investor. You must lower your stock allocation when prices get out of control or you are likely to lose years and years of gain in a stock crash that may not come in a year or two but that is sure to come eventually.

Oops!

I can link you to scores of places where the new research is discussed. But rarely do
the big-name “experts” point out how critical it is to engage in long-term timing. A macho attitude prevails in InvestoWorld. The feeling is that any “expert” who acknowledges a mistake can no longer be viewed as a true expert.

Yucko!

The research that brought us Passive Investing is important research. Learning that short-term timing does not work truly was a breakthrough. But if we are going to turn investing into a science (and that is what we are doing when we use research into the historical data to inform our decisions) we are going to need to adopt more than the trappings of science.

Real scientists always remain open to new findings. Real scientists avoid dogma.
Real scientists don’t ignore their mistakes, they learn from them.

Passive Investing has failed us. It was a mistake. It has caused great human misery for millions.

It’s time to move on. This time, we need to encourage the Investing “experts” to
take a far more humble attitude in the presentation of their advice.

We know more today than we did 30 years ago or 50 years ago. But we still do not even come close to knowing it all. Let’s work hard as we try to pull ourself out of the wreckage of the Passive Investing avalanche  not to repeat the oldest mistake of them all — forgetting that Pride Comes Before a Fall.

For more of Rob’s articles and postcasts, see his blog A Rich Life. What do you think – are you sticking to passive investing or trying to second-guess the market wisdom?