Pssst… did you hear? Standard & Poor (S&P) downgraded the US credit rating from the highest AAA to one notch down at AA+. Let’s remember what these guys are famous for. The ratings agencies missed Enron a decade ago – they didn’t reduce Enron from investment grade to junk until days before they shut down. Then they missed the Worldcom accounting scandal and the Global Crossing meltdown, marking them investment grade months before bankruptcy. Then they missed Bear Stearns, only cutting their rating one business day before they never opened again. Oh, and all those mortgage-backed securities rated AAA when they were stinking piles of poo.

Now, this doesn’t mean that the S&P is necessarily wrong. I just smell a ton of politics, and I hate politics. Also, how often have they sounded an alarm that actually helped small investors? As in “Watch out, you thought this was safe but it really isn’t! Look what we figured out with our in-depth analysis!” As opposed to “Yup, we read a newspaper last week.”

I was looking through some old posts looking for writing inspiration, when I found this one that I had completely forgotten about:

S&P 500 at 750: Thoughts From A Market Timer – Published 11/21/2008

I still remember that night rather vividly. I was on a business trip in yet another bland hotel, stuck watching CNN. The S&P 500 index had closed at 752.44, a number I though I’d never see. I logged into my Vanguard account from my laptop and watched my account values dropping, but I also sensed an opportunity. Investing gurus were always saying to buy when people were most scared. This Hussman fellow made a convincing argument that the odds were in my favor. I actually had another draft of that post with the alternate title “S&P 500 at 750: Time to Back the Truck Up?” I tentatively put in a buy/sell order to move all my money into stocks.

But I didn’t execute it. Why? I was scared. And if you read the comments on that 2008 post above, lots of other people were scared too. And it did get worse for a while. I managed not to sell everything in a panic. In fact, I didn’t sell any stocks at all. I just kept with my asset allocation and rebalanced, which meant that all my new paycheck money went into stocks. Here’s the chart of the S&P 500 since I graduated college:

Not exactly a smooth ride! Today, my portfolio is bigger than ever, but I still feel the some uncomfortableness investing with the S&P 500 at 1300. Is it too high now?

Buy, hold, rebalance. This method will always have its doubters, but I believe in it more strongly as the years have passed. This means that I’ll never be able to brag on the internet how I was “100% cash right before the crash” or “Moved all my money into stocks right before the big boom”. However, I do feel it has improved my investment returns, and that’s the real goal.

I was looking through the Barnes & Noble bargain bin and found a book called “How to do just about everything”. Okay, how to unplug a toilet… how to carve a turkey… hey, a personal finance section! Wow, quite awful. After coming home and looking up the book, I found out it was by eHow.com. I should have known. Check out this gem on How to Select a Good Mutual Fund (eHow link), which offers the following advice:

2. Determine how many mutual funds you will invest in. Three to five funds is generally considered an adequate amount of diversification.

Yes, let’s determine diversification by the actual number of funds. One… two… three… done! Never mind that I could easily have more diversification in one mutual fund than in 15 separate niche funds. This is like deciding the best book is the one with the most pages. At least later on it says to vary the size of companies in the funds. However, there is no mention of real diversification between stocks vs. bonds, domestic vs. international, passive vs. active management, etc. What else?

5. Choose high-performance funds by using Internet resources and newspapers to pick those funds that have had the best performance over at least the last three years.

Huh? I don’t know how the advice could get much worse than this. Picking whichever funds that had the best performance over the last three years will virtually guarantee that you will have below average returns going forward. Check out these articles on the persistence of mutual fund returns based on studies of actual mutual fund return data over decades. “The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.”

Don’t chase performance! Again, we see no mention of better indicators like expense ratio, turnover ratio, tax-efficiency, manager ownership of shares, etc.

Content Mills Warning
So how does such a poor article get prominent placement in search engines, not to mention published in a book? eHow is a content mill that encourages people to churn out large numbers of articles with low quality standards, promising them a cut of all future ad revenue. Google has recently penalized them for their low-quality articles as well.

In addition, eHow has a history of treating their freelance writers poorly, and their most recent move was to cut off their share of ad revenue completely, offering them either a lowball buyout or nothing. I’m sure they have some good articles, but in general I would say you’re better off avoiding them, especially for money-related topics.

The Dow Jones Industrial Average (DJIA) is an antiquated, somewhat-arbitrary, poorly constructed, incomplete indicator that does a subpar job of tracking the actual performance of the U.S. stock market. There, I said it. Every time I see it mentioned in the financial media down to the decimal points like it’s some hyper-accurate holy number, I get a bit annoyed.

A recent BusinessWeek article Why Apple Isn’t in the Dow served as another reminder of why I feel this way. Whether or not you like Apple, it’s the second largest company by market value in the country. Is it in the Dow Jones? Nope. Why not?

The Dow only includes 30 stocks, picked by WSJ editors. In 1896, the DJIA had 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. It’s still just 30 stocks over 80 years later. Not only that, but it’s not even clearly defined as the largest 30 companies or something like that. It’s simply 30 companies chosen by a committee to best represent the market out of the ~5,800 publicly traded companies out there. As a result, new companies like Microsoft, Intel, and now Apple are added rather late, and major sectors like transportation and utilities aren’t even represented.

The Dow is a price-weighted index. The DJIA is not weighted according to the relative value of the companies like the S&P 500 or other “Total Market” indexes. Instead, it’s weighted by share price, something that is very arbitrary. The same company could have a million shares at $10 each, or 1,000 shares at $10,000 each. It’s worth the same, but the second company would have 1,000x the effect on the Dow Jones Index. This means Apple stock (about $330) would have the 18 times the effect of General Electric, even though it’s market value is only about 1.5 times more.

This also means you shouldn’t invest in any mutual funds or ETFs that follow the Dow either. I’m looking at you “Diamond”, the SPDR Dow Jones Industrial Average ETF (ticker DIA). By extension, this is also one of my problems with the investing start-up Betterment.com. I would never take advice from a financial planner that said a Dow Jones ETF was a critical part of my portfolio’s asset allocation.

Morningstar.com helpfully provides two types of performance data for mutual funds: total returns and investor returns. Total returns are what you usually see elsewhere, and assumes that one buys all at the beginning and holds the entire period given – the last 5 years, for example. Investor returns account for the timing of the buying and selling of investors on average. An example given is:

Assume a fund generated a 10% total return in a calendar year, with most of those gains coming in the year’s first quarter. If investors added substantial sums of money to the fund after its first-quarter runup, the fund’s investor returns for that year would be lower than the fund’s 10% total return.

Using this data, Morningstar can basically tell how the average investor was at market timing. Apparently, not so good. On average they sold too quickly after losses, and bought too late and missed part of the rebound. From the article Mind the Gap 2011:

In 2010, the average domestic fund earned a return of 18.7% compared with 16.7% for the average fund investor, making for a gap of 200 basis points. For the trailing three years, that gap was 128 basis points. For the past five years, it was 98 basis points, and for the past 10, it was 47 basis points.

For taxable bonds, the return gaps were 138 basis points for one year, 52 basis points for three years, 57 basis points for five years, and 106 basis points for 10 years. That 10-year figure is pretty large considering it meant that returns fell to 4.47% annualized from 5.53%. Municipal bonds have consistently had an even bigger gap ranging from 113 basis points last year to 173 annualized for the trailing 10 years.

To make it clear, those are huge performance gaps over time. Like saying goodbye to 25% of your nest egg huge. The data also found that people who owned balanced funds that owned both stocks and bonds did much better comparatively. This includes target-date style funds. That makes perfect sense to me, because the type of people who buy balanced funds are not the type to try to time the market.

They found similar results when comparing investors in Vanguard mutual funds that had both Investor and Admiral share classes. The more patient (and more wealthy) investors had better performance in 13 out of 15 cases, with a margin greater than the difference in expense ratios:

For example, in the firm’s flagship Total Stock Market fund, Admiral shareholders enjoyed returns of 6.16% annualized compared with 5.35% for Investor shares. At Vanguard Value Index, Admiral shareholders earned a 4.84% annualized return compared with 2.61% for Investor shares.

If you do try to time the market, you owe it to yourself to track your moves carefully (and honestly) to calculate if they were really better than doing nothing at all. Chances are, they weren’t. If you don’t do better after a certain time, say a couple years, it may be a good idea to stop while you’re not too far behind. Here are a couple of ways to find your personal rate of return that accounts for inflows and outflows.

• Estimate Your Portfolio’s Rate of Return (Calculator) – Even an estimate can be pretty helpful.
• Calculate Your Exact Portfolio Rate Of Return (Spreadsheet) – Wrote this a few years ago, but it’s still applicable.

Scott Burns of Assetbuilder has a new article that shows the benefit of diversifying your portfolio beyond the often-cited S&P 500 index fund that you probably have in your 401(k) plan. During the recent financial crisis, nearly every asset class involving stocks crashed. Large cap stocks, small cap stocks, REITs, international stocks.

From January 2000 to December 2009, the total return (not annualized) of the S&P 500 was negative 9.67%. That means money that you invested in the S&P 500 in 2000 was worth about 10% less an entire decade later. This is the so-called “lost decade” that numerous media articles have focused on.

Well, if you’ve been following this blog since 2004 or many other similar ones, you would have also read about research and historical data that advises you to diversify your investments across some other asset classes. Here are the total returns of other asset classes during that same 10-year period:

* Domestic large cap value stocks returned 53.7 percent
* Domestic small cap value stocks returned 139.5 percent
* REITs returned 170.9 percent
* Large cap international stocks returned 15.1 percent
* International large cap value stocks returned 90.7 percent
* Emerging markets stocks gained 147.8 percent
* Domestic micro-cap stocks, domestic small cap value, international small cap value, emerging markets value stocks, and emerging markets small cap stocks all enjoyed enormous gains. Emerging markets value stocks, for instance, returned 266.7 percent.

The S&P 500 is a good proxy for large-cap stocks in the US, but it doesn’t necessarily make your portfolio complete. Adding other asset classes that zig when others zag can help. Below is a summary of my target allocation, with further details here.

This is not a blanket recommendation for everyone, just an example of what I’m invested in to provide a nudge to read some more.

Ready for the next new investing start-up idea? It’s “customer stock ownership plans” from Loyal3. Basically, companies encourage consumers to buy shares of their stock with only three clicks of the mouse, in the hopes that this will ownership will garner loyalty (get it?) and thus higher sales. Think Apple, where shareholders of AAPL are more likely to buy MacBooks. [Via Bits]

You’ll be able to buy in increments of as little as $10 via fractional shares, all with no transaction fees at all (they’re covered by the company). Loyal3 hasn’t actually announced the stocks available, but one would guess they’d be brand name makers of consumer goods like clothing, electronics, or food.

My initial impression is lukewarm. Sounds like an easier version of DRIPs. But the stocks will be likely limited to visible brand names, so it won’t really provide investors with actual diversification. Otherwise, I can’t think of any brand I like that much. I have a hard time being emotionally attached to a corporation. The one thing I do like is that they promote individual shareholder activism, which can keep management on their toes.

The other thing that caught my eye was the fact that they accepted credit cards for the stock purchases. Given their “no fees whatsoever” mantra, without fees this means you can get cash back/points/miles from your stocks purchases, kind of like getting a commission instead of paying it :). (The most you can invest per company is $2,500 a month.) Stocks are likely too volatile to easily profit from this, but perhaps someone can figure out a way to take advantage of this feature.

You may or may not believe me, but even though I blog daily about money I only check my investment portfolio balances every few weeks. It’s part of my selective information restriction diet. I found it curious that the S&P 500 is now at ~1350. This reminded me of this earlier WSJ article about how long-term savers actually haven’t done all that poorly over the last decide. Their example is a young worker starting investing in 2000, investing regularly, and taking advantage of the 401(k) match from their employer amongst other stated assumptions:

Since the article was published, the S&P 500 is up nearly another 8%. Of course, if you invested in bonds for that decade you’d be even better off, but seriously who was 100% bonds the entire time. I know I wasn’t, but I was invested in some bonds, so I get some comfort that my personal return is a bit better. I’m relatively at peace with my investments, other than being a bit nervous after seeing the S&P so high without any proof of improved economic stability.