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.

There have been a lot of comings and goings in the person-to-person social lending arena, so here are some updates and opinions as a casual observer sprinkled in.

Prosper Steps Away
The first and biggest (by total outstanding loans) P2P lender, Prosper, recently shut down to lenders while pursuing registration with the SEC to allow folks to buy and sell existing loans:

Until we complete the registration process, we will not accept new lender registrations or allow new commitments from existing lenders. If you’re an existing lender, your current lender agreements will be unaffected; your existing loans will continue to be serviced; you’ll be able to track and monitor your loans; and you’ll be able to withdraw funds from your Prosper account.

If you’re a borrower with an existing loan, you will continue with your current borrower agreement and be unaffected by the registration process. If you’re a borrower seeking a loan, you will still be able to create a new loan listing, which we will endeavor to fulfill through alternative sources.

Personally, I think having a liquid secondary market for these loans is a great idea in the long run. I always disliked the idea of making a 3-year loan that could be repaid by the borrower early, but not sold early. As a point of reference, Lending Club took around 6 months to complete the SEC registration.

More posts: Review Part 1, Review Part 2, Default rates, Scary graph

Lending Club Returns
After going through their own quiet period, Lending Club is now accepting new lender registrations again, as well as allowing existing lenders to bid on loans. But now, you can also buy and sell existing loans now on partner site FOLIOfn. It costs you a 1% fee to sell your loan, in addition to any possible gain/loss in the open market.

Right now, it would seem that Lending Club is the best game in town. For lenders, the loan performance stats seem to be better on average than Prosper, with much lower default rates so far, although there is still definitely risk these days. For potential borrowers like credit card consolidators, you can try them first to see what rate you can get. When you apply, you get an overall credit rating which determines your interest rate.

More posts: Lending Club Review

Zopa US Quits Pretending
Even at first glance, I thought Zopa US was a credit union in disguise. Well, right before Halloween, Zopa takes off the mask and reveals that… hey! We are a credit union. Now “lenders” are directed to buy a certificate of deposit at a credit union, and borrowers are offered a credit union loan from USA Federal CU.

It was (and still is) a shame that Zopa could not bring their UK model here due to legal issues. Hire some better lobbyists!

Loanio Arrives
A new competitor arrives to stir things up as well. Loanio is now open for business. Their model is pretty similar to Prosper, in that you bid on specific loans and the interest rates adjust downwards like a reverse auction. They have a referral program as well, and new lenders can earn a $25 bonus:

Every time you refer a new borrower who gets a loan, you’ll earn $50.00 and for every new lender referred, you and the new lender will receive $25.00!

Here is my referral link. I opened a new account last week. You must deposit $100 to start, but can withdraw it later. However, you must fund a loan ($50 minimum bid) to get the $25 bonus.

First impressions? Reminds me of Prosper, but the site design could be better, and it loads slowly. I’m also having trouble finding a loan to fund. If you see a good one that’s nearly funded, let me know!

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. 🙂

A couple of people asked my opinions on all this financial market turbulence. I really don’t have that many coherent thoughts these days, but if you really want to know, here is a sample of what has been going through my head:

• People need to stop refreshing CNN.com and staring at those ticker symbols. Watching doesn’t change anything. It’ll just give you indigestion. If not, can I have your spicy ahi bowl?
• For some reason, I am not worried. I am actually a bit excited. But if I was close to retirement and more than 60% stocks in my portfolio, I would definitely have fear. I understand my parents’ fear.
• Check out this Vanguard article on the benefits of diversification.
• Negative sentiment and recessions are part of investing. If you are young, it would be a bit naive to think that you would never see a recession in your investing experience. Perhaps you used to wonder how you would handle a real stock market drop. Well, how are you taking it so far?
• Simple and easy are not the same thing. Buy-and-hold is a simple investing strategy. But it is not easy. Right now, cash looks pretty good to a lot of people. Can you stick it out?
• People should vote.
• “Why not just sell and wait things out for a while? This isn’t the bottom!” Sure, this may not be the market bottom. But chances are you’ll miss the bottom. If you try and catch the market on the way up, you’ll probably miss most of the rise before you jump back on the bandwagon.
• A lot of behavioral finance research has shown that humans are pretty stupid when predicting trends. If we see things go up for even a little while, our natural instinct is to predict that next it will go up again. If things go down twice in a row, then we predict the third time it will go down… and down… and down… oops! It went back up!
• As of today, I personally do think things can and probably will get worse. But again, I also don’t know when the bottom will hit. So I will be making regular buys all the way down.
• If you haven’t already, try this charting game I pointed out before. It helped to convince me that I am especially bad at market timing. 😀
• For the individual stock investors, I hope that you continue to track your performance (including cash balances). I am content being guaranteed to be slightly above average due to having very low investment expenses through index funds.
• The real yield on individual inflation-protected bonds (TIPS) is pretty high right now, around 2.5%. I might buy some, as the real yield and maturity combination seems a lot better than what is available in VIPSX. But I need to do more research.

Okay, that’s me. So what do you think?

I should really stop looking at CNN.com and CNBC.com, but nobody will stop talking about it so here I am talking about it too. Moo. 🙂 If you watch your portfolio closely and are feeling nervous and/or scared, then perhaps this is a good time to self-reflect and ask yourself if you are as risk tolerant as you thought you were.

Many financial experts like to give out a simple “risk questionnaire” to figure out your risk tolerance, and then guide you into an asset allocation afterwards. The problem is, it is really easy for people to say “I’m not scared!” and then tell themselves they don’t need to save as much. The more you save, the less risk you need to take. Back when stocks were booming, so many folks had 100% in stocks, and even some retirees had 60-70% in stocks.

Back in 2006, I tried out a bunch of these risk surveys and remarked that

I think it’s really hard for people to gauge how they would react to losing 30% of their assets in a year unless they had actually experienced it.

I still don’t think we have experienced true fear yet, but maybe now is a better time to take the survey questions again? These samples are taken from the ShareBuilder website’s PortfolioBuilder application.

Sample Question 1

Well, the year-to-date total return of the S&P 500 is only about -12% as of the end of today. It was about -15% yesterday.

Sample Question 2

The recent bouncing around puts this question in a new light, eh?

Sample Question 3

Even now, we are nowhere near dropping 25% in 3 months. Are you sure what you would do?