Do you see the data supporting index funds, yet still have the urge to try out some other theories? One way that financial folks try to resolve this conflict is with the concept of “Core and Explore” investing. I have no idea who came up with the name first, but essentially you split up your portfolio into two parts: a Core portion made up of low-cost index funds, and a Explore portion with which you can do whatever you want. This way, you can still watch CNBC, talk stocks around the water cooler, and try to decipher Cramer’s squealing. You get the rush of working to beat the market, but in the worst case you won’t fall too far behind.

Core Ideas (80-95% of total portfolio)
100% Target Retirement Fund, or
33% Total US Stock Market Index, 33% Total International Index, 33% Total Bond Index, or
Something based on one of these model asset allocation portfolios.

This part should be rebalanced regularly according to your pre-set asset allocation.

Explore Ideas (5-20% of total portfolio)
Individual Stocks
Actively Managed Mutual Funds
Options and Futures
Sector bets (Healthcare, Energy)
Currency Exchange, Gold, Commodities
Country bets (China, Russia, Japan, Brazil, India)
Market Timing (i.e. switching to 100% cash when bearish)

Many people mix index and non-index funds, but not necessarily consciously like this. I did have a “play money” account that I put a flat $5,000 towards before (as opposed to a percentage of my portfolio), but then I got busy/bored/disillusioned and liquidated it six months ago. I keep planning to revive it, but it just hasn’t made it up the priority list yet.

Now and then, I get asked if I recommend any specific stock newsletters. I usually assume these people haven’t read much of my blog 😉 I’m often given specific examples, like one that touts a 145% supposed return last year, or another one run by a group of Harvard MBA graduates. My reply is always the same: I don’t recommend any stock newsletters. There are a couple of reasons why:

First of all, the ones that you can go back and check on reliably haven’t done so hot. The Hulbert Financial Digest has been tracking the recommendations of investment newsletters for over 25 years. It’s research shows that 80% of these professional stock pickers can’t beat the market indexes.

According to this FundAdvice article, chasing last year’s hot newsletter is a very bad idea. From 1981-2002, if every year an investor put his or her money into the prior year?s top performing newsletter, the result would have been an annualized loss of 31.4 percent a year. That?s the same as starting with $10,000 and ending up 21 years later with $2.32. Ironically, most people that subscribe to Hulbert’s are looking to buy a stock newsletter!

Don’t forget the Motley Fool’s 100% failure rate for their 2006 predictions. Better luck this year, Fools!

As for the rest, how do you know if they are lying? Recently, FundAlarm caught one of these newsletters in the act of changing their historical trade data after a dismal year:

Using the market-timing system from Intelli-Timer, my return for the year came in at less than 2%, and I wondered how Intelli-Timer was going to update its Web site, and continue selling its system, after such a dismal performance. Now we have the answer: My year never happened. With no explanation, the Intelli-Timer Web site has completely revised its historical performance information… Faced with a system that was failing, it looks like Intelli-Timer has simply backtested a new system that produces dramatically better — and totally fictitious — results.

Nothing like making up crap when all else fails. Since there is essentially nobody policing these newsletters and websites, why not? Link via Diehards Forum.

I’ll say it again – commentary from stock analysts always sounds great and logical. They can throw out nice figures like rising margins, economic statistics, or fancy PQI ratios. If they are right, the can toot their own horn. If they aren’t, they can either ignore it or even lie! I really think most of you don’t need to hear all this, but it’s always good to have some links to help convince others.

To recap the first half of this review, my initial impression of Prosper was that is a somewhat risky investment opportunity with poor liquidity. However, along with the risk of loss comes the potential for a healthy return. Each of us can decide the rates that we wish to lend at. The question is, can I get a return that compensates me adequately for the risk I’m taking? Let’s dig into the numbers and see.

What kind of data do we get? What are the fees?
Again, I will focus only on the lender perspective here. My previous conclusion is that I would rely primarily on the credit information given. This turns out to be a letter credit grade (A,AA,B,C,D,E, or HR) derived from the Experian ScoreX PLUS credit score, not a FICO score. They are similar, but the range for a FICO score is 300-850 and the Experian ScoreX is from 300-900. Here are the relationships, as well as the corresponding historical default rates for borrowers with debt to income ratios of less than 20%.

As for lender fees, it’s pretty straightforward. You are charged an annual servicing fee of 0.5% for AA/A borrowers, and 1.0% for B-HR borrowers. So whatever your final lender interest rate is, 0.5-1.0% is automatically taken off the top. This was raised recently from the old rate of 0.5% across all loans.

How are the outstanding loans doing so far?
One of the reasons I didn’t loan any money on Prosper initially is because I simply didn’t trust myself or others to set the correct interest rates. All I had was the Experian chart above to try and estimate defaults, and that just didn’t seem enough. Would borrowers treat Prosper with the same respect as Citibank or Bank of America? Would the rates be too low due to an excess of lender money?

The bad news is that Prosper is barely one year old, still too young to make reliable judgments in my opinion. The good news is that Prosper does release what data it has. One thing you have to watch out when looking at the numbers is that many of the loans are so new that there simply hasn’t been time for them to default. A loan originated on January 1st won’t have its first payment due until February 1st, and it won’t be able to be considered late until March 1st. For an official default, it has to be 4 months late, or June 1st! And that’s only if not one single payment is ever made.

Therefore, I want to look at loans that are at least a few months old. I choose two periods to look at – loans originated in the 1st half of 2006, and loans from the 2nd half of 2006. Let’s see how those loans have done as of February 1st, 2007.

See here for definitions.

[Read more…]

Prosper.com is a person-to-person lending service where you can lend out money to complete strangers. My first and only post about Prosper was back on February 13, 2006, when it was first released to the public. Since then, I haven’t written a peep about them. An online service that offers high interest rates for my cash? Why haven’t I written about them? The simplest answer is that I’ve been waiting for more information to review.

Here is a first look at Prosper from a potential lender perspective.

This is not a short-term, safe investment.

You may have seen this ad, it says something to the effect of “Why settle for 5% APY from banks? Get 15%+ interest from Prosper”. Comparing itself to an online savings account is misleading for a couple of reasons:

Your money is not 100% liquid. The loan term is three years. All loans on Prosper are lent for 3 years. In a bank account, I can just walk over and take my money out. You will gradually get your principal back and might have some pre-payments, but your money is pretty much locked up for the short term.

Your money is now unsecured debt, which carries the possibility of loss of principal. Bank accounts are FDIC-insured. Your Prosper loan is not backed up by anything except for the word of the borrower. The only thing keeping them paying is either a sense of personal responsibility, or the threat of a black mark on their credit report. What happens when their credit is already bad? Will they view Prosper as a serious lender on par with credit card companies? What happens if Prosper goes out of business?

There are a variety of ways you can get higher interest for extra risk. Look at some Canadian Oil Trusts like PGH (15% yield), or high-yielding REIT stocks like LUM (13% yield). I don’t recommend these either, but my point is that you should compare apples to apples.

Prosper is an intermediate-term investment opportunity with lots of inherent risk. In addition, not everyone will get the same results. While one person may get 16% annual return, another person with a similar loan portfolio may have low or even negative returns.

What am I basing my decisions on?

Let’s look at the three major pieces of information you get when you are deciding on which loan to fund:

The Story. This is coming from the cynic inside me, but how accurate are these? I do believe most of them to be truthful, perhaps with a little positive glow on things. But how do I know if it’s not? Do I really need to read “I am very dependable and promise to pay you back”? Some group leaders will vouch for borrowers, but in the end, I put very little weight on this area.

Besides, which is better? The business start-up loan? The “fresh start” loan? The credit card consolidation loan? The I-want-a-new-Lexus loan? Here we might also be mixing emotion and business, which is fine if you want, but I’d personally rather not be emotionally invested in my lending.

Credit Profile. This is actually very useful. In addition to the credit grade which essentially gives you a range for their credit score, you can find out some details on the credit report. These include the number of delinquent accounts, how much was delinquent, negative public records, and their current revolving credit balance. More information here.

Employment Data. This includes both whether they are employed or not, how long they’ve been employed, and their income. This gives you their current debt-to-income ratio. Again, this is all self-reported by the borrower. I believe it would be far too costly for Prosper to actually verify this data, but it would be nice.

Of course, Prosper says that it is a crime to lie on a lending application, but my question is how many people have they caught and prosecuted for this crime? My guess is zero. In June 2006, in response to this criticism they started performing spot-checks for the “identity, address and income of a select number of borrowers.” They do not release the frequency or passing rate of these checks. Therefore, I also put relatively little weight on this area. I treat it like a very rough estimate.

In the end, all I am comfortable relying upon is the credit report, just like the credit card companies. I think the card companies are pretty good at what they do, so the only way us individuals are going to make money is to be satisfied with thinner margins than them (lend at cheaper rates), while at the same time trying to achieve close the same level of diversification.

Is this possible? Is it worth the effort needed? Check out Part 2, where I dig into the numbers.

Apparently the S&P 500 dropped 3.5% yesterday. Not bad for one day!

Let’s see what I haven’t done yet:

1. I haven’t logged into Vanguard.com, where all my IRAs are.
2. I haven’t logged into Fidelity.com, where my 401(k) is.
3. I haven’t logged into Scottrade, where… oh wait, I don’t have any individual stocks right now.

Why don’t I care? Because not only do I not have any control over the numbers, but there is also nothing I am going to do in response to what I see. I won’t be relieved, nor will I get depressed.

Remember, for every trade there is a buyer and a seller. The buyer thinks he’s getting a good deal. The seller think she’s getting a good deal. Both can’t be right. So now you must ask, how much do you want to bet that you are smarter then the next person? Many of us are competitive people, and it’s hard to admit that you’re average. This pervasive human tendency to overestimate one?s achievements and capabilities in relation to others is sometimes referred to as the Lake Wobegon effect (where all the children are above average).

For example, do you think you are an above-average driver? During one such survey, 80% of respondents rated themselves in the top 30% of all drivers. Hmm…

On top of that, you are going against the headwind of trade commissions, the bid-ask spread, and taxes on generated capital gains.

By essentially investing in every publicly-traded company out there (although not on a perfect market-cap weighted basis), I am able to take a different, non-competitive view of things. The way I see it, every single day millions of people are waking up and going to work in order to create value. They are thinking up new ideas, making better widgets and services, and selling those widgets and services to new people. And then they go to sleep, and people on the other side of the world wake up and do the same thing. It doesn’t matter if they are working for Ford or GM, Intel or AMD, Sirius or XM Radio. As a whole, value will be created using my money, and I sleep well at night.

I just finished watching my first episode of Deal or No Deal, a new game show on NBC. I personally thought it was amazingly dull, but it did remind me of a good parallel to investing that I read in the book The Coffeehouse Investor (Yes, I know. Who’s the dull one?). If you’ve never seen it, that’s okay, this is a simplified version which I will explain. (You can also play an online version if you’d like.)

Let’s say you have ten open suitcases, each with a different amount of money in them:

Obviously, if you had a choice you’d pick the one with $10,000 in it. But the Banker then closes the suitcases and mixes them all up. Next, he reveals the $8,000 suitcase. You can still choose any of the suitcases to take home. Which one would you pick?

Added: It’s interactive now! Click on a suitcase if you want to gamble.

This is similar to the situation that you are faced with when picking an active vs. passive mutual fund. Over extended periods, approximately 75-85% of actively managed mutual funds fail to match the total market average. Yes, you could pick the $9,000 or $10,000 suitcase, but do you want to take that risk? We should all the take $8,000 happily.

Knowing the $8,000 suitcase is readily available is another analogy to knowing about index funds. Otherwise, you might be walking around with the $6,000 or $7,000 suitcase thinking you got lucky… Remember, even picking the active mutual funds with the best 10-year historical returns doesn’t work! For example, the top 35 mutual funds from 1978 to 1987 cumulatively under-performed the stock market average by 7 percent annually the next ten years (data also taken from The Coffeehouse Investor.)

Ever wonder how the world’s liquid, investable assets are currently broken down by geographic area?

This is based on market capitalization as calculated by the MSCI Global Capital Markets Index. The United States by itself is approximately 45%. It will be interested to see how this graph will change in the next decade.