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Here are some good reads about investing from this week:

How to Survive and Succeed Through a Bear Market
This letter to shareholders is written by John Montgomery, founder of Bridgeway Funds, which are a group of actively managed mutual funds with a reputation of high ethical standard and putting shareholders first. It provides his insights into investing and reminds us that there is also a risk when we only invest in safe investments. An excerpt:

This is my fourth* bear market as an investor, three of which have happened since I founded Bridgeway Capital Management in 1993. Even before the last three bear markets, I studied stock market data in detail going back to 1926. I spent quite a bit of time focusing on the downturns and thinking about how to survive them and why stock market investing is still very attractive even when predictably it doesn’t feel that way. From this research I formed five principles of long-term investing that became part of Bridgeway’s investment philosophy and are interwoven into our investment process. […] I thought I’d share what I learned with our investors.

When should you change your asset allocation strategy?
This post on the Bogleheads forum was written by Rick Ferri, investment portfolio manager at Portfolio Solutions and author of several good books on index and passive investing (including All About Asset Allocation). As a portfolio manager, of course he’s been fielding a lot of phone calls recently. Here are his thoughts for the general investor. An excerpt:

Significant changes to your stock and bond asset allocation strategy is a major decision and can be compared to changing careers. There are several good reasons to change your asset allocation strategy along life’s journey. Below are three reasons I believe a person has a legitimate reason to make an asset allocation change:

1) Your target retirement goal is well within reach.
2) You realize that you will not need all your money during your lifetime.
3) You have realized that your tolerance for risk is not as high as you once thought.

Why stock picking is a losing game
This article on CNN Money is by William Bernstein, another well-known portfolio manager and author of investment books such as the Four Pillars of Investing. Here he tries to remind us that just because the indexes are dropping, it doesn’t mean it’s time to switch to something that sounds better.

I’m sure you’ve heard that while it’s fine to ride the market’s gains when times are good, you need an expert stock picker when the bear roars. Wrong: Active money managers do not suddenly gain an extra 20 IQ point advantage over the rest of the market just because the Dow is falling. The record shows that their funds have trouble competing with the index in the bad times too.

Why do we think that the stock market will always go up? Why has it gone up over long periods of time historically? For instance, let’s look at this graph:

Source: A Random Walk Down Wall Street

There is one theory that I have read about in the writings of respected authors like Jack Bogle and William Bernstein. It states that there are three main components to long-term stock market performance:

Part 1: Dividend Yield
Obviously, if your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return.

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

These two parts added to together are coined the fundamental return:

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history:

Adding these two up finally gives you:

Predicting Fundamental Return
Now, what if your portfolio was all of the stocks traded in the United States? This would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

Here’s my quick take: If you invest in a globally diversified portfolio, do you believe that the world’s GDP will continue to increase in the future? I believe that this is a very good bet, and is a major reason why I continue to invest in the world markets with very low management expenses.

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 6% still.

Predicting Speculative Return
However, the speculative return has greatly contributed to the high returns of the last 25 years for the S&P 500. This is due to a great increase of the overall P/E ratio of the stock market in recent history:

Source: Bespoke Investments

In 1950, the P/E ratio was only 7. During the dot-com bubble, it was over 40. Recently, the P/E ratio was as high as 24. It is very unlikely that this huge increase will happen again. So what does the future hold if P/E ratio either stay flat or fall? This will lead to a zero, and quite possible negative, future speculative return!

Source: Little Book of Common Sense Investing, Exhibit 7.1

Summary
In my opinion, the fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe the the passion and motivation of all the people out there, from Sweden to China to Brazil.

However, there is good evidence that you might not be getting that 8-10% annualized return that many investment calculators seems to guarantee. You have to look at all the sources of expected future return, and the possibility of P/E ratio contraction.

But wait, why don’t people time the overall market based on P/E ratio? Some authors do recommend this. The problem is that the P/E ratio can also vary wildly for decades (see above), and most people don’t have either the patience or cash to fully see it through. For example, historically this has meant staying out of stock for 15 years at a time.

Will the P/E ratio ultimately settle at 15? 20? 30? 10? I have no clue. As the saying goes – the market can stay irrational longer than you can stay solvent. If it makes you feel better, as of this week, the P/E ratio is around 16. So the future speculative return from this point is starting to look more promising. 🙂

I’m always flattered when anyone (online or offline) asks me for investing advice, but at the same time I’m very cautious about giving it out. And it’s not just the usual *I’m not a financial professional* legal concerns, but the fact that it’s hard to give useful advice in a few paragraphs or a 5 minute chat. Over time, I’ve been refining my “amateur, informal financial advice over coffee” speech. My goal is to give specific ideas but to keep it simple. Let me know what you think.

1. Put your money in a Vanguard Target Retirement Fund. These mutual funds are an all-in-one basket of different low-cost index funds. You get some US stocks, some international stocks, and some bonds. The mix is automatically adjusted for you. No, they might not be perfect, but they are pretty darn good and very simple to hold. I have specifically have told my own mother to open an account at Vanguard. I withhold any theory talk about passive investing because this is when most people’s eyes seem to glaze over.

Just buy the fund with the date closest to when you want to start making withdrawals. All lifecycle or dated funds are not made the same. The ones in my 401k stink, and I don’t even like the Fidelity Freedom 20XX funds.

The Vanguard funds do have a $3,000 minimum initial investment. Until you have $3,000, just stick your money in an savings account paying decent interest and with an automatic deposit system. I know it sounds nice to “start investing with $100” (and here are some ways to do that), but honestly, if you don’t have $3,000, your focus should be more on saving money by spending less/earning rather than investing at this point. There is no need to rush.

2. Read a good investing book
Websites and blogs are great, but it is still very hard to replace a good book. They tend to be professionally edited, better organized, cover all the bases, and are easy to refer back to. I think the following books are great and are definitely worth the $10-$20 cost:

• Four Pillars of Investing – Most detail, for those with longer attention spans
• Bogleheads’ Guide to Investing – Somewhere in the middle
• Coffeehouse Investor – Least detail, short and easier to read

If you’re not convinced (perfectly understandable), first borrow it from the local library and then buy a copy if you like it. Read as much as you can!

3. Hey, no skipping ahead. Please do #2.
My friends ask me for advice. I say to read a book. Months later, most of them (not all) haven’t read any books but still want advice. Yes, I know, this involves effort. (Gasp!) Please, spend a weekend doing something that will dramatically increase your net worth in the future. If you don’t, then at least if you did #1, you’ll be ahead of most investors who pay too much money chasing hot stock tips or pay other people to chase hot stock tips for them.

4. Pay someone to do it for you
If it’s been years and you still haven’t read a darn book and don’t plan to, go to NAPFA.org and find yourself a fee-only financial advisor that you click with. Pay that person to keep you on track. If they are fee-only they are less apt to be biased on what investments they recommend. But remember, the person who will care most about your money is still you.

In Part 1 of this series, I talked about basing investing decisions on what I feel is most likely to persist in the future. This is another “big picture” post.

We invest our money because we want to do something besides just sit there. We want it to grow while we’re also busy working. The most basic way of doing that is to either start a business, or buy shares of another business. Some businesses will fail, some will do great, and it can be risky to bet on which one will do what. But as a whole, it is a pretty safe call to say that profits will be generated and value will be created. In the long run, you will end up with these profits. Therefore, one way to invest is simply to buy all the companies. And if you buy them in proportion to how much they are valued, then you end up with a good representation of the entire “market”.

This idea has been promoted by many financial experts. Jack Bogle offers a good explanation is his book The Little Book of Common Sense Investing. This excellent article on investing in total markets lists many others.

It may seem a bit crude at first (kind of like using a shotgun), but in fact it’s actually quite an elegant idea. You let the individual companies fight it out, and you just sit back and enjoy. For example, let’s say there is a growing desire for alternative fuels. Well, many companies are bound to pop up try and profit from that. Some will be wildly successful, some will fail. Maybe such energy companies become a huge part of the economy – well, if you bought total stock market fund you’d own all those winners. To paraphrase author Burton Malkiel – “My advice is that rather than futilely attempting to find the needle in the haystack, buy the haystack”.

This can be implemented on a country level, or even on a world level. The Vanguard Total Stock Market ETF (VTI) tracks the total US market via the Wilshire 5000 index and includes over 3,600 stocks. The Vanguard FTSE All-World ex-US ETF (VEU) tracks the entire world’s publicly traded companies, minus that of the US, and holds over 1,500 representative stocks from 47 countries. Since by the market capitalization of the world is currently split up about 45% Non-US/55% US, if you buy 3 shares of VEU for each share of VTI, and you’d be tracking the performance of virtually all of the world’s liquid companies.

I like this as a portfolio idea, but there are some other theories to consider as well…

Read more: Index of Posts On Building My Portfolio

Alan Greenspan was a guest on The Daily Show with Jon Stewart recently, mainly to promote his new book The Age of Turbulence but conveniently after the recent rate cut. It was amusing seeing Greenspan in the hot seat. Via the Bogleheads.

Update: Having some problems with the embedded video, so here is the direct link to the clip.

While reading The Little Book of Common Sense Investing by Vanguard founder Jack Bogle, I found one of the chapters on predicting future stock returns especially interesting. Here’s my attempt at summarizing it.

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).

As an example, let’s take a fictional company and call it Bob’s Taco Shack. The taco stand has earnings of $20,000 a year. It has 1,000 shares, so it’s earning $20 per share (EPS). Bob gives out $10 of that $20 as a dividend to shareholders, and reinvests the remaining $10 back into the company. Currently, the share price is $200, which gives us a price/earnings ratio of 10 and a dividend yield of 5%. Now, let me pose some statements, which I hope make sense.

1. If earnings stay constant, then one would expect the share price to stay constant as well. The stream of money coming is the same, so the price should be the same.
2. If earnings stay constant, and dividends are 5% year, then your return should be just that 5% a year. From the example, you just get that $10 in dividends (5% of $200).
3. If earnings grow by 5% a year, and there are no dividends, then your return would again be 5% a year. You are paying 10 times earnings. If the earnings go up by 5% to $21 per share, then the share price should go up to $210. You earned the same amount as the earnings grew.

This leads to the formula for what Bogle terms the “fundamental” return:

Now, if Bob announces that he plans to expand into fancy shrimp tacos and fish tacos, then maybe people will expect higher future profits and be willing to pay more per share, raising the P/E ratio. But this is based on speculation. Bob hasn’t actually done anything yet. So now we have speculative return:

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)

What about the future?
Great, right? As long as corporate earnings growth keeps chugging along and we keep getting some dividends, we should be good to go. Over the past 25 years, the U.S. stock market has had earnings growth of 6.4% and an overall dividend yield of 3.4%. Nice! But wait – there was also a speculative return of 2.7% due to the overall P/E ratio expanding from about 9 to 18!

As you can see below, that gave us really strong annual returns of 12.5% since ~1980. The problem is, this isn’t likely to continue. For one, dividend yields continue to drop, and are now about 2%. As Bogle states, even if you assume a continued corporate earnings growth rate of 6%, now you have a total of 2 + 6 = 8%. But the P/E ratio is not likely to get any bigger. If anything, history says it should shrink back a bit. If it goes back to 16, that alone will subtract 1% from expected returns.

Data taken from Little Book of Common Sense Investing, Exhibit 7.1

(If you don’t agree with the 7% number, make up your own based on your expected dividend rate, earnings growth, and future P/E expansions or shrinkage.)

As you can see, this shows that it is unlikely that in the next 25 years we will earn much more than 8% annually from stocks alone, and chances are it will be more in the range of 7%. Add in those bonds as you get older, and that return decreases even further. Food for thought…

My comment was – Will earnings growth rates increase, as companies are presumably re-investing money not paid as dividends in themselves? I sure hope so, but it seems like a lot to ask.