From the NYT:
May 21th
“Lies, Damned Lies and Statistics”
An excellent reminder for anyone who looks at information, particularly we who swim in it all day long.
How to think like a statistician, without the math.
Attention to Detail
Oftentimes it’s the little things that end up being the most important. There was this one time in class when my professor put up a graph on the projector. It was a bunch of data points with a smooth fitted line. He asked what we saw. Well, there was an increase in the beginning, a leveling off in the middle, and then another increase. However, what I missed was the little blip in the curve in the first increase. That was what we were after.
The point is that trends and patterns are important, but so are outliers, missing data points, and inconsistencies.
Read the rest of the article here.
Courtesy of Forefield
Balancing Your Investment Choices with Asset Allocation
A chocolate cake. Pasta. A pancake. They’re all very different, but they generally involve flour, eggs, and perhaps a liquid. Depending on how much of each ingredient you use, you can get very different outcomes. The same is true of your investments. Balancing a portfolio means combining various types of investments using a recipe that’s right for you.
Getting the right mix
The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, accounts for most of the ups and downs of a portfolio’s returns.
There’s another reason to think about the mix of investments in your portfolio. Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may be chosen for their growth potential. Others may provide regular income. Still others may offer safety or simply serve as a temporary place to park your money. And some investments even try to fill more than one role. Because you probably have multiple needs and desires, you need some combination of investment types.
Balancing how much of each you should include is one of your most important tasks as an investor. That balance between growth, income, and safety is called your asset allocation. It doesn’t guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.
Balancing risk and return
Ideally, you should strive for an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. Your financial professional tells you that in in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that’s 30 years away. Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn’t be seen as definitive. Your asset allocation is–or should be–as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances.
Many ways to diversify
When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don’t necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in foreign companies. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.
Asset allocation strategies
There are various approaches to calculating an asset allocation that makes the most sense for you.
The most popular approach is to look at what you’re investing for and how long you have to reach each goal. Those goals get balanced against your need for money to live on. The more secure your immediate income and the longer you have to achieve your investing goals, the more aggressively you might be able to invest for them. Your asset allocation might have a greater percentage of stocks than either bonds or cash, for example. Or you might be in the opposite situation. If you’re stretched financially and would have to tap your investments in an emergency, you’ll need to balance that fact against your longer-term goals. In addition to establishing an emergency fund, you may need to invest more conservatively than you might otherwise want to.
Some investors believe in shifting their assets among asset classes based on which types of investments they expect will do well or poorly in the near term. However, this approach, called “market timing,” is extremely difficult even for experienced investors. If you’re determined to try this, you should probably get some expert advice–and recognize that no one really knows where markets are headed.
Some people try to match market returns with an overall “core” strategy for most of their portfolio. They then put a smaller portion in very targeted investments that may behave very differently from those in the core and provide greater overall diversification. These often are asset classes that an investor thinks could benefit from more active management.
Just as you allocate your assets in an overall portfolio, you can also allocate assets for a specific goal. For example, you might have one asset allocation for retirement savings and another for college tuition bills. A retired professional with a conservative overall portfolio might still be comfortable investing more aggressively with money intended to be a grandchild’s inheritance. Someone who has taken the risk of starting a business might decide to be more conservative with his or her personal portfolio.
Things to think about
- Don’t forget about the impact of inflation on your savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.
- Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investing goals and whether the strategy you’re pursuing is worth the lost sleep.
- Your tax status might affect your asset allocation, though your decisions shouldn’t be based solely on tax concerns.
Even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.
Instructive in the debate surrounding the levels and trajectory of the Federal Debt and deficit…
SOURCE: dshort.com
May 17th
GoM Oil Spill, Indexed
SOURCE: ThisIsIndexed.com
May 14th
Independent Market Commentary
Whew, another week of earnings done! To this point, about 90% of companies have reported their Q1 earnings. I feel as if the ear buds I wear to listen to conference calls are permanently embedded in my ears. As I mentioned a couple of weeks ago, it has been an unusual earnings season, and the markets have definitely been behaving in an unusual manner in the past 7 trading sessions.
I will start with the markets. I assume that most of you saw the violent declines in the equity markets at the end of last week. The markets then rallied for the first three days of the week, only to sell off strongly into today, with the S&P 500 down just under 2% for the day. There has been much speculation as to the cause of the severe drop in the markets late last Thursday morning, and I will not speculate on the cause here. However, in my opinion, if there was significant confidence among investors that stocks are fairly valued, then the bid side of the market would not in essence “disappear.” This argues that there isn’t that level of confidence. Recently I commented on how I thought that the lackluster behavior of the markets in light of what appeared to be stellar earnings boiled down to two issues. One, outside of the S&P 500, earnings have not been that stellar. Second, I felt that we were possibly entering a period whereby investor’s expectations might actually exceed reality. In a previous commentary I referenced the late 90’s and early 2000’s when I discussed “whisper numbers.” Cisco was the king of always beating estimates, but eventually investors caught on and expected them to beat. Guess what? Cisco reported earnings Wednesday afternoon that handily beat estimates and they guided future revenues higher. Yet the stock sold off on the news because supposedly they did not guide higher to the extent that some had expected. And my wife wonders why I don’t have a hard time dealing with children. I am doing it all day long! The behavior of Cisco’s stock further indicates to me that investor confidence may be waning. Have a great weekend, and for those of you in Boise, get out and enjoy the beautiful weather.
Exchange-traded funds (ETFs) have become increasingly popular since they were introduced in the United States in the mid-1990s. Their tax efficiencies and relatively low investing costs have attracted investors who like the idea of combining the diversification of mutual funds with the trading flexibility of stocks. ETFs can fill a unique role in your portfolio, but you need to understand just how they work and the differences among the dizzying variety of ETFs now available.
What is an ETF?
Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and exchange-traded funds attempt to replicate the performance of a specific index.
However, a mutual fund is priced once a day, when the fund’s net asset value is calculated after the market closes. If you buy after that, you will receive the next day’s closing price. By contrast, an ETF is priced throughout the day and can be bought on margin or sold short–in other words, it’s traded just as a stock is.
How ETFs invest
Since their inception, most ETFs have invested in stocks or bonds, buying the shares represented in a particular index. For example, an ETF might track the Nasdaq 100, the S&P 500, or a bond index. Other ETFs invest in hard assets–for example, gold bullion. In such cases, a commodity or precious-metals ETF may buy futures contracts or quantities of bullion. With the rapid proliferation of ETFs in recent years, if there’s an index, there’s a good chance there’s an ETF that invests in it.
The new wave of ETFs
New and unique indexes are being developed every day. As a result, ETFs that might seem similar–for example, two funds that invest in large-cap stocks–can actually be quite different. Many indexes define which securities are included based on their market capitalization–the number of shares outstanding times the price per share. However, other indexes and the ETFs that mimic them may select or weight securities within the index based on fundamental factors, such as a stock’s dividend yield.
Why is weighting important? Because it can affect the impact that individual securities have on the fund’s result. For example, an index that is weighted by market cap will be more affected by underperformance at a large-cap company than it would be by an underperforming company with a smaller market cap. That’s because the large-cap company would represent a larger share of the index. However, if the index weighted each security equally, each would have an equal impact on the index’s performance.
Pros and Cons of Exchange-Traded Funds
| Pros |
| ETFs can be traded throughout the day as price fluctuates |
| ETFs can be bought on margin, sold short, or traded using stop orders and limit orders, just as stocks can |
| ETFs do not have to hold cash or buy and sell securities to meet redemption demands by fund investors |
| Annual expenses are often lower, which can be especially important for long-term investors |
| Because ETFs typically trade securities infrequently, they have lower annual taxable distributions than a mutual fund |
| Cons |
| Dollar-cost averaging will require paying repeated commissions and will increase investing costs |
| If an ETF is organized as a unit investment trust, delays in reinvesting its dividends may hamper returns |
| An ETF doesn’t necessarily trade at its net asset value, and bid-ask spreads may be wide for thinly traded issues or in volatile markets |
More and more new indexes are being introduced, many of which cover narrow niches of the market, or use novel rules to choose securities. Many so-called rules-based ETFs are beginning to take on aspects of actively managed funds–for example, by limiting the percentage of the fund that can be devoted to a single security or industry.
The cost advantages and tradeoffs of ETFs
As indicated above, one of the reasons ETFs have gained ground with investors is because of their low annual expenses. Passive index investing means an ETF doesn’t require a portfolio manager or a research staff to select securities; that reduces the fund’s overhead. Also, investing in an index means that trades are generally made only when the index itself changes. As a result, the trading costs required by frequent buying and selling of securities in the fund are minimized.
However, don’t forget that you’ll pay a commission each time you buy or sell ETF shares. That means a one-time lump-sum investment in an ETF will be more cost-effective than dollar-cost averaging, which involves frequent, regular investments over time.
ETFs and taxes
ETFs can be relatively tax efficient. Because it trades so infrequently, an ETF typically distributes few capital gains during the year. In the past, there have been times when some investors found themselves paying taxes on capital gains generated by a mutual fund, even though the value of their fund may actually have dropped. Though it’s not impossible for an ETF to have capital gains, ETFs generally can minimize the ongoing capital gains taxes you’ll pay.
Just how much impact can reducing taxes have over the long term? More than you might think. Even a 1% difference in your return can be significant. For example, if you invest $50,000 and earn an average annual return of 5% (compounded monthly), you would have a pretax amount of $82,350 after 10 years. Even a 1% increase in that return would give you $90,970 at the end of that time. (This hypothetical example is for illustrative purposes only and does not represent the performance of any particular investment. Actual results will vary.)
Make sure you consider just how an ETF’s returns will be taxed. Depending on how the fund is organized and what it invests in, returns could be taxed as short-term capital gains, ordinary income, or even (in the case of gold and silver ETFs) as collectibles, all of which are taxed at higher rates than long-term capital gains.
What are some other reasons investors use ETFs?
- To get exposure to a particular industry or sector of the market. Because the minimum investment in an ETF is the cost of a single share, ETFs can be a low-cost way to make a diversified investment in alternative investments, a particular investing style, or geographic region.
- To limit losses. Being able to set a stop-loss limit on your ETF shares can help you manage potential losses. A stop-loss order instructs your broker to sell your position if the shares fall to a certain price. If the ETF’s price falls, you’ve minimized your losses. If its price rises over time, you could increase the stop-loss figure accordingly. That lets you pursue potential gains while setting a limit on the amount you can lose.
How to evaluate an ETF
1) Look at the index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it.
2) Look at how long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.
3) Look at the fund’s expense ratios. The more straightforward its investing strategy, the lower expenses are likely to be. An index using futures contracts is likely to have higher expenses than one that simply replicates the S&P 500.
The economic data released during the week ending 14 May was quite positive. The data supports our theses that economic growth has been lead by the industrial sector, although the continued strength in retail sales points to a larger-than-expected contribution from the American consumer.
- International trade figures showed sharp growth in both export and imports, suggesting broad firming of the economy. The reported strength in exports to emerging markets (+38% YoY) was noteworthy.
- Retail sales were better than expected, although it’s difficult to account for the effect of Easter’s timing. This was the latest in a string of releases showing greater-than-expected spending, given weakness in employment and housing.
- Industry continues to lead the way as businesses invest to replenish inventories and meet stronger-than-expected demand. The important manufacturing segment again showed solid growth, while other segments were mixed.
- Capacity Utilization has risen 4.5% from a year earlier but remains almost 7% below its long-term average, with particular weakness at “semifinished” and “finished” stages of production.
- The sole fly in this week’s ointment was the continued difficulty faced by small businesses. In the NFIB survey, nine of 10 components rose and one was unchanged, but job measures and capex plans were flat. The report seems a step in the right direction but only a tentative one. There clearly remains a dichotomy between large businesses (ISM surveys) and small businesses.
| RELEASE (leading, coincident or lagging indicator) | PERIOD | ACTUAL | EXPECTED (consensus) | LAST |
| International Trade (lagging) | March | -$40.4B | -$40.5B | -$39.7 B |
| NFIB Small Business Optimism (lagging) | April | 90.6 | 87.1 | 86.8 |
| Retail Sales (leading) | April (MoM) | +0.4% | +0.2% | +1.6% |
| Industrial Production (coincident) | April (MoM) | +0.8% | +0.6% | +0.1% |
| Capacity Utilization (coincident) | April | 73.7% | 73.7% | 73.2% |
TRADE BALANCE
Graph: Bureau of Economic Analysis
NATIONAL FEDERATION OF SMALL BUSINESS INDEX OF SMALL BUSINESS OPTIMISM
NFIB Small Business Optimism Index, 5/31/07 – 4/30/10
GRAPH: Bloomberg
ADVANCE RETAIL SALES
CHART: Census Bureau
INDUSTRIAL PRODUCTION / CAPACITY UTILIZATION
GRAPH: Federal Reserve
May 11th
Housing Overhang
We’ve mentioned in a number of previous posts the large overhang of existing homes that have and will continue to hit the market. Courtesy of T2 Parthers via InvestmentPostcards.com is a table and chart that effectively captures the issue.
The additional 7.2 million units that are forecast to hit the market are in addition, of course, to homes put up for sale due to “normal” circumstances – relocation, divorce, death, up- or down-sizing, etc. – and new construction. Housing is, and will remain for some time, a very large fly in the economic ointment.
May 28th
“The Great Arbiter, Part 2″
Author: Kenn Lamson
Comments: 0
I’m taking advantage of a much-needed lull in the rather volatile market action of late (otherwise known as Memorial Day weekend) to follow up on a post I wrote in late March discussing the municipal bond market’s evaluation of Idaho’s fiscal situation.
BMO Capital Markets, which kindly allowed me to cite their state-by-state credit quality research, has recently updated their information to consider, among other things, the April recalibration of state credit ratings by Moodys Investors Service. Idaho’s rating, like that of many other states, was raised from Aa2 to Aa1 as the rating agency adjusted their municipal credit scoring model to align with the one used for grading corporate risk. A snapshot from Relative State 05 2010, comparing Western states, is below:
As is apparent from the table, Idaho’s fiscal situation, while far from pristine, compares favorably with its Western neighbors. Idaho’s bond yield spread over a theoretically riskless muni, at 0.35%, is wider and therefore more attractive (all other things being equal) than its similarly rated neighbors. The additional yield available on Idaho bonds could be due to the market’s anticipation of further fiscal trouble in 2011, expectation of more bond issuance in the near future or simply an opportunity created by the market’s preference for and understanding of bonds issued in larger states.
The updated graph plotting the yield spreads versus BMO’s Financial Strength Index is provided below. Compared to the chart provided in the earlier post, Idaho’s yield spread and Financial Strength Index are basically unchanged.