Christian financial principles are rooted in God's Word

SMI helps “prepare God’s people for works of service, so that the body of Christ may be built up until we all reach unity in the faith and in the knowledge of the Son of God and become mature...” (Ephesians 4:12-13).

We focus on teaching Christians how to set and implement financial priorities that are honoring toward God. Therefore, our teaching begins with the principle that the things most worth knowing are rooted in God’s Word:

• “All Scripture is God-breathed and is useful for teaching, rebuking, correcting and training in righteousness” (2 Timothy 3:16). It’s worth knowing that we should look primarily to God’s wisdom, not the conventional wisdom, for principles to guide our decision-making. The principles God has given us are practical and personally relevant.
• “Now it is required that those who have been given a trust must prove faithful” (1 Corinthians 4:2). It’s worth knowing that we must each accept personal responsibility for making knowledgeable, biblically-consistent financial decisions. We cannot look to others to make the tough choices for us.
• “The rich rule over the poor, and the borrower is a servant to the lender” (Proverbs 22:7). It’s worth knowing that debt is enslaving and that we should avoid it as much as possible.
• “In the house of the wise are stores of choice food and oil, but a foolish man devours all he has” (Proverbs 21:20). It’s worth knowing that maintaining a proper balance
  between current spending and long-term saving is a sign of wisdom.
• “The plans of the diligent lead to profit as surely as haste leads to poverty” (Proverbs 21:5). It’s worth knowing that we should consistently invest from a carefully considered strategy rather than impulsively on a case by case basis.
• “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth” (Ecclesiastes 11:2). It’s worth knowing that we should rely on diversification—rather than a preoccupation with market cycles—as a means of controlling risk and protecting our capital.
• “Do not wear yourself out to get rich; have the wisdom to show restraint” (Proverbs 23:4). It’s worth knowing that we must be on guard against greed and spending our energies in a futile attempt to get the highest possible returns.

God has given us protective principles to help make day-to-day financial decisions. By following these principles consistently, you and I can have confidence that, whatever the short-term sacrifices may be, we are making wise spending, saving, and investing choices. That frees us to leave the results with God, knowing that “Godliness with contentment is great gain” (1 Timothy 6:6).

Inflation History: The Rise and Fall of the U.S. Dollar

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Category(s): Christian Interest, Family Finances, Giving and Stewardship, Investing Principles
Tag(s): Christian interest, giving and stewardship, investing principles

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Hazards of confidence when investing

The field of behavioral economics studies why people make the financial decisions they do. We visit the topic occasionally, as in August's cover article, Why Smart People Make Big Money Mistakes—and How to Correct Them ( Members Only). This area of research has discovered a number of fascinating things about the way humans are wired, and how that wiring often works to our detriment in the financial arena.

Daniel Kahneman is one of the founders of this field. Last weekend, The New York Times Magazine ran an article titled Don’t Blink! The Hazards of Confidence, which is an excerpt from Kahneman's latest book. It's an interesting read if you're into this sort of thing.

I thought I'd pull a couple paragraphs where Kahneman tells about one of the most famous of all the behavioral economics experiments. It clearly highlights his theme that investors are typically overconfident and that overconfidence hurts their long-term returns,

Odean analyzed the trading records of 10,000 brokerage accounts of individual investors over a seven-year period, allowing him to identify all instances in which an investor sold one stock and soon afterward bought another stock. By these actions the investor revealed that he (most of the investors were men) had a definite idea about the future of two stocks: he expected the stock that he bought to do better than the one he sold.

To determine whether those appraisals were well founded, Odean compared the returns of the two stocks over the following year. The results were unequivocally bad. On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year, in addition to the significant costs of executing the trades. Some individuals did much better, others did much worse, but the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas. In a paper titled “Trading Is Hazardous to Your Wealth,” Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns. In another paper, “Boys Will Be Boys,” they reported that men act on their useless ideas significantly more often than women do, and that as a result women achieve better investment results than men.

This is why we emphasize having a long-term plan and sticking with it. This helps protect you from your own overconfidence. It's also why all of SMI's investing strategies are mechanically based; i.e., they don't rely on us to make lots of judgment calls or predictions. This helps protect you from our overconfidence!

None of this guarantees that you'll be optimally positioned when the market shoots up nearly 20% in 17 trading days, as it did this month. But it does stack the odds in your favor that over time, you're hopefully going to make more right calls than wrong ones. Hopefully, and again over time, that will lead to better results (and much more peace of mind along the journey). That's certainly how it has played out for those who have been investing according to SMI's strategies over the past decade or more.

Inflation History: The Rise and Fall of the U.S. Dollar

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Category(s): Investing Principles, SMI Model Portfolios
Tag(s): investing principles, market uncertainty, SMI model portfolios

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It's beaten the market by 185%: Fund Upgrading explained

In Upgrading, each month we rank more than 1,500 mutual funds by type and determine which ones have been delivering the best recent performance. We recommend the purchase of the top funds in each of five SMI risk categories. These funds will be held until they stop outperforming. At that point, we recommend replacement funds that are showing stronger recent performance.

Upgrading works because, market leadership rotates among different investment approaches and companies of different sizes as economic conditions change. But even though market conditions are constantly changing, fund managers rarely do. Managers who excel under one set of market conditions often are only average (or worse) under a different set of conditions. So, rather than buy a fund and hold it through both the periods that favor the manager's approach and the periods that don't, Upgrading continually guides us to funds that are in favor right now.

This means we move in and out of funds more frequently than some people are used to, but it has helped us establish a track record of beating the market over an extended period of time, under both bullish and bearish market conditions.

The chart below shows the cumulative effect of this advantage, comparing the 11-year growth of a $25,000 Upgrading portfolio (dark shaded area) vs. the market return (light shaded area).

The $25,000 invested in Upgrading at the beginning of 1999 grew to $71,250 while the market portfolio (as measured by the Wilshire 5000) increased to only $35,250. In other words, the Upgrading portfolio was worth almost twice as much after 12 years than a portfolio that earned the market's return.

2. The asset allocation chart shows you exactly what percentage of your portfolio we suggest be invested in each category of mutual fund.

3. SMI's monthly Recommended Funds page shows which funds are currently recommended. Choose one (or more) funds from among the four recommendations in each category.

4. Each month, you simply review the new Recommended Funds page to see if any of the funds you own have been replaced. If any have, the new funds are clearly noted, and you just sell the old fund and buy the new recommendation.

Upgrading isn't complicated. It requires your attention only once per month, and its track record is exceptional. What are you waiting for? Order your subscription to Sound Mind Investing today!

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Category(s): Investing Principles, SMI Model Portfolios
Tag(s): beat the market, investing principles, proven strategy, upgrading, Wilshire

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10 market rules to remember

Bob Farrell was a legendary analyst for Merrill Lynch from 1967-1992. As this MarketWatch article summarized, "Over several decades at brokerage giant Merrill Lynch & Co., Farrell had a front-row seat to the go-go markets of the late 1960s, mid-1980s and late 1990s, the brutal bear market of 1973-74, and October 1987's crash. Out of those and other experiences came Farrell's 10 "Market Rules to Remember."

Here they are:

1. Markets tend to return to the mean over time
2. Excesses in one direction will lead to an opposite excess in the other direction
3. There are no new eras — excesses are never permanent
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
5. The public buys the most at the top and the least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are strongest when the are broad and weakest when the narrow to a handful of blue chip names
8. Bear markets have three stages — i) sharp down, ii) reflexive rebound, iii) a drawn-out fundamental downtrend
9. When all the experts agree, something else is going to happen
10. Bull markets are more fun than bear markets

Inflation History: The Rise and Fall of the U.S. Dollar

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Category(s): Current Market Events, Investing Principles
Tag(s): christian investing, current market events, investing, investing principles

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Focus on what you control

It's so easy to get caught up in the headlines of the day and their potential impact on our investments. Today it's the debate over how to go about addressing the debt ceiling. But there's always something: interest rates rising (or falling), the stock market rising (or falling), tax rates rising (or falling), and on and on.

If we stop and think about it, most of us probably recognize that the one variable we have no control over is our rate of return. Yet that's where we focus much of our effort. Instead, we're usually better off focusing on those areas where we are directly in control.

Times that seem particularly uncertain tend to paralyze many investors. They can't figure out what to make of the information bombarding them, so they shrink into a defensive posture where they're afraid to do anything.

If that's been you, SmartMoney author Glenn Ruffenach has a list of areas for you to focus on as you work on your retirement plan. The good news is these are all under your direct control. (Read the full article for more on each one.)

Setting a budget. It's among the most important steps in planning for later life, but less than half of workers have put pencil to paper, according to the Employee Benefit Research Institute. Why are budgets so critical? Projecting expenses and income can help you pin down your "number," the amount of money you need to save for retirement.

Timing Social Security. If you're married, the timing of exactly when each spouse first files for benefits can translate into thousands of dollars gained — or lost — in retirement.

Reducing debt. Between 2000 and 2008, the average debt for households headed by a person age 55-plus almost doubled to $66,000, according to Strategic Business Insights, a research firm in Menlo Park, Calif. Again, here's where would-be retirees can take the reins.

Creating a pension. If nothing else, the recent financial meltdown underscores the need for investments that throw off income, regardless of what's happening in the markets.

Managing taxes. No, you can't control tax rates, but you can practice "tax diversification," says Randall, of Financial Enlightenment. ... "You don't know what your effective tax rate will be in retirement," Randall says. "That's why you should diversify."

Planning for long-term care. Yes, this is a tough one. But it's also an area where failing to act could prove devastating. Among your options: self-insuring, if you can set aside sufficient funds. Long-term-care insurance, which is complicated and expensive, is another possibility, as are so-called hybrid policies that provide some long-term-care benefits and some life insurance (but perhaps not enough of either).

Too strapped for time to dig into these areas? Ruffenach isn't buying it:

I know: The invariable response is, "But I don't have time." Please. It never fails to amaze me how people will spend weeks planning a visit to Disneyland with the grandchildren but won't take a few hours to assemble a retirement budget that could easily last 30 years. Believe me: You can find time. Take control of what you can control — and take the anxiety out of your retirement planning.

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Category(s): Investing Principles
Tag(s): investing principles

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Two sides to every market

One of the least appreciated keys to becoming a successful investor is resigning yourself to operating under uncertain circumstances.

This may seem an odd statement. Some new investors assume that during bull markets the investing landscape looks good so investors buy stocks, whereas during bear markets the bad news is obvious so investors sell stocks. If only it were so simple.

Getty Images via @daylife

The reality is there are always two sides to every market. Markets are made up of buyers and sellers interacting — every trade requires a buyer and seller. Naturally there are all types of buyers and sellers (people buying and selling for various reasons), but at essence, most of the trades that will be made today — and every other day — will be made between one party that believes the current price is a good one to sell at and another party that believes the exact same price represents a good buying opportunity.

This is the main reason why Sound Mind Investing spends so little effort trying to forecast what the market will do next. There are always two (or more!) compelling arguments regarding the most likely future path for the market. Equally brilliant experts line up on either side of the debate, half arguing the market will go up for one set of reasons, the other half arguing it will decline for a different set of reasons.

I bring this up today because it occurs to me that the negative (seller's) side of the market equation seems to be getting most of the headlines lately, and I suspect many investors aren't even aware of the primary positive (buyer's) argument.

The negatives at present are numerous and well known:

1. Massive financial problems in Europe threaten to unleash another act in the unfolding world credit drama;
2. The U.S. can't seem to come to any sort of solution regarding its own debt problem — with the seemingly important deadline of Aug. 2 for raising the national debt ceiling looming;
3. The Federal Reserve's "QE2" program officially ended on June 30, leaving significant questions as to what happens to our economy without this significant stimulus (not to mention if there will be adequate demand for our Treasury debt without the Fed as a buyer, and the impact that may have on interest rates);
4. The economy seems to be weakening, as was vividly demonstrated in last week's dismal jobs report.

What is the counterbalance to all this bad news? Or put differently, in light of all these negatives, what positive has been responsible for limiting losses in stocks this year to the roughly 7% decline in May-June?

The answer: Company profits have been strong. And not just a little strong. Really strong.

Starting in 2007, S&P 500 profits fell for nine consecutive quarters, with annual profits bottoming out at $60.59 per share in 2008. According to the article, earnings are forecast to reach $99.34 this year — a remarkable turnaround, even if the estimate does prove to be a bit high.

As a result of this tremendous earnings growth, the closely-watched P/E (price/earnings) ratio for the S&P 500 is actually still bouncing around the same level it was when the market was bottoming out in March 2009. That is quite unusual — P/E ratios typically expand during market-doubling bull markets. This leads many bulls to believe there is still plenty of room for stock prices to move higher.

Whether or not that's true is a discussion for another day. Just keep in mind that in the long-term, stock prices are tied to corporate earnings. So it makes sense that prices would rise as these earnings have rebounded.

Posted by Mark at 11:25 AM | Comments (0) | TrackBack
Category(s): Current Market Events, Investing Principles
Tag(s): bulls and bears, earnings

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The economy's strong! Oh no, it's weak! Wait, it's... whatever...

Whatever the market is doing, the financial press will make up find an explanation. That's their job.

Last Thursday, the market continued its upward move and the WSJ provided an explanation: the economy is looking stronger.

Investors have begun to assume a more bullish view of the U.S. economy in recent days after a series of surprisingly good reports on manufacturing, retail sales and jobs.

That followed a string of disappointments and worries about global growth in general. Now, many say they have renewed confidence that the second half of the year will be strong.

"The soft patch is now in the rear-view mirror, and the market is resuming to a more optimistic stance where it is pricing in more positive growth," said Howard Ward, chief investment officer for the Gamco Growth Fund. "It's going to be a much stronger second half than the first."

Then on Friday, the market is dropped and the WSJ explained why: the economy is looking weaker.

The U.S. economy barely added jobs for the second month in a row in June and the unemployment rate rose to the highest level this year, adding to concerns the labor market will take years to recover....

The jobless rate, which is obtained from a separate household survey, increased for the third straight month to 9.2% in June from 9.1% in May. It was the highest level since December 2010. There are 14.1 million Americans who would like to work but can't get a job. The choppy two-year-old recovery is proving to be one of the worst since the 1930s. It has been too slow to make up for all the jobs lost after the financial crisis of 2008 and 2009....

Manufacturing employment remained weak, adding 6,000 jobs. Economists were expecting a rebound as disruptions to manufacturing production stemming from Japan's earthquake should be easing. Employment in the battered construction sector was broadly unchanged. The housing sector remains a big drag on the economy.

All this to say, as we've pointed out before, that financial reporters have a tough job. They can't possibly know all the reasons that millions of individual and institutional investors decide to buy or sell on any given day. But they're expected to come up with an explanation. So they do.

They emphasize the news of the day that seems most likely, in their view, to be responsible for said buying and selling. If the next day requires a completely different view of reality to explain the market's behavior, that's not a problem — that's just the news business.

So, are investors optimistic about the economy, or are they pessimistic? Some of each. Always. Thus the continuous tug-of-war between buyers and sellers. That's why you should largely ignore the press accounts and think inside-out.

Posted by Austin at 9:35 AM | Comments (0) | TrackBack
Category(s): Investing Principles
Tag(s): Ignoring the news, Inside-out investing, investing plan

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SMI audio: Getting the best value for your investment dollar

Today SMI founder and publisher Austin Pryor explains an investing technique known as "dollar cost averaging." It's a simple approach that can help you stick to your plan through thick and thin.

To learn more, click the arrow (1:25).

For more on this topic, read Taking the Guesswork Out of When and How Much to Invest from the June 2011 issue of the Sound Mind Investing newsletter.

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Category(s): Investing Principles
Tag(s): dollar-cost averaging

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The impact of aging on your financial decision making

Closing out last week's Morningstar investment conference was Harvard's Robert I. Goldman Professor of Economics David Laibson. He tackled the unpleasant but important topic of cognitive decline among the elderly and the impact it has on their financial and investing decisions.

Combining information from this summary of Laibson's address as well as this follow-up interview following the address, here are some of the highlights that stood out:

Laibson highlighted two kinds of intelligence. Crystallized intelligence is the ability to accumulate wisdom, experiences, skills, and knowledge. This type of intelligence rises until age 60 when dementia is more likely to set in. Fluid intelligence is the ability to solve new problems. This type of on-the-fly intelligence peaks at 20 and then declines rapidly.

According to memory and analytics tasks performed by all age groups, 80-year-olds perform at the bottom 16th percentile. Moreover, age is a greater hindrance to economic rationality than is being low-income or of low-education. As a result, the retired are among the most impaired in terms of economic reasoning. The prevalence of dementia (or cognitive impairment) plays a huge role. Laibson noted a startling but compelling statistic — the likelihood of developing dementia doubles with every five years of age after age 60.

Unfortunately, in the 80s, about half the U.S. population either has full blown dementia or cognitive impairment, which is short of dementia, but still a clinical diagnosis — half the population. So, every investor in their 60s should be preparing for the possibility, an enormous possibility, that things are going to go badly in the 80s.

Laibson says that risk-adjusted returns for investors in their 80s run about 3% below "baseline" (which I don't see precisely defined, but from context seems to indicate what other investors of other ages get when investing with a comparable set of goals). This also helps explain why 20% of American seniors report being taken advantage of financially.

Laibson's primary point is that investors need to plan ahead for the potential that cognitively they just may not be as sharp in their 80s as they were in their 60s. Naturally, people aren't always aware of the decline as it happens, which makes planning ahead for it crucial.

In terms of investing, Laibson's opinion appears to be that all "complicated" aspects of your investment strategy ought to be wound down (or on a very specific, written plan made out years in advance) before an investor reaches these ages.

There are other applications as well. One important one is in the area of estate planning and making sure the four primary estate documents are in order while you're still relatively young.

What are those documents? You should have a durable power of attorney or a springing power of attorney. You should have a living revocable trust that protects your assets. You should then have two health-care documents. A health-care proxy, that basically assigns someone to help you make health-care choices if you are no longer mentally competent, and you should have a living will, which is providing instructions to that person about what kind of care you'd like. How extensive intervention do you want if you are, say, on life-support.

While this isn't a pleasant topic, it's an important one. Reading one or both of the links above is probably time well spent. Beyond that, putting in the effort to simplify your investing/financial decision-making as you get older is smart. Think of it as doing a favor for your older, potentially less-capable self. If none of this decline happens to you, you still haven't lost anything, as your financial plan will be that much more organized and well thought out.

That's a benefit worth working for at any age.

Posted by Mark at 1:55 PM | Comments (0) | TrackBack
Category(s): Investing Principles, Retirement
Tag(s): aging, financial decisions, retirement

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SMI commentary: What I learned by going to the beach

Here is an audio version of SMI founder Austin Pryor's editorial from the June issue of Sound Mind Investing — recorded on location at the beach (well, at least the sound effects were!).

Austin explains the many investing lessons he's learned from his annual beach trip. Everything from devising a travel plan to being prepared for rainy days has an investing application. (And don't forget about not comparing yourself to those muscle-bound guys on the beach.)

To listen, click the arrow on the player below (3:25).

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Category(s): Investing Principles
Tag(s): investing guidelines, investing principles

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SMI audio commentary: 6 key attitudes of an effective investor

Here's another short audio commentary from SMI founder and publisher Austin Pryor. Today, Austin explains how to become an effective long-term investor.

To listen, click the arrow on the player below (2:35).

Do you have a workable, long-term strategy in place — one tailored to your personal circumstances — that will protect your family and help secure their financial future? If not, get our free report, Seven Key Principles for Christian Investing.

Using Scripture as a guide, we explain how creating specific boundaries and fostering certain attitudes will help you implement a focused, long-term plan. These include:

• objective criteria for your investment decision-making;
• a portfolio that is broadly diversified;
• a long-term, get-rich-slow perspective; and
• a manager's (rather than owner's) mentality.

To learn how to get your free copy of Seven Key Principles for Christian Investing, go here.

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Category(s): Investing Principles
Tag(s): audio, investing guidelines, investing principles

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SMI audio commentary: Clear-cut investing guidelines

Here's another short audio commentary from SMI founder and publisher Austin Pryor. Today, Austin explains why having clear-cut investing guidelines for your portfolio allocations, as well as for buying and selling decisions, can help you invest with confidence.

To listen, click the arrow on the player below (1:35).

Posted by Joseph at 2:55 PM | Comments (0) | TrackBack
Category(s): Investing Principles
Tag(s): audio, Austin Pryor, investing and emotions, investing guidelines

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SMI audio commentary: The basics of bond investing

Here's another short audio commentary from SMI founder and publisher Austin Pryor. Today, Austin offers an overview of bond investing.

To listen, click the arrow on the player below (1:45).

Learn more about investing in bonds by reading Austin's recent article, The Bond Basics You Need to Know in 2011.

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Category(s): Investing Principles
Tag(s): bond funds, bonds

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Don't trust your emotions when investing

Do average investors make good decisions about when to buy and sell? In a word: no.

The New York Times reports on research done by Philip Z. Maymin, an assistant professor of finance and risk engineering at the Polytechnic Institute of New York University (whew — how's that for a job title!):

[R]esearch into 17 years of call records at a boutique investment adviser shows that [investors are] likely to buy or sell at the worst possible time.... [NYU's Maymin] studied comprehensive records kept by the investment firm Gerstein Fisher from the firm's founding in 1993 to mid-2010....

The study, which will be published in the spring edition of The Journal of Wealth Management, found that the value of investment advisers was not in the stocks or mutual funds they recommended but in their ability to restrain investors from impulsively trading at the wrong time. It cites data showing that aggressive orders by individuals can cost them about four percentage points a year....

[Interestingly, the study found that most] investors did not trade in expectation of intense volatility or even during it.... They waited until the period of greatest volatility had passed and then looked to do what any adviser would tell them not to do: sell at the bottom or buy at the top....

[T]o too many investors, yesterday matters a lot and threatens to ruin tomorrow.

Although Maymin's research looked at a fairly small number of investors (about 600), the findings are consistent with other studies that have found that average investors, driven by their emotions and instincts, tend to do the wrong thing at the wrong time.

This, of course, is why the Sound Mind Investing approach is based on "mechanical" (i.e., non-emotional) decision making. Buying and selling decisions are made based on performance data, not on the news of the day. Allocation decisions are not made on a whim, but are based on one's season of life and particular risk tolerance.

Emotions certainly aren't a bad thing. They are part of our God-given make up, part of the divine image He has stamped on us. But in the investing arena, emotions tend to war against wisdom.

To experience investing success over the long haul, you must learn to set aside your emotions and follow your plan. Years from now, you'll be glad (an emotion!) you did.

Posted by Joseph at 11:35 AM | Comments (0) | TrackBack
Category(s): Investing Principles
Tag(s): investing and emotions, investing plan

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5% market pullbacks

Over the past month or two, I've mentioned several times in conversations that the market was "overdue" for some sort of pullback. What impact has that had on my personal investing, or the information we've discussed here and in the Sound Mind Investing newsletter? Absolutely none.

Confused? Let me explain. As the chart below shows, we are currently in the sixth decline of at least 5% since the current bull market began two years ago.

Surprised? It only seems like the market has gone straight up for the past two years. In reality, these minor pullbacks happen quite often. Think of them as "the pause that refreshes." Two steps forward and one step back is absolutely normal behavior for the stock market.

Now if you look at this chart and the frequency of these pullbacks, what stands out? Notice the length of the uninterrupted blue line from Sep-10 to Mar-11. Big gains over an extended period without a significant pullback. That simple fact is what has made me feel like some sort of pullback was likely before too long.

If that's true though, then why not do something about it? Well, the main reason is that I just don't have any confidence in our ability to play "the trading game" successfully. Those short-term movements aren't what we're about. It's difficult to know when these pullbacks are coming (note the variation in length between them). And the consequences of riding them out are pretty insignificant (note the overall rising line of the chart, despite these relatively frequent pullbacks).

Here's some analysis from Birinyi Associates, who created the chart (hat tip to The Big Picture, where I saw it):

What is perhaps more encouraging is the fact that 5% declines do not usually result in a further 10% decline, and a bear market is even less likely. An initial 5% decline, such as the one beginning on 2/18/11, only results in a correction (10% decline) 33% of the time, and in only 11 of 106 instances has a 5% decline turned out to be a bull market top.

It's common sense that all bear markets start with a drop of 5%. But only 10% of those 5% drops turn into bear markets. The other 90% don't. Two-thirds of them don't even continue on to 10% official correction territory.

So while last week was a tough week and some people are understandably nervous, there really isn't anything at this point to suggest this is more than a normal pullback within a continuing bull market. In fact, I would go as far as to suggest that even if the horrendous earthquake in Japan hadn't happened, the market would have still found a reason/excuse to sell off by 5% or so soon. It's just the nature of the market.

Posted by Mark at 10:45 AM | Comments (0) | TrackBack
Category(s): Current Market Events, Investing Principles
Tag(s): market correction, market pullbacks, market volatility

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How to respond to today's unsettling news

Concerned about how the Japanese earthquake, rising oil prices, or Middle East turmoil may affect your investments? You're certainly not alone!

Today for our Personal Finance Friday post, Sound Mind Investing founder and publisher Austin Pryor presents a brief audio commentary on what to do when the news of the day seems particularly unsettling.

To listen, click the arrow on the player below (2:00).

Posted by Joseph at 2:05 PM | Comments (0) | TrackBack
Category(s): Investing Principles
Tag(s): market volatility, Personal Finance Friday

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Revisiting "Dow 36,000"

SMI publisher Austin Pryor's editorial in the current Sound Mind Investing newsletter notes that our human "ignorance of the future is staggering." Even the smartest of the "experts" can't know for sure what is going to happen.

James K. Glassman, co-author a dozen years ago of the bestseller Dow 36,000, conceded as much (subscribers' link) in a column last week in the Wall Street Journal.

In 1999, I co-authored a book called Dow 36,000 that became, in some circles, a notorious symbol for bullishness about the stock market. While the book had a provocative title, its fundamental message was mainstream: Long-term investors should load up on U.S. stocks....

Today, the Dow Jones Industrial Average is just 20% higher than it was when Dow 36,000 was published in September 1999 and the markets stood at 10,318....

What happened? The world changed....

The first major change is that the relative economic standing of the U.S. is declining. The Congressional Budget Office estimates that U.S. growth will average a little more than 2% over the next 70 years, compared to about 3.5% during the second half of the 20th century. This is a stunning decline....

The second big change involves risk. Along with most investment analysts, I used to consider only one kind of risk: the volatility of an asset's price. While stocks have returned a yearly average of about 10%, their actual returns bounce around from year to year. [See SMI executive editor Mark Biller's recent post on this.]....

But there is a second kind of risk, the kind that we can't really measure or expect — the murder of 3,000 Americans by terrorists in a single day, the Dow losing 1,000 points within minutes in a "flash crash," or home values in the U.S. suddenly plummeting. These discontinuous risks — or "uncertainties," as the famous University of Chicago economist Frank Knight called them — are multiplying in a world in which technology provides instantaneous connections among markets and allows just about anyone to do just about anything, anywhere....

In theory, historical averages show that stocks are a good buy if you can hang on through the miserable periods. But most investors find that excruciatingly difficult to do — a fact that I never fully appreciated in my 30 years of writing about investing.

Fear, or simply a need for cash, triumphs, and people sell before stocks bounce back. I've gotten tired of telling investors to buckle up and hang on. Instead, I am urging them to adopt a more cautious strategy than the conventional financial wisdom — or Dow 36,000 — would dictate.

Glassman is making a concession to human nature. In other words, he is acknowledging that the long-term investment approach that may make the most sense mathematically doesn't always work in the crucible of daily life and human decision-making.

Austin touched on this same topic in his November editorial, and he laid out an alternate strategy for investors feeling particularly nerve-wracked by the events of the past three years:

For those investors, it's better to have a less than optimum stock/bond allocation that they can stay with long term than an allocation suggested by our "seasons of life" approach that they can't tolerate and stick with during down markets.

The specifics are here.

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Tag(s): investing predictions, investing principles

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Austin Pryor commentary: Learning to think inside out

Here's another short audio commentary by Sound Mind Investing founder and publisher Austin Pryor. Today, Austin explains one of the keys to long-term investing success: ignoring the news of the day.

To listen, click the arrow on the player below (1:15).

For more on this topic, read Austin's article, Make Sure Your Investment Decision-Making Is Inside-Out.

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Tag(s): audio, investing news, investing principles

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When will the market turn "normal"?

I started reading through an interesting book a month or two ago, called The Little Book of Sideways Markets. It's primarily about how the stock market tends to go through long periods of stagnation followed by long periods of appreciation, then back and forth again. These are the "secular" bull and bear markets that we hear about so frequently.

Two weeks ago, John Mauldin — who wrote the forward — featured a chapter of this book as his "Outside the Box" weekly article (which I get via email). This particular chapter is a good, relatively quick synopsis of why this secular bull/bear pattern recurs. I recommend clicking through and reading the whole thing if you're interested in this topic, as this is a good, short overview of it.

For those who aren't inclined to read the whole thing, let me pick out a single point that I found particularly interesting. Toward the end of the article/chapter, the author is talking about how P/E expansion and contraction is what is responsible for these secular bull and bear markets.

In other words, secular (extended) bull markets occur when investors become willing to pay higher prices for each dollar of company earnings, expanding the P/E ratio. Secular bear markets, in contrast, occur when investors (for a variety of reasons) become less willing to pay up for each dollar of company earnings, causing the P/E ratio to contract. If the P/E ratio didn't change, these "secular" bull and bear market swings wouldn't happen.

In his discussion of expanding and contracting P/E ratios, he deals with the concept of "mean reversion." He argues that this concept is largely misunderstood.

What mean reversion is: the "tendency (direction) of a movement towards the mean."

What mean reversion is not, but what many investors think it is: the tendency for a data item (like P/E) to settle at or around the average for that data series.

He illustrates the huge difference between the two this way:

Although P/Es may settle at the mean, that is not what the concept of mean reversion implies; rather, it suggests tendency (direction) of a movement towards the mean. Add human emotion into the mix and P/Es turn into a pendulum — swinging from one extreme to the other (just as investors' emotions do) while spending very little time in the center. Thus, it is rational to expect that a period of above-average P/Es should be followed by a period of below-average P/Es and vice versa.

Since 1900, the S&P 500 traded on average at about 15 times earnings. But it spent only a quarter of the time between P/Es of 13 and 17 — the "mean zone," two points above and below average. In the majority of cases the market reached its fair valuation only in passing from one irrational extreme to the other.

In other words, there is no "normal" P/E. There is such a thing as an average P/E, but the market doesn't spend much time there. Most of the time, the market is swinging either considerably higher or lower than that long-term average.

This is also true of annual returns, by the way, as we wrote about a couple years ago in No Such Thing As Normal. Everyone seems to know that the stock market's average return has been around 10-11% over many, many years. But the market provides relatively few years when returns are actually close to that average amount.

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Austin Pryor commentary: Two keys to investing success

Today, we begin a new occasional feature on the SMI blog — short audio commentaries by Sound Mind Investing's founder and publisher Austin Pryor.

First up, Austin explains two key principles that can help you become a successful long-term investor. To listen, click the arrow on the audio player below (1:40).

(If the audio player won't work for you, click here.)

Want to learn more about the keys to long-term investing success? Read Austin's Sound Mind Investing Handbook: A Step-By-Step Guide to Managing Your Money from a Biblical Perspective (5th ed.).

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Tag(s): audio, planning, self-discipline

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What investing is

Today's Personal Finance Friday post, by SMI founder and publisher Austin Pryor, focuses on what "investing" is — in contrast to two other things that are often confused with investing.

• Investing occurs when you put your money to work in a commercial undertaking, subject to modest levels of risk, and expect a reasonable return over a long period of time.

  What's reasonable? About 3%–5% more than the rate of inflation.

• Speculating also involves putting your money to work in a commercial undertaking, but it involves a level of risk so great that it's theoretically possible to lose most or all of your capital (the actual amount you invested).

  In return for this high risk, the speculator has the possibility of making an unusually large return (perhaps doubling or even tripling his/her money) in a relatively brief period of time — usually a couple years at most. (Speculating is frequently accompanied by borrowing additional sums for the undertaking and accepting personal responsibility for repaying those sums regardless of the outcome of the venture.)

  Financial options, commodity futures trading, and leveraged real estate projects are common forms of speculation.

• Gambling subjects your money to an exceedingly high level of risk in an attempt to profit from the outcome of a contest or game of chance. There is the possibility of an unusually large return in an exceptionally brief period of time — perhaps measured in minutes or hours. A sure sign that an activity falls under the “gambling” heading is when the activity exists solely for the sake of creating wagering opportunities. For example, apart from wagering, there would be no reason for casinos, horse racing, or lotteries to exist.

What is SMI's position on these three approaches to trying to get a return on your money?

We think gambling should be avoided by all, while speculating should be avoided by all except those with a professional interest and degree of expertise.

In contrast, investing is an activity that all of us, as stewards of God’s resources, are unavoidably called to. Like it or not, as a steward of God-given time, talents, and resources, you are an investor.

Investing, in its broad sense, is simply giving up something now in order to have more of something later. For example, when you put your money into a savings account, you are making an investment decision (less spendable money now in order to have more spendable money later). Or when you volunteer your professional services or personal talents now to serve in a ministry, you're making an investment decision (less free time or current income now in order to have a greater sense of fulfillment and eternal gains later).

In the financial area, there are many ways to invest. But you will increase the likelihood of becoming a successful investor over the long-term if you will take only prudent risks and seek only reasonable returns.

That's foundational to our approach that we call "sound mind" investing.

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A Ponzi-scheme epidemic

The sad tale of Bernard Madoff — a multi-billion dollar swindle in which trusting investors lost huge sums — is only the most prominent of many such stories, reports Dow Jones columnist Al Lewis.

Confessed Ponzi schemer Sean Mueller received a 40-year prison sentence last week.

I watched as he pleaded for mercy in Denver District Court, but the damage was done. He'd fleeced the Mile High City's elite, including football great John Elway, and many not-so-elite, out of more than $70 million.

Mr. Mueller, 42 years old, did this with one of the oldest tricks around: A classic Ponzi scheme, taking money from new investors to pay off the old. He touted an amazing, risk-free stock-trading strategy until April, when he sent his investors an email saying he was sorry he blew it. He was then intercepted by police while considering a jump from a parking garage.

Lewis notes that the Justice Department recently announced the results of a crackdown on financial fraudsters called Operation Broken Trust. The effort "rounded up 343 criminal defendants and 189 civil defendants," he reports, with a tally of "120,000 victims and $10.3 billion in losses."

In remarks (text) at a Dec. 6 news conference, Shawn Henry, executive assistant director of the FBI, noted that the most successful financial fraudsters excel at building trust.

The perpetrators of these crimes are those who you might trust: friends and colleagues, people from your workplace, your child's soccer team, even your church.

Criminals have always preyed on the trust of individuals with offers too good to be true — and while the schemes might change, the underlying greed does not.

One victim of a large Ponzi scheme in Tennessee said, "He sat about four rows behind us in church. We were very good friends. We went to his house often. He was a brilliant man. That's how he was able to con people for eight years."

The FBI offers this summary of some of the frauds stopped by Operation Broken Trust and suggests a few ideas (at right) that can keep you from being taken.

And keep in mind, as columnist Lewis points out, that that most financial fraud is small-scale, not large.

[There are] penny-ante Ponzis just about everywhere.

You know, $10 million here, $50 million there. Many of them get only a brief in a local newspaper, aren't a matter for the Feds and don't generate loud complaints from victims.

The characters, the settings and the dramas differ, but Ponzis are all the same. Someone gains trust, promises profits that are too good to be true and fabricates statements. The money is then either blown in desperate trades or on mansions, cars, planes, art and jewelry....

Why do people keep falling for these sorry characters after Charlie Ponzi pulled his frauds a century ago? Colorado Securities Commissioner Fred Joseph, who has handled his share of Ponzis, puts it this way: "People want to believe."

Be wary.

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Category(s): Investing Principles
Tag(s): financial fraud

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Employees still taking huge risks with their 401(k)s

We've been writing for years about the huge risk employees take with their 401(k) savings when they invest a large portion in the company stock of their employer. And while the trends have improved over the years, this new Forbes report indicates a whole lot of employees have yet to get the message.

For example, when we last wrote about this issue in December 2007, 57% of the assets in Coke's 401(k) plan were invested in Coke stock. Forbes says that level is 51% today. Better, but not much.

Let me put it bluntly for the benefit of new readers. This is one of the biggest risks "normal" people take with their retirement savings. It's also one of the most easily correctable ones, in most cases.

I've heard people agonize about the decision to reduce the amount of company stock they own. In many cases they legitimately believe their employer is a great investment — significantly better than the alternatives they would invest in if they were to sell company stock. Some of them are even right about that.

Unfortunately, it's a risk you can't afford. The landscape is littered with the carcasses of blue-chip, brand name companies whose employees never dreamed they would fail. And yet they did. You simply can not take the chance that your retirement savings will be devastated at the same time you lose your job and benefits. That's way too many eggs for any one basket, no matter how confident you are in that basket.

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Category(s): Investing Principles, Retirement

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Big picture finances

Back in April I was thumbing through Consumer Reports' annual auto issue when I came across an article entitled, "Best Values: Small Cars and Family Cars Provide the Most Bank for Your Buck." No real surprise there, but always looking to reassure my value-seeking sensibilities, I continued on to read about road-test scores, predicted reliability ratings, and five-year owner-cost estimates — which is when it got really interesting.

On the next page was a list of 60+ cars with various data points (here's a similar article). The most compelling data to me was called "cost per mile." I quickly scanned till I found our two-year-old Honda Odyssey (which I LOVE and have NO problems whatsoever saying as much). Cost? $.71/mile. I remember thinking, "Man that's high." But then I went on with life and didn't give it too much extra thought.

The significance of this expenditure didn't dawn on me till the other day when we were carpooling with some folks to an out-of-town event in Frankfort, Kentucky. From where I live in Louisville, that's about 50 miles — i.e. $35.50...one way.

Yes, Consumer Reports' cost-per-mile factors in gas, maintenance, depreciation, insurance premiums, even sales tax. And it's based only on a five-year ownership. But for someone who hems and haws over spending $.99 on an iPhone app, it occurred to me that thinking about cost-per-mile could be revolutionary.

For instance, I often hop in the Odyssey (yeah, I could use our other car, but like I said, I'm the Minivan Man) and drive two miles up the road to the quickie mart for a Diet Coke. I now realize this is costing me $3.78/soda rather than the mere $.94 that I was rationalizing.

So I'm now thinking in terms of MPM (money per mile) rather than MPG (miles per gallon). Where we live, a trip to the grocery is not seven miles away, it's $4.97 away. And another $4.97 if I want to come back.

Okay, okay, I know — it's not technically "costing" me this at the time I'm driving. But it's roughly "equating" to this over the first five years. And yes, Consumer Reports is making some assumptions, so it's not 100% precise (Edmunds.com's True Cost to Own calculated the ownership operation to be $.58/mile).

So why bring this up? Because you and I often lose site of the big picture when we think about our finances.

We fall into the trap of "the-more-you-buy-the-more-you-save" sales (an oxymoron if I've ever heard of one — the more you buy the more you spend!). We hold on to a falling fund with a lot of our assets in it just so we don't get hit with a $50 early redemption fee. Or worst of all, we're stingy with our tithing on earth, even though we're promised eternal rewards in heaven. We would do better by keeping the big picture in mind.

So the next time your debating whether to buy a shirt that you only "kinda like" but it's 95% off (this is me nearly every time I go to Old Navy), or to drive an extra three miles out of our way to save $.02 on a gallon of gas, maybe you should stop and ask some questions:

• "Do I really need this?"
• "Can it wait?"
• "Is it part of my long-term plan?"
• "Am I being penny wise, dollar dumb?"

And most importantly:

• "Am I being a good steward of what's been entrusted to me by storing up treasures in heaven?"

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Category(s): Family Finances, Investing Principles

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Long-term vs. short-term

This probably seems counterintuitive, but in investing short-term outcomes are much less predictable than long-term outcomes. That's why being successful over the long haul involves ignoring much of what is happening in the short term.

Consider this quote from Bob Reynolds, CEO of Putnum Investments, in an interview published this week by Morningstar:

So much of investing — probably the most critical point — is time horizon. It's having a real grasp on what you are investing for.

The most interesting thing about the market is that the longer-term your time horizon, the more predictable the market is. I think it's...being able to put together the right portfolio, and then taking that type of view of the market and not react to day-to-day movement. (emphasis mine)

That's easy to lose sight of, particularly because the market seems to flit from one short-term preoccupation to the next. One month it's the collapse of the dollar, then it's the debt troubles in Greece, then it's slowing growth in the U.S and the fear of a double-dip recession.

It's important to recognize that the market always has a boogey man. There has to be one, almost by definition, for the market to function in balancing the bullish and bearish case.

That's where the importance of time horizon comes in. The longer yours is, the more you can tune out this day-to-day, week-to-week, month-to-month endless cycle. The shorter your time horizon is, the more damage these short-term issues can do to your portfolio.

But that's also why you adjust your portfolio allocation as you age, to counteract the fact that you are more vulnerable to short-term market displacements due to your shorter time horizon.

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Category(s): Investing Principles
Tag(s): long-term perspective, time horizon

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Steady investing in an unstable economy

In the midst of high unemployment and growing concern about federal spending, the stock market (despite yesterday's sharp loss) has been moving along very nicely, thank you.

Why? SMI's executive editor Mark Biller (right) discusses that question — and explains why it's so important to have a long-term investing plan — on today's MoneyLife radio program. Mark talks with host Chuck Bentley of Crown Financial Ministries.

Click the arrow below to listen (20 min.) — or use this link to download an mp3 (right click/save as).

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Category(s): Economy, Investing Principles
Tag(s): Crown Financial Ministries, investing principles, radio

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Investment forecasters and horse-race gamblers

A huge audience tuned in to a sporting event that took place in my hometown over the weekend: the Kentucky Derby. In addition to the tens of millions who watched on television, almost 156,000 crowded into Churchill Downs on a rainy day to experience the tradition, wagering, and cheering firsthand.

Before the race, a "vote" was taken as to which horse would win. Participants voted with their pocketbooks by placing their bets, and the horse on which the most money was wagered became the favorite. Rarely do the fans in any sport spend more time studying data, reading commentary, or listening to experts before reaching a decision.

The eventual favorite reflected the collective wisdom of the racing world. Given this, you'd expect the favorites in this race to have a record of success. Surprisingly, you'd be wrong — very wrong.

Over the past 30 years (including this past Saturday when pre-race favorite "Lookin At Lucky" came in sixth), the favorite has made it into the winner's circle only twice. That's a failure rate of 94%!

Based on their extensive knowledge of the horses' recent histories, people "in the know" make educated judgments about how the horses will perform on a given day. But actually, they're just guessing. No one knows for sure.

In a sense, the financial markets aren't much different. When an investing professional offers stock, bond, and mutual fund recommendations, he doesn't know where the markets are going any more than you do.

He knows where they've been, of course; that is, he knows how they've behaved in the past under similar economic circumstances. Based on that knowledge, he forms opinions as to how the markets will behave in the near future. But reality isn't that simple.

There are two difficulties in making accurate forecasts. The first is that one or more of the governing assumptions will turn out to be wrong. The forecasters don't know which ones, so they can't fix them. The other is that the underlying assumptions are incomplete. But the forecasters don't know which factors have been left out, so they can't include them.

Despite this, publishers of the leading financial magazines and web sites regularly offer bold headlines such as "Where to put your money now" or "Eight stocks to buy today."

This incorrectly conveys a sense of predictability concerning the economy and markets, and downplays the reality of risk. (Frankly, financial magazines have a mediocre track record when it comes to their specific investment recommendations.)

Sound Mind Investing typically doesn't make forecasts as to what the future holds for the markets. We're willing to admit we're clueless about that. It's our belief, however, that it is impossible to self-destruct financially if your decision-making is pointed in the direction of God's glory.

One characteristic of investing that glorifies God is that it respects His wisdom, not man's. If it's your desire to have confidence in managing your finances rather than relying on the guesswork of others, ask God to help you learn the essential basics you need to become a faithful and effective steward. In tandem with your praying, begin your education by reading our recent Financial Literacy 101 series.

And here's something to keep in mind: Asking for the Lord's help is not a gamble. It's a sure thing. "If any of you lacks wisdom, he should ask God, who gives generously to all without finding fault, and it will be given to him" (James 1:5).

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Tag(s): christian investing, investing principles

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Financial Literacy 101: Your most important investing decision

Ninth in a series for
Financial Literacy Month

April is National Financial Literacy Month — and at SMI we've been doing our part with a series of posts on basic principles of investing and personal finance. (Each post in the series is identified by the orange character at right, diligently working on his financial plan.)

Here's our final post in this series, with advice on the one investing decision that will have greatest impact on your eventual returns.

What determines the performance of your investment portfolio more than any other single factor? Many investors think it's the specific investments they choose. Certainly that can make a big difference.

But even more important is how much of your portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. Academic studies over the years have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.

A portfolio's stock-to-bond mix does more than dramatically influence future returns — it also tells you how those results are likely to be obtained. Look at these charts. The vertical lines represent the returns for each calendar year between 1926 and 2008, ranked from worst to best.

Starting with Chart A, you can see that a 100% stock portfolio is going to provide many years of big moves, both up and down.

The other charts reduce the stock portion in increments of 20% each, putting that money into intermediate-term government bonds instead. This has the clear effect of narrowing the range of results. Not only are the bars on the other graphs smaller (illustrating that the gains and losses of these portfolios are less extreme), but the frequency of negative returns declines as well.

The 100% stock portfolio suffered losses in 29% of the years, compared to just 10% of the years for the 20% stock portfolio.

It's safe to say then, that the more bonds in your portfolio, the smoother the ride. By contrast, the higher your stock allocation, the more you can expect returns to come in a "two steps forward, one step back" fashion.

If owning stocks subjects you to greater swings in performance and produces losses more frequently, why use them at all? Because that's where the biggest long-term gains are! The net effect of all those stock market ups and downs is greater overall returns, which you can see in the average annual returns shown on the charts.

So, on the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?

The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be quite confident that stocks will provide higher returns than bonds.

Here's a good example to illustrate this point. Think about tossing a coin. You know that the probability of getting heads on any single toss is 50%. So if your goal is to get 50% heads, then what matters most to you is having a lot of tosses. If there are only going to be two tosses, you should be much less confident of getting 50% heads than if there are going to be ten tosses. With 100 or 1,000 tosses, your confidence should grow correspondingly that the long-term averages will emerge.

So it is with investing. The more years ("tosses") you have ahead of you to invest, the more confident you can be that you'll benefit from the higher average returns stocks have historically provided. The fewer years you have to invest, the more you need to protect against the possibility that the results over your shorter time period may not match the long-term averages.

That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

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Financial Literacy 101: Making the 'right' investing decisions

Eighth in a series for
Financial Literacy Month

At Sound Mind Investing, we're doing our part for National Financial Literacy Month by featuring a series of posts on basic principles of investing and personal finance.

Here's post eight — on how to make investing decisions with confidence.

Having seen a horrendous bear market in 2008 (and early '09) and now a sharp run up over the past 14 months, many people are finding it difficult to know the "right" steps to take going forward. They wonder:

"Is this a bad time to buy stocks, since the market has already risen so strongly?"

"If I move from one kind of investment to another, will I actually be better off?"

"How much of my retirement money should I put in stocks versus bonds?"

It's important to keep in mind that since you can't know the future with certainty, your investment portfolio will never be perfectly positioned to profit from upcoming events. In retrospect, it is always possible to think of ways you could have made more money (or lost less) than you did.

The human inability to make fully accurate predictions means it's pointless to think of the "right" investment portfolio simply in terms of making the highest possible profit. If that's your approach, you will always be second-guessing your decisions, and you'll end up frustrated and disappointed.

Instead, the "right" portfolio is one that realistically faces where you are right now, looks years ahead to where you want to go, and has a very high probability of getting you there on time.

Let me describe a few characteristics of the "right" steps to take:

The right investing decision is one consistent with a specific, biblically sound long-term strategy you've adopted. I have discovered a common trait among many people I counsel: their current portfolio is simply a random collection of "good deals" and assorted savings accounts. Each investment appears to have been made on its own merits, without much thought of how it fit into the whole.

Their portfolios tend to be an incongruous collection of savings accounts (because the bank was offering a "good deal" on money market accounts), a savings bond for the kids' education (because they read an article that said they were a "good deal" for college), a universal life policy (because their insurance agent said it was a "good deal" for someone their age), and 100 shares of XYZ stock (because their best friend let them in on this really "good deal").

Those who hold this kind of random assortment of "good deal" investments are what I call responders (i.e., reacting to sales calls, making decisions on a case-by-case basis). I urge you instead to become an initiator (i.e., one who develops an individual investing strategy tailored to your personal temperament and goals).

The right step is the purchase of an investment that you seek out purposefully, knowing where it fits into the overall scheme of things.

The right investing decision is one you have taken time to pray over, and about which you have sought experienced Christian counsel. Because your decisions have long-term implications, you should take all the time you need to become informed. Don't be in a hurry; there's no deadline.

You need time to pray, ask for the counsel of others, and reflect. You should consider the alternatives, examine your motives, and continue praying until you have peace in the matter. If you're married, you should pray with your spouse and talk it out until you reach mutual agreement. Remember, you're in this together.

The right investing decision is one you understand. It's not likely that your situation requires exotic or complicated strategies.

In fact, the single investment decision of greatest importance is actually quite easy to understand. It is simply deciding what percentage of your investments to put in stocks (where your return is uncertain) as opposed to bonds and other fixed-income investments (where your return is relatively certain). This one decision has more influence on your investment results than any other.

Another aspect of understanding your investments is to educate yourself on the basics. The right investment step is the one where you understand what you're doing, why you're doing it, and how you expect it to improve matters.

The right investing decision is one that is prudent under the circumstances. Does it pass the "common sense" test? How much of your investing capital can you afford to lose and still have a realistic chance of meeting your financial goals? Investments that offer higher potential returns also carry greater risks of loss.

The right investment step is the one that protects you in the event of life's occasional worst-case scenarios. Generally, this moves you in the direction of increased diversification.

I realize many people find investing to be a nerve-racking, if not downright scary, experience — and the turmoil of 2008 certainly didn't calm any nerves. Unfortunately, anxiety and the fear of doing the "wrong" thing cause many people to "freeze up." They become frightened into inaction. In mail from readers, we get many variations of these three comments:

"There's so much at stake. I'm afraid I'll make the wrong decision."

"I don't have much experience. I'm afraid I'll make the wrong decision."

"My savings aren't making enough now, but if I make a change I'm afraid I'll make the wrong decision."

What is the "wrong" decision, anyway? If you think a wrong investing decision is like saying 2+2=5, then you're off track; such thinking implies that investing decisions can be made with mathematical certainty. They can't.

It's not that the economy and investment markets are completely random — they aren't. But investing deals with probabilities, not with certainties and predictable events. We can know some things but not others.

All of this is actually good news. It means anybody can play. It's like learning to drive a car. After a couple of lessons, you know enough to travel around town if you follow a few basic safety guidelines. After all, you're not trying to qualify for the Indy 500 — you just want to reach your destination.

In the same way, once you understand certain core concepts (such as those taught in our Sound Mind Investing Handbook and monthly newsletter), you're fairly well equipped to make basic investing decisions — and to do the thing that's "right" for you.

Adapted from chapter 20 of The Sound Mind Investing Handbook (5th ed.) by Austin Pryor. Copyright © 2008 by Austin Pryor.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

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Category(s): Investing Principles

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Financial Literacy 101: Inside-out investing

Seventh in a series for
Financial Literacy Month

April is National Financial Literacy Month. So this month we're featuring a series of posts on basic principles/strategies related to investing and personal finance.

Here's post seven — about a counterintuitive approach to becoming a successful long-term investor.

This may sound strange at first, but it's best to make your investing decisions with little regard for what's going on in the investment markets. No kidding.

Think about this: Where do investment decisions originate for many investors? The starting point is found in the impersonal "outside" world of current events, magazine articles, and brokers' recommendations. Their decisions are guided primarily by outside considerations. As they respond to the data thrown at them — sometimes buying, sometimes selling — their personal "inside" financial worlds take shape.

Their thinking is "outside-in." They need a continual stream of outside information to stimulate their thinking and provoke them to action. Decision-making would be impossible without it.

For other investors, the starting point of decision-making is "inside" information. The focus is on their own financial needs and a personalized long-term strategy designed to meet those needs. Their buy/sell decisions are made based on what's required to make sure their financial holdings are in accord with the game plan. The "outside" world of investment professionals comes into the picture only because assistance is needed in executing decisions already made.

This is "inside-out" thinking, where decisions are primarily shaped by inside considerations. Thus, current market fads, trends and so-called expert opinions are largely irrelevant to inside-out investors.

As you have probably guessed by now, we're encouraging you to be an inside-out thinker. In other words, make your investing decisions as you would other consumer purchasing decisions.

For example, if your family has grown to the point you need a minivan to haul everyone around, you wouldn't buy a sporty new Camaro SS instead because a magazine article said they're "hot" at the moment. Or, if you need a medicine that lowers your blood pressure, you wouldn't let a glowing recommendation from your druggist convince you to bring home the leading antihistamine for allergies instead.

This is obvious, you say. Yet many people have a difficult time applying this consumer mindset to their investing decisions, even though they should.

Here are a few of the questions an inside-out investor should be asking:

• Is my financial foundation rock solid — that is, am I debt-free and is my contingency fund sufficient?
• Am I overly invested in one sector of the economy or in a single stock, or are my investments well diversified?
• Am I meeting my giving goals?

Notice that the focus is on personal needs and circumstances, not on the headlines of the day (which almost never tell you anything that will enhance the quality of your decision-making).

Current events — whether good or bad — may prompt you to run through your personal list of review questions, but if you want to be a successful long-term investor, the news of the day should not dictate your answers.

To learn more keys to long-term investing success, read The Sound Mind Investing Handbook (5th ed.) by Austin Pryor. Copyright © 2008 by Austin Pryor.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

Posted by Joseph at 8:55 AM | Comments (0) | TrackBack
Category(s): Investing Principles

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Financial Literacy 101: A simple and steady investing strategy

Sixth in a series for
Financial Literacy Month

At Sound Mind Investing, we're participating in National Financial Literacy Month by posting a series of articles covering basic principles/strategies related to investing and personal finance.

Here's post six — about an investing strategy that is easy to understand and implement.

A consistent theme of the Sound Mind Investing philosophy is the importance of taking charge of your own financial future by becoming an "initiator" rather than a "responder." Initiators take action based on specific guidelines that flow from a specific strategy. Initiators, as the old saying goes, "plan their work and work their plan."

At SMI, we like "formula" strategies. A formula strategy requires you to make your buying and selling decisions based solely on mechanical guidelines. There is no judgment involved; it's all automatic. Such strategies protect you against your own emotions and the tendency to go along with the crowd.

Probably the best-known formula strategy is dollar-cost-averaging (DCA). It's not complicated. It's not time-consuming. In fact, nothing could be simpler.

Here's all you do: (1) invest the same amount of money (2) at regular time intervals. That's it.

The amount and frequency are up to you. The important thing is to pick an amount you can stick with faithfully over many years.

Your constant dollar investment automatically results in buying more shares when prices fall and buying fewer shares when prices rise. In effect, you are buying more at bargain prices and relatively little at what might be considered high prices. (Of course, only when you look back years from now will you know when prices really were bargains and when prices were too high.)

The beauty of DCA is that it frees you from the worry of whether you're buying stocks at the "wrong" time.

It is critically important to ignore all market fluctuations when employing a dollar-cost-averaging strategy. Most investors who obtain poor returns in the market are victims of their own emotions. Only after stock prices have risen sharply do they work up enough courage to buy stock fund shares. And they often sell when they become fearful after prices have plunged. The consequence is that they buy high and sell low, the very opposite of their goal.

It is important, then, not to let your emotions control you. You must exercise the discipline of maintaining your systematic investment program.

The benefits of DCA can be illustrated with a simple example. Let’s assume you can afford to invest $100 every month in your stock fund program. At the time of your first new investment, the fund shares sell for $10.

The next month, the market soars and you pay $14 for your shares. Finally, the third month the market falls back, and your fund retreats to $12, midway between your two buying levels.

Ordinarily, that would put you at break-even. But look at what has happened. The first month you were able to buy ten shares at $10 per share. The second month you acquired only 7.1429 shares at $14 per share. Now, at $12 each, your 17.1429 shares are worth $205.71. Instead at being at break-even, you have a small profit.

One caution: DCA does not protect you against losses. While it does result in your average cost per share being lower than the average price of the shares over time, in a bear market you can nevertheless have temporary losses.

In summary, dollar-cost-averaging is the systematic investing of a fixed amount of money on a regular basis, usually monthly. DCA eliminates the need to ask the question, "Is this a good time to buy stocks?" As far as DCA investors are concerned, every month is a good month.

Adapted from chapter 19 ("Systematic Investing") of The Sound Mind Investing Handbook (5th ed.) by Austin Pryor. Copyright © 2008 by Austin Pryor.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

Posted by Joseph at 9:05 AM | Comments (0) | TrackBack
Category(s): Investing Principles

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How important are mutual fund expenses really?

You've probably seen articles explaining that mutual fund investors pay higher costs than they realize due to funds incurring "hidden" costs that aren't reflected in the published "expense ratio." Such articles (here's a recent example from Morningstar) usually disparage funds that do a lot of trading because they tend to incur higher levels of these "hidden" costs.

The argument is true to a point: Any investor who selects funds primarily based on their stated expense ratios probably isn't aware of potentially expensive trading costs or 12b-1 fees (i.e., marketing expenses) that aren't reflected in those ratios.

But is that the best way to select funds in the first place?

At Sound Mind Investing, we take a different approach to the issue of expenses. Brace yourself — we're not all that concerned about them. It's not that they don't matter — they certainly do. It's just that we're much more concerned about overall performance. If we wind up paying higher expenses as part of the price of obtaining better overall performance, that's a trade we're willing to make.

The types of articles mentioned above usually don't present it that way. They argue that if Fund A has high trading costs, Fund B has a high 12b-1 fee, and Fund C has neither, then you should invest in Fund C. That would be true if A, B, and C all generated the same performance. But if A and B strongly outperform C — so that you come out ahead even after expenses are subtracted — then, relatively speaking, the expense levels of A and B weren't all that important.

Fundamentally, this issue boils down to two competing belief systems. On one side, you have those who say it's virtually impossible to determine in advance which funds will outperform in the future. Therefore, the only approach that makes sense is to diversify and minimize expenses. This is the basic essential argument for indexing.

On the other side, there are people like us who say you can predict which funds will outperform in the future. Not every time. And trying to do so doesn't afford you the luxury of buying a fund and holding it for years or decades at a time. But over time, we do believe it's possible to get a market-beating result if you're willing to stick rigorously to a specific discipline of buying and selling funds. We call this discipline our Fund Upgrading strategy.

So how can you know in advance that A and B will perform better than C? You can't know for sure, not on any single fund choice. But research has shown that recent mutual fund performance tends to persist into the short-term future. In other words, superior recent performance tends to translate into superior near-term future performance. That's the basis of Upgrading.

It certainly doesn't work on every single fund selection. That's why we have to follow a vigorous selling discipline as well, to cut our losing trades short. But over time, the Upgrading process steers us towards enough funds that outperform their peer group.

That's how our Upgrading has been able to beat the market in 10 out of the past 11 years (in the graph below the light-shaded bars represent the performance of the overall market as measured by the Wilshire 5000; the dark-shaded bars represent Upgrading's performance).

Further, as noted in the current issue of SMI, Upgrading is a strategy that works remarkably well even when implemented on limited scale.

At the end of the day, our emphasis is not on expenses and costs, but rather on the final returns a fund produces after already accounting for all the costs of ownership. It's not that we don't care about expenses, it's that all of a fund's costs are already baked into the performance numbers we use as the basis of Upgrading. So if a fund can outperform in spite of higher costs, we're willing to overlook them.

Posted by Mark at 10:10 AM
Category(s): Investing Principles, Mutual Funds, SMI Model Portfolios

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Spiritual money myths

From SMI's audio archive, executive editor Mark Biller explains how Scripture can correct common mistaken ideas about money. Mark was interviewed by host Bob Crittenden on Faith Meeting House, a program produced by Alabama's Faith Radio.

Click the arrow below to listen (30 min.) — or use this link to download (right click/save as).

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Making progress by dollar-cost averaging

Lots of number crunching has been going on since early January, as fund companies and related organizations compile data for the decade just ended. (SMI is no different: you can find our recently released 2000-2009 performance data here.)

Fidelity, the top provider of employer-based retirement plans, has completed an analysis of the 10-year experience of 11 million investors who have Fidelity 401(k) accounts. Here are the overall results (from a Fidelity news release):

Even during a decade that included unprecedented volatility coupled with two of the worst market downturns in history, analysis of employed participants with a Fidelity 401(k) plan for the past 10 years ([2000] to 2009) showed their account balance increased nearly 150 percent to $163,900 at the end of 2009 from $65,800 at the end of 1999.

The increase in balance was due to continued participant and employer contributions, dollar cost averaging and market returns. The analysis also showed that these continuous participants had a median age of 51 years with a deferral rate of 10.4 percent.

The New York Times' Bucks Blog digs a bit deeper:

While [results differ] for every employee, about three-quarters of [the increase reported by Fidelity] was from worker and employer contributions. And roughly one-quarter could be attributed to market returns and what's known as dollar-cost averaging (when investors make regular investments over time, thereby evening out their chances of buying at market highs and lows).

In other words, over the decade most workers just kept plugging away at making contributions to their retirement accounts. Sometimes stock prices were high (e.g. September 2007), sometimes they were low (February 2009 anyone?). Regardless, most 401(k) investors stuck with their plan.

Looking back now, it is clear that these workers — despite one of the worst market decades ever — made substantial progress toward their retirement goals simply by being diligent to the task of setting aside about 10% of their income, paycheck after paycheck.

Sure, a worker who 1) pulled out of the market before each downturn and 2) got back in at the bottoms would have come out much better, but who can know when such drops begin and end? They're easy to see in hindsight but almost impossible to spot, at least consistently, in the present.

The moral of the story: slow and steady wins the race — or at least it's a solid strategy for moving you toward where you want to go. For more, here's a 2007 SMI article on dollar-cost averaging.

Posted by Joseph at 9:05 AM | Comments (0) | TrackBack
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Persevering through the rough places

Market reversals will come. If you didn't know that before, the period from October 2007-March 2009 made it abundantly clear!

Unfortunately, many investors run for the exits as bear markets unfold, and then are skittish about getting back in for fear that another drop might occur (statistics suggest many investors who bailed during '08 and early '09 still haven't returned). Such an approach to investing is rarely productive. Often, it all but guarantees poor long-term returns.

A better approach is to persevere through the tough spots. But you're not likely to persevere unless you have a plan — a plan you can stick with even when the going gets tough.

SMI's assistant editor Joseph Slife talked about this a few days ago with host Bob Crittenden on Faith Meeting House, a program produced by Alabama's Faith Radio.

Click the arrow below to listen (22 min.) — or use this link to download (right click/save as).

Posted by Matthew at 9:02 AM | Comments (0) | TrackBack
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Tag(s): radio

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Longer-term thinking about money

"Investing is simply giving up something now in order to have more of something later." So writes Austin in the Sound Mind Investing Handbook.

It's a simple concept, but one that's difficult to keep in the forefront of our minds because human nature doesn't lend itself to focusing on the long-term. Today and tomorrow seem much more real and important to us than 10 or 20 years from now.

Duke University behavioral economist Dan Ariely, author of Predictably Irrational: The Hidden Forces That Shape Our Decisions, offers a few helpful ideas for longer-term thinking about money in the video below from BigThink.com.

Partial transcript:

[We] went to a Toyota dealership and we asked people, "What will you not be able to do in the future if you bought this Toyota?"

Now, you would expect people to have an answer. But people were kind of shocked by the question. They never thought about it before. So, the most we got was people said, "Well...if I buy this Toyota, I can't buy a Honda."

So, they were making a substitution from the same product in the same time, but in reality, this is not a substitution. They [should be] substituting something in the future. In the future, I will have to give up two weeks of vacation and 70 lattes and 1,700 books. I don't know what exactly the translation is — but when we do consume something now, something else has to give at some point. What is this thing? What is this value of price? Very hard to think about it.

Dr. Ariely also explains how to make better decisions about spending by making the "pain of paying" more apparent.

Imagine you go on a cruise to Alaska and you can either pay six months in advance, or the moment you get off the ship. It's much more reasonable, economically, to pay the moment you get off the ship. But how much would you enjoy the last day of the cruise? It will be kind of miserable knowing that tomorrow you have to pay all of this money.

We [try to] reduce the pain in paying. So, for example, credit cards are wonderful mechanisms to reduce the pain of paying. If you go to a restaurant and you are paying cash, you would feel much worse than if you were paying with credit card. Why? You know the price, there's no surprise, but if you're paying cash, you feel a bit more guilt. It's a bit more difficult. It's more painful to part with your money. With a credit card, eh — it's another time....

Imagine if you had envelopes and your envelopes were telling you how much money you have in each category for the rest of the month. You had an envelope for coffee, you had an envelope for restaurants and you had an envelope for grocery. Now, when you take month out, you also see how much what you have left is shrinking, and that will actually increase the pain of paying more.

Now, I don't think we should go around life and being miserable all the time and feel the pain of paying. It's a question of what categories we want to spend more on and what categories we feel that we are spending too much on and we want to cut down.

It is remarkable that these matters, considered simple common sense just a few generations ago, are now the subject of academic discussion and inquiry. But nonetheless, it is a good thing that "behavioral economists" are helping people understand how to plan their finances and spend responsibly.

Posted by Matthew at 2:50 PM | Comments (0) | TrackBack
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Here's a quiz that attempts to measure how risk tolerant you are

Early on at SMI, I developed a brief quiz to help our readers determine how risk averse they are. The results from that quiz, in combination with our "seasons of life" chart, help them arrive at a stock/bond allocation suitable to their risk tolerance and age.

At least that's the idea. As we all know, however, the way you answer questions in what is essentially an academic exercise can lead to outcomes that are quite uncomfortable in the depths of a severe market selloff. As the recent bear market demonstrated, many folks are much more risk averse than they had imagined.

The current issue of Money magazine has an article on this subject, pointing out...

The asset-allocation tools you'll find online or that an adviser will employ when working with you routinely recommend stock allocations of 70% or more if you're younger than 55 or so.... That's because, over the long run, stocks return more than bonds, so odds are (notwithstanding the past decade's lousy returns) that a heavier stock allocation will give you more money in the end.

Rational, yes. But some of the best work done in the study of risk tolerance concludes that many people can't handle the swings that come with such big stock weightings. As a result, they'll frequently sell at or near market bottoms.

FinaMetrica, an Australian company that has developed a respected risk questionnaire used more than 250,000 times by financial planners, has found that only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87%. "The investment industry tends to encourage people to take on more risk than they're emotionally equipped to handle," says FinaMetrica co-founder Geoff Davey....

Risk tolerance isn't about how much risk you ought to take when you invest; it's about how much you can take before you'll crack.

The article goes on to say that FinaMetrica usually charges $30 for the quiz and calculating/explaining your personalized results, but it's free via Money through the end of November. An opportunity to know my investing self better and free to boot? Irresistible. I clicked on the link and spent about 10 minutes taking the quiz.

For what it's worth, I ended up in Risk Group 5, meaning only about 7% of all investors are more tolerant of risk than I am. In terms of the SMI quiz, I'm a "daredevil." Even so, I was told I'm "somewhat less risk tolerant" than I thought I was. If that's true, I can only imagine the wild level of risk I thought I would be comfortable with.

If you'd like to take the quiz, click here. How'd it rank you?

Posted by Matthew at 1:34 PM | Comments (0) | TrackBack
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A tale of 1,000 points

The Dow reclaimed the 10,000 level yesterday, roughly a year after it last held that level, and more than 10 years since it first passed that milestone.

As David Callaway of Marketwatch points out, a look back clearly shows that it's anybody's guess what happens next:

When the Dow first closed above 10,000 in 1999, it only took another 24 trading days for it to close above 11,000, according to Standard & Poor's. It took seven years and a bear market after that for the Dow to achieve 12,000.

Which path will lead to the next 1,000 points? The 24-day path? Or the 7-year and a bear market path? Nobody knows.

But if you don't have your money invested, it doesn't matter either way. On the flip side, if you have at least a 7-year time frame until you need the money, you can take the risk that the next 1,000 points will take the wandering road. And hopefully you'll be pleasantly surprised by something closer to the 24-day path.

Posted by Mark at 2:58 PM | Comments (0) | TrackBack
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When investing turns into gambling

USA Today ran a story last week about recent trading in old GM stock. General Motors, of course, declared bankruptcy while saddled with huge amounts of outstanding debt, making it virtually certain that their old stock will wind up being completely worthless. So why do millions of shares continue to change hands each day?

There are two reasons that I can see.

One is ignorance: some unfortunate people apparently think what they are trading is new GM stock. Sadly, these people are misinformed. If anyone reading this is among this crowd, please understand that there is no new GM stock available yet. If you own or are trading GM stock, it's the old stuff, and it's going to be completely worthless at some point in the not-too-distant future.

The second reason so many shares of GM continue to change hands is simple greed. Knowing that an asset is eventually going to zero, yet jumping in and out of it in an effort to ride sharp price movements, is no longer investing. It's gambling.

Investing is when you put your money to work in some productive enterprise with the hope of earning a return. Gambling is when you put money at risk in a game of chance with the hope of winning a quick profit. Note, these are my off-the-top-of-my-head definitions, nothing official. But they sum up the difference pretty well, I think.

Granted, there are times when the lines between investing - speculating - gambling can seem to get a little gray, leading some Christian investors to question if there's really a clear difference between them. Despite the fact that some investing involves luck, and some gambling involves skill, I'd still argue there is still a sharp distinction between the two activities. On one side is the GM stock investor of a decade, or even a year, ago. On the other is the GM stock trader of last week. Same stock. Big difference in intent and outlook.

Posted by Mark at 4:07 PM | Comments (0) | TrackBack
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Good advice

From Bill O'Neill, via Chuck Jaffe's latest column:

Bill O'Neil, the founder of Investor's Business Daily and author of "How to Make Money in Stocks," told me this week that the idea for most investors is to find a system that works for them and to then stick with it, knowing that they will never be right all of the time but that if they win more often than they lose, they'll make money in the market.

"Most people would be better off if they found a system they could live with," O'Neil said. "You will always have times where you say 'I could have made some money in there,' but if it's against your rules and your rules work over time, you can live with the mistakes."

Posted by Mark at 11:10 AM | Comments (0)
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Past performance is no guarantee of...

We've said it before and we'll say it again: just because an investment performed well in the past doesn't necessarily mean much for the present or the future.

Fortune magazine senior editor Allan Sloan makes the point in the Washington Post, with a focus on Treasury bonds:

If you put $1,000 into the S&P 500, 10-year Treasurys and 30-year Treasurys at the start of last year, you ended up with about $630, $1,230 and $1,450, respectively. The advantage: a stunning 60 percentage points over stocks for 10-year Treasurys, an even more stunning 82 points for the 30s.

But if you didn't adjust your portfolio at the beginning of this year, you've given a batch of that gain back.... 10-year Treasurys have given back 30 percent of their gains from last year relative to the S&P stocks and 30-year Treasurys have given back about 45 percent....

What makes a lot of money one year can lose a lot the following year. Within the past decade, we've seen various red-hot investments turn ice cold almost overnight: tech stocks, telecom stocks, commodities and, of course, houses. Now, long-term Treasurys.

How to protect yourself? Diversification and selling discipline.

Posted by Joseph at 1:19 PM | Comments (0)
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Forecasting follies

Joseph's post from Friday linked to an editorial I wrote a few years back. In it, I said:

A certain humility is in order concerning one's ability to profit (and help others profit) from correctly anticipating coming economic events. Unfortunately, this does not seem to have occurred to the publishers of the leading financial magazines. The bold headlines, which claim the ability to know what's going to be best for you in the coming months, virtually shout from the covers. For example, Kiplinger's January cover promised to explain "where to put your money now" along with "eight stocks to buy today."

This is potentially harmful stuff. It incorrectly conveys a sense of predictability concerning the economy and markets, and downplays the reality of risk. As we have documented previously, financial magazines have a mediocre track record when it comes to their specific investment recommendations. Compounding the damage, they rarely revisit their recommendations and announce when it may be time to sell.

This reminded me of a regular feature of SMI during our first decade. "False Prophets" was a column wherein I would take an occasional look, with the benefit of hindsight, at how various magazines' recommendations fared. I would examine the track records of Forbes, Money, Consumer Reports, and others. Invariably, their recommendations trailed the market.

I guess I stopped running the articles because I assumed everyone got the point — don't rely on financial magazines for portfolio recommendations. But we have thousands of new readers since those days, and perhaps many of the new ones don't understand the poor history of the magazines' forecasts.

So, for old times sake, I dug out the 2006 Kiplinger's that I had quoted from to see how their stock picks had done that year. Keep in mind, here is what Kiplinger's said at the time:

Stocks to Own in 2006
Look for these eight companies to deliver great returns for investors.
Our picks are riding the improved economy.

As a group, the eight stocks returned +8.9% in 2006. That compared rather unfavorably to the +15.9% return for the overall market. Three of them lost money. Discovering this was not in the least surprising. Based on my previous experience checking into these kinds of forecasts, I would have been shocked if they had, as a group, beaten the market.

As I pointed out in the editorial: If it's your desire to have confidence in managing your finances rather than relying on the guesswork of others, ask God to help you learn the essential basics you need in order to become a faithful and effective steward.

Posted by Austin at 10:15 AM | Comments (0)
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How your brain processes investment advice

Our January 2009 cover story, "How to Avoid Panic and Reduce Fear," reported on recent research in the field of neuroeconomics. That research suggested that "[i]nvestors are biologically induced into short-term thinking by the stress hormones released during episodes of acute fear. Fear has the effect of inducing concrete short-term thinking with poor flexibility in judgment."

Now, researchers at Atlanta's Emory University (School of Medicine and Department of Economics) say getting financial advice appears to suppress areas of the brain responsible for making value judgments. In other words, people tend to simply accept financial advice and act on it without weighing that advice carefully in the context of their own situation and goals.

The research is published in the March issue of PLoS One (from the Public Library of Science) in an article titled, "Expert Financial Advice Neurobiologically 'Offloads' Financial Decision-Making Under Risk."

Here is a summary from an Emory news release:

Study participants were asked to make a series of financial choices...while undergoing fMRI scanning. During portions of the testing, the participants had to make decisions on their own; during other portions, they received advice from a financial expert about which choice to make.

"Results showed that brain regions consistent with decision-making were active in participants when making choices on their own; however, there occurred an offloading of the decision-making process in the presence of expert advice," says Jan B. Engelmann, PhD, Emory research fellow in the Department of Psychiatry and Behavioral Sciences....

"This study indicates that the brain relinquishes responsibility when a trusted authority provides expertise," says [Gregory Berns, professor of neuroeconomics and psychiatry at Emory University School of Medicine]. "The problem with this tendency is that it can work to a person's detriment if the trusted source turns out to be incompetent or corrupt."

The research appears to underscore a point Austin makes in the first chapter of The Sound Mind Investing Handbook (excerpt here):

Most people have only vague notions as to what their long-term investments goals are. As a result, they move through life as responders, deciding on a case-by-case basis whether to say yes to the various investment opportunities that randomly come to their attention....

Because they're not quite sure where they're going, they tend to watch the crowd to see where it's going. They begin listening for the hot tips, taking the gurus seriously, and putting too many eggs in the same basket....

To find peace of mind in your investment decisions, you need to become an initiator rather than a responder. Initiators have a concrete game plan in mind. They have made the effort to develop a strategy that specifically takes into account their long-term financial goals as well as their own personal investment temperament.

At SMI, our purpose is not to make decisions for you. Our purpose is to supply you with information that will help you make decisions for yourself, so you can be a "good and faithful steward" of the Lord's resources.

So when you get advice from us, keep your brain in gear! Weigh that counsel. Pray over it. See if it fits with your priorities and your temperament. Then act with the confidence that comes from knowing you have a long-term, God-honoring plan.

Jason Zwieg, author of our February 2008 cover article, "The High Cost of Fear," has more on the Emory research here.

Posted by Joseph at 4:03 PM | Comments (0)
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Battle plan for reinvestment

I see some familiar thoughts expressed in this interview with Jeremy Grantham:

Grantham recommends that each of us devise a detailed plan now of when we will put new money into the stock market: "You absolutely must have a battle plan for reinvestment and stick to it."

A corollary of this recommendation is that we accept that we won't catch the exact day of the bottom. Perfection is the enemy of the good here, since the pursuit of perfection actually is a "snare and a delusion: it will merely serve to increase your paralysis.

One of the biggest concerns I had in writing this month's cover article is that it might lead some readers to act defensively here (i.e., sell stocks), only to then have them stay fearfully on the sidelines until stock prices were much higher at some point in the future. While it may feel good to reduce your stock market exposure during a bear market, you obviously aren't being well served by selling at Dow 7,500 and buying back in at Dow 9,000.

That's why I tried to emphasize that anyone doing any selling this late in the bear market should establish up front a trigger for getting back into the market. The all-clear signal is a good tool, but slow. It's probably more appropriate for those who reduced their stock allocations way back in January 2008 when the bear-alert was triggered.

For those making adjustments now, a better approach is probably to draw a "line in the sand." The line in the sand approach is to simply pick some level around the point at which you sell that will force you back into stocks. For example, if you sell at Dow 7,500 you might resolve to buy back in if the market should move above Dow 8,000. (You could simply draw your line at the level at which you sell, except that a quick move above that point could whipsaw you into buying immediately after selling. So it's probably smart to build in a margin of at least a few percent to avoid that.)

Anyone who reduced stock exposure earlier in this bear market should also be going through mental exercise of determining what will cause you to get back into stocks. You may have made a brilliant move by getting out a year ago, but you need to follow that up with an intelligent decision of when to re-enter.

I'm not oblivious to the recent market conditions, and I recognize that most readers probably aren't inclined to take defensive actions fresh on the heels of a 20% spike in stock prices. Nor am I encouraging them to! Truth be told, my preference for the cover article would have been to just write "Hold on, you're probably better off not selling anything this late in the bear market." But that would have ignored the fact that just three short weeks ago, many investors were throwing in the towel. It's not a stretch to think that a couple of weeks of sharp losses would bring many investors right back to that point.

So, if you were one of those who, just a few weeks ago, were seriously questioning whether you should sell some of your stock holdings, you need to take advantage of the oxygen provided by the recent gains. Those gains help give you the ability to think more clearly and rationally about what your best approach will be IF this turns out to be a bear market rally and things start heading south again. If you think through the mental exercise now while your head is unclouded by fear, you'll probably make a better decision than if you wait until the market is retesting the early-March lows.

Of course, we can all relax if the market keeps going up, up, and away. But better to be prepared and not need that contingency plan than to need it and not have it.

Posted by Mark at 2:04 PM | Comments (0)
Category(s): Current Market Events, Investing Principles

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Two big risks

Sorry to be absent here this week. I've been rocked by the flu, and only today started to feel human again. But I'm guessing I'm not the only one feeling a touch of nausea this evening.

The stock market devastation of the past 17 months (particularly since last September) has reached beyond what most people ever imagined. To erase 12 years worth of gains, 56% of the value of the S&P 500, has been staggering. Worse, there's no obvious reason for the slide to stop now.

In every bear market, there are two main risks. Unfortunately, to a large degree, protecting against them is a mutually exclusive situation — you can guard against one or the other, but it's difficult to guard well against both at the same time.

The way most bear markets play out goes like this. The market falls substantially (~30% on average) over a period of 15 months or so, but it rarely does so in a straight line. Instead, the market tends to have several drops of 10-20%, with significant rallies in between. Those rallies keep hope alive as the months pass, until the pain finally becomes too great. Then, in a final selling climax, investors throw in the towel en masse and a bottom is made. Needless to say, this final selling takes place after many months of losses, but before investors have any reason to believe conditions are going to improve.

This is by far the most common bear market scenario and it brings us to our first main risk: selling near bear market bottoms. This is classic investor behavior and is largely responsible for the fact that small investors have earned roughly one-third as much as the market as a whole in recent decades (see Dalbar survey). It's completely natural, completely destructive, and it's how virtually every bear market plays out.

Because this risk is far and away the most common, yet incredibly hard to avoid despite that fact, it's the risk we at SMI have spent almost all of our effort trying to defend against. The 2000-2002 bear market was classic in this sense, and readers who were able to resist the urge to sell near the bottom looked good (at least until the past few months, but realistically even those who sold at the bottom of 2002 were likely back into the market by 2007).

The second risk is probably obvious: there's always a chance that the current bear market is going to develop into something truly devastating. Make no mistake, nearly every bear market appears to carry this potential at the time. Even the market shocks that never develop into full-blown bear markets often look as serious as a heart-attack. Consider these "end of the world" scenarios we've faced just in recent years.

• In 1997, the world faced the "Asian Contagion" which raised fears of a worldwide economic collapse.
• A year later, in 1998, the Russian debt crisis triggered the collapse of Long-Term Capital Management, a situation so serious that the Fed and big investment banks felt they had to bail them out to avoid the whole financial system potentially collapsing (hmm...sounds familiar).
• Throughout 1999, many people stockpiled basic living supplies (and pulled all their money out of the stock market) in anticipation of the Y2K crisis. It's easy to shrug off now, but at the time there were many serious and credible experts floating predictions of utter doom and ruin when the world's computers stopped functioning properly all at once.
• In 2001, 18 months into a nasty bear market and with the economy still teetering on the verge of recession, terrorists struck us here at home. Many experts went on record shortly thereafter predicting that terrorists would strike another U.S. city with some sort of biological or nuclear attack at some point over the next few years. Thankfully that hasn't happened and we pray it never will.

In each of these cases, it was completely reasonable to believe the dire warnings and expectations of doom. Yet none of those scenarios were responsible for the problems the market and economy faces today.

In truth, the really devastating bear markets and economic collapses come along so infrequently that they're extremely hard to prepare for. We had one in the 1930s obviously. Before that, you'd probably have to go back to 1873 to find anything comparable. Before that, 1837.

This is already getting long, so I'll try to wrap it up. Obviously in hindsight, we all wish we'd paid more attention to things like the bear alert indicator that would have allowed us to side-step this carnage. Unfortunately, we can't go back and undo those decisions.

So at this point, with the market down some 56%, 17 months into this bear market, the truly relevant question is this. Is today a replay of the Great Depression, 1873, or 1837? It can't be totally ruled out. And if it's true, there would potentially be some benefit in making defensive moves even at this late date.

But we also have to put today's situation into context. Many people expect some sort of replay of the 1970s as this financial crisis winds down, with lingering economic weakness and robust inflation ahead. If that were the outcome, should we be pulling money out of stocks now? Probably not with them down this far already. The 1970s weren't any fun economically, but if 1973-74 winds up being the parallel, you'd want to be invested with stocks already down 56% from their peak. (The same is true of virtually every other recession or bear market in US history, with the exception of the few mentioned above.)

It's easy to look at the current situation and see the catastrophe outcome. It's more difficult to imagine we're near the tail-end of a severe-but-not-historically-devastating bear market. Again, is today's economy about to develop into one of the worst in the past 200 years, with all that entails? In that context, it's easier to concede there's at least a decent chance that it's not.

So even here at this relatively late date, we're back to the two primary risks of bear markets. Do you protect primarily against being a seller near this potential bear market bottom? Or do you accept that risk and make changes now to protect against "the big one?"

The handful of modest steps we've suggested lately — making small changes to your stock/bond allocation, using SMIVX for some (perhaps more) of your Upgrading money — these are ways to hedge a little against the big one, without being undone by the more common risk that this won't turn into an utter disaster of Great Depression proportions.

We don't know how this will play out. I wish we could tell you, I really do. All we can do is outline the risks as we see them and let you decide what to do with that information. I will say that Austin and I are not selling here. We're not raging bulls here either. We just don't see the risk/reward benefit — at this late date and with the losses we've already absorbed — favoring being a seller here.

Posted by Mark at 8:12 AM | Comments (0)
Category(s): Investing Principles

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Investing is boring...and that's okay

Was catching up on some reading over the holidays and came across a great interview with Charles Schwab in the October issue of Portfolio magazine. If you've got a few minutes, I definitely recommend it.

Among the issues he tackles:

• Why it's smart to invest during a bear market.
• Why nobody knows when we've hit the bottom.
• Why our savings rate is a national emergency.

Plus lots more.

Posted by Mark at 4:34 PM | Comments (0)
Category(s): Investing Principles

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