One of the eternal questions in investing is whether performance results are due to skill or luck. We’ll probably never get a universally-accepted answer, but Michael Mauboussin (chief investment strategist at Legg Mason Capital Management) explores the subject in his new book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.

I haven’t read the book, but in a WSJ interview the author shares a graphic illustrating where he views investing on the skill-to-luck continuum. At the extremes are the pure luck of roulette and the overwhelming dominance of skill in chess.

Mauboussin is quick to explain that the luck factor comes into play because making money is a hugely powerful motivator and thus draws in the smartest people in the world. This leads to competition at such a high level that differences in results are mostly luck, especially in the short-term.

This reminds me of another famous skill vs. luck argument by Warren Buffett called The Superinvestors of Graham-and-Doddsville (Wikipedia). You can feel his annoyance at the academics suggesting that his mentors were simply statistical anomalies.

For the record, I don’t believe in the academic definition of the efficient market hypothesis either. But as the graphic above suggests, market efficiency is not a yes/no situation but a matter of degree. Even Buffett has repeatedly stated that most investors would be better off in low cost index funds, and even wagered $1 million that the Vanguard S&P 500 index fund would outperform a basket of hedge funds over a decade. The bet started in 2008, and as of March 2012 the index fund is ahead. Of course, no matter who wins, was it skill… or luck?

(This post is for investors and lenders. If you need a loan or debt consolidation, check out my LendingClub vs. Prosper comparison for borrowers.)

As part of my new Beat-the-Market Experiment, I have dedicated $5,000 to Prosper. As a quick recap, Prosper.com securitizes person-to-person loans so that you can lend money to other people in $25 increments and earn interest. The idea is to replace banks and credit cards as the middlemen. Since their mid-2009 re-launch after SEC registration, there have been a full cycle of 3-year Prosper “2.0” loans fully maturing with an average net return of over 8% annualized. However, this is still unsecured lending which means no car or home as collateral, and thus there is a risk of loss (which can be mitigated by diversifying in multiple loans).

Prosper looks at the credit history of prospective borrowers and charges them an interest rate based on a Prosper Rating of AA, A, B, C, D, E, or HR (high risk). (The ratings are relative; the minimum credit score is 640.) Now, if Prosper’s grading system was perfect, life would be simple. The interest rate charged would be high enough to cover any defaults plus a little extra for the added heartburn. Ideally, after defaults and fees are accounted for, perhaps AA loans would earn 6%, C loans would earn 8%, and E loans would earn 10%.

However, things aren’t quite that neat. Prosper publicly shares all its loan information, and smart folks have made tools to analyze that data. Currently, the best place to go is Prosper Stats. If you take all the loans, we see that AA loans have a net return (after estimating losses from late loans and actual losses from defaults) of ~6%, C loans had a net return of ~11%, but E loans only returned ~9%. Hmm. Look further and you’ll see other small inconsistencies. For example, loans to people with 2 or less open credit lines actually have a measly 3% net return, while loans to folks with 18+ open credit lines open have net annualized returns of over 11%?!

As a result, many investors avoid investing in Prosper loans blindly and instead use specific search filters. Indeed, Prosper makes it easy with their “Automated Quick Invest” service which automatically invests in loans that satisfy your custom search rules. There’s no need to spend time every day looking for loans. So, what are some possible criteria?

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One of my online friends, Nomadic Matt, approached me for some investing advice. Matt changed his career path and now travels around the world and writes about it for a living. Not a bad gig, eh?

Matt and I had a short chat about his goals and situation, which he agreed to open up to outside advice as he has some specific investment ideas and leanings that he’d like to explore. I believe he is single in his late 20s or early 30s, and he also has an MBA so he’s not starting from scratch.

MMB: So roughly how much money are we talking about here? How is it currently invested and in what types of accounts (bank, IRA, brokerage, etc)?

Matt: I have a small five figure sum invested in a SEP IRA.

MMB: What is your timeline and goals for this money? Are you looking to save for retirement, a house, or something else? Would you want access part of it if needed? If retirement, are we talking at age 40 or 65?

Matt: It’s in an IRA, so retirement. I just want it to grow. I wouldn’t need to before 65.

MMB: Approximately how much additional money are you going to be able to contribute in the future?
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Update: Check out the monthly updates on this experiment.

Do you think you’re a below-average driver? Of course not. Everyone thinks they’re above-average. This is why I’m a big proponent of the “Core and Explore” or “Play” portfolio. You should set aside a small percentage of your portfolio and try your best to beat a passive benchmark. If you track things carefully, chances are that after a few years you’ll discover you really aren’t so good and hopefully end up settling into the slight-but-guaranteed outperformance of low-cost, passive investing. Or, you’ll find you’re meant to be a rich and successful hedge fund manager. Win-win!

I’ve been running a little side portfolio for years, but I haven’t been following my own advice about tracking my relative performance. I think it’s time. I’m taking $30,000 and using it for my “Beat the Market” experiment. This is less than 5% of my actual portfolio, which is still overwhelmingly in low-cost index funds rebalanced to a target asset allocation. I’ll track the balances monthly with actual screenshots starting today, November 1st, 2012. Here’s how I’m breaking it down.

$10,000 “Good Boy” Passive ETF Benchmark Portfolio

My real portfolio is held primarily at Vanguard and Fidelity but also includes non-index funds due to limited 401k choices. To create a separate benchmark, I opened a new account at TD Ameritrade as they offer 100 of the most popular ETFs commission-free, including the Vanguard and iShares ETFs that I use. My benchmark portfolio will be based on my usual target asset allocation, except fully-invested in 100% stocks (details coming). As the portfolio will consist of commission-free ETFs and there are no maintenance or service fees, the overall cost drag should be very, very low.

I will not make any deposits or withdrawals to this account, and will report the total balance on a monthly basis. I suppose I could also track after-tax efficiency, but that sounds like too much work and most people invest predominantly in 401k’s and IRAs anyway.

(I know, it has $15,000 in it right now, I already submitted a withdrawal request for $5,000.)

$10,000 “Bad Boy” Beat-the-Benchmark Portfolio

In this account, I’ll be able to buy whatever: individuals stocks, ETFs, options, and even short stocks as needed in my attempts to crush the Benchmark portfolio above. I liquidated the holdings in my existing TradeKing account and left $10,000 in there. This will serve as a low-cost, no-fee brokerage account with $4.95 trades and 65 cent options contracts. (TD Ameritrade standard pricing is $9.99 a trade.)

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Tax-loss harvesting (TLH) is a technique used to minimize taxes on your taxable investments – without altering them significantly – by “harvesting” capital losses during market declines. There are many lengthy articles about TLH out there, but Wealthfront recently released a brief video about tax-loss harvesting that is a good intro to the subject:

Wealthfront is now including tax-loss harvesting in their 0.25% advisory fee for clients with taxable accounts of $100,000 or more. (Advisory fee is on top of ETF and/or mutual fund expense ratios.) I think it’s great that they are offering tax-loss harvesting at a reasonable price, but I don’t know about their contention that tax-loss harvesting is “traditionally only available to accounts in excess of $10 million”. Respectable portfolio managers, include low-cost passive portfolio managers, have been providing tax-loss harvesting to all their clients for a long time. It is true that other online portfolio managers like Betterment currently don’t offer this, however.

(I’m also skeptical about their finding that TLH boosted returns by a full percentage point, I’d be worried about data mining. I mean, sure, if you harvested losses perfectly during every little decline, maybe, but 1% is a lot.)

Indeed, if you’re a DIY investor with a portfolio of a 2-6 index ETFs, you can harvest losses on your own. Here’s an tax-loss harvesting example with ETFs from an old blog post. Wealthfront’s materials suggest that their own method is to sell a primary ETF (ex. Vanguard/VEA) when it’s down and buy the low-priced secondary ETF equivalent (ex. Schwab/SCHF) to replace it. Then, you sell the secondary ETF again after 30 days to get your Vanguard ETF back with a lower basis while avoiding IRS wash sale rules. They believe that their pairings satisfy the IRS requirement that the ETFs can’t be “substantially identical”. You’ll have to decide for yourself if you want to do those extra two trades to swap things back (and paying extra commisions) every time you TLH, or if you should just keep holding the secondary ETF until the next time you want to sell for whatever reason.

Update: I received the following message from Wealthfront:

I wanted to point out when reading your post is that we offer continuous tax-loss harvesting as opposed to year end tax-loss harvesting. We agree with you that the expected benefits on year end tax-loss harvesting is not 1% a year but rather that is for continuous tax-loss harvesting where you are continually harvesting throughout the year.

Here is their whitepaper on the subject, although I should note that the 1% alpha is based on the assumption that you are in the highest 35% tax bracket (while long-term gains are at 15% tax rate). The continuous algorithm deciding when to harvest is interesting, being based partially on “each ETF’s volatility parameter estimated over a rolling time window.”

The Vanguard Total Bond Market Index Fund is designed to track the entire spectrum of US bonds (well, those that are publicly-traded, taxable, and investment-grade). It is the second-largest bond fund out there, with $160 billion in assets and behind only the PIMCO Total Return Fund. It is available to retail investors as a mutual fund (VBMFX/VBTLX) or ETF (BND). If you own a Vanguard Target Retirement or LifeStrategy fund, you own some version of this fund. Let’s take a closer look.

Vanguard founder Jack Bogle wrote an article called The Bond Index Fund which talks about how the Vanguard Total Bond Index fund got started and its subsequent performance:

It’s now 25-year lifetime rate of annual return averaged 6.9 percent, a nice margin of 1.2 percentage points over the average 5.7 percent rate of return of its taxable peers. That superiority comes despite the Fund’s assuming far less credit risk, for the fund (and the bond market index itself) typically hold more than 70 percent of assets in securities backed by the U.S. Treasury and its agencies, including mortgage pass-through certificates. Compounded, the appreciation of a $10,000 investment made at the close of 1986 was remarkable: average actively-managed bond fund $29,900; Vanguard’s passively-managed bond index fund, $42,600—an enhancement in profit of more than 40 percent. This stunning advantage once again reaffirms the timeless truism: Never forget either the magic of long-term compounding of returns, nor the tyranny of long-term compounding of costs.

You have to admit, this historical growth chart looks pretty good:

So, what’s inside this bond juggernaut? For that, we look at the popular benchmark Barclays US Aggregate index, which started in 1986. As it is a market-cap weighted index, the composition shifts constantly over time. The iShares blog has an illustrative chart:

What do all those acronyms mean?

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