Weekend Reading 3/3/2014

Here are some articles that caught my attention this past weekend. Topics include: The value of Diversification, Investing in a bull market and of course, Warren Buffett’s annual shareholder letter.

 

 

On Diversification:

JP Morgan’s 2014 “Guide to The Markets”

 

I always try and catch this report as soon as it is released. JP Morgan’s quarterly “Guide to the Markets” are always filled with valuable information for any investor. I am a little late with this one for 1st Quarter 2014, but its information is no less valuable today.

 

The report consists of over 70 slides, nearly all of which have some interesting facts and figures. But there is one slide I continually look at which really helps bring home the power of diversification and long term investing for me.

 

JP_Morgon_Guide_to_Markets_Diversification

It has long been proven that investors in general are horrible at trying to time the stock market. As shown above, the average investor gets an annualized 2.3% return over the last 20 years! That is terrible!

The slide shows 2 pie charts; a simple “3 fund” portfolio and a much more complicated portfolio consisting of 8 different asset classes. Both of these portfolios drastically outperform the average investor. But what I think is important is the outperformance by adding diversification. Not only does diversification help reduce the volatility of the portfolio, in the past 20 years it has also helped increase returns at the same time!

 

The discussion of diversification is continued with our next link:

 

The Rick Ferri 60/40 Portfolio

 

A simple 60/40 (meaning 60% stocks, 40% bonds) portfolio can be set up by buying just 2 funds. Usually an S&P 500 index fund (Such as ETF: SPY) and a total bond fund (Such as ETF: BND).

And this simple portfolio has performed very well over long periods of time. The article points out that a simple 2 fund portfolio with 60% in SPY and 40% in BND has averaged a respectable 6.2% return over the last 10 years.

 

But, similar to the JP Morgan slide above, adding some extra diversification has actually improved returns!

Rick Ferri’s 60/40 portfolio looks a little more complicated:

Rick_Ferris_60-40

 

 

Rick_Ferris_60-40-breakdown

Adding these funds changes your average return over the past 10 years to 8.1% annual return. Nearly 2% per year higher than a simple 2 fund portfolio.

 

To quote the article:

“Diversification is still the most consistent way to extract value from the financial markets over the long run.”

 

A couple of concerns with these portfolios:

Increased cost – As you add more funds to your portfolio and get away from the simple stock index funds, you are going to run into increased costs. ETFs that invest in asset classes such as emerging markets, commodities and high yield bonds will inevitably have much higher expense ratios. Keep a cautious eye out for the expense ratios of the additional funds and strive keep costs low whenever possible.

 

Active Management – These portfolios only work when you apply patience to the diversification. Adding a lot of these funds typically exposes investors to the inclination to increase their trading habits. They see small cap funds outperforming and boost the allocation to small cap funds, while reducing the allocation to emerging markets for example.

 

The returns by asset class vary wildly from year to year. JP Morgan offers a chart in their Guide to Markets linked above:

JP_Morgon_Guide_to_Markets_asset_class_performance

 

The goal is not to predict what asset class will be on top next year. The goal is to be certain to own what will be on top next year. That means owning a little bit of everything, within reason, and re-balancing the portfolio as required. This results in certain underperformance in short time frames, but near certain satisfactory results in the long term.

 

 

 

On Long Term Investing

Speaking of long term, there is no better example to the powers of having a long term approach to investing than Warren Buffett. And this week he sent out his 2013 letter to shareholders, which is found here:

http://www.berkshirehathaway.com/letters/2013ltr.pdf

This is always one of my top reads for the year. For most investors, reading all of his letters from start to finish probably provides more education than any other resource can offer. And this year is no exception.

Some of my favorite quotes and graphics from this year’s letter:

 

“The “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.”

 

 

Buffett’s largest investments:

 

Buffett_letter_to_shareholders_-_equity_investments
Buffett’s Largest Holdings

 

 

You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you

must recognize your limitations and follow a course certain to work reasonably well. Keep things simple

and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

 

Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough

estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every

investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake

 

 

I will have a post shortly on Begin To Invest which will go into much more depth on this letter, so let this be a little teaser for things to come.

 

On The Market in General

I can’t help but wonder how some of the massive price appreciations in stocks like TESLA (Ticker: TSLA), Facebook (Ticker: FB) and others play out. We have quickly swung from the depths of 2009 into one of the greatest bull markets in history. Many investors missed it, and are just started to get back into stocks now. The market as a whole is not ridiculous yet, but certain stocks and sectors are.

 

I really liked this quote by Josh Brown on his Reformed Broker Blog:

 

“My friend Helene Meisler noted that “users” are to 2014 what “eyeballs” were to 1999. History doesn’t repeat and it doesn’t necessarily rhyme. It Retweets. It’s hilarious what we’re valuing “users” at these days, as if there’s some permanence to the fact that someone downloaded and app and uploaded a few dick pics. I’m trying to convince my dentist to call his patients “users” and then sell his practice to Sequoia or Union Square Ventures.”

 

I say all of this not to offer my prediction to what the market holds. My prediction of Tesla, Facebook and several other “hot stocks” falling drastically within the next year or two will probably be proven to be very wrong.

 

I say this to remind you of the actions an “intelligent investor” should be taking today. Stocks are rising significantly and portfolios should be rebalanced to account for that. If you have not rebalanced for this year yet that most likely means selling small cap growth stocks and buying emerging markets and some bonds. Its not the fun thing to do, but it is the most responsible.

 

It doesn’t mean get out of everything, which would be equally as dumb as going all in Tesla right now. It means keep your portfolio responsibly diversified, even if your neighbor is making a killing on Tesla right now. Because if history is any lesson, an investor today with a simple diversified portfolio will still be standing a decade from now, where an investor is Tesla will not.

 

Hope you enjoyed your weekend. It was a quiet week on Begin To Invest. Posts and updates should be much more frequent for the foreseeable future. I am hitting the social media accounts hard, so if you haven’t seen and followed our Twitter and Facebook pages, check them out!

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