One of my New Year's resolutions is to lose some weight. So I started a strict diet on January 1st. I go to Dunkin' Donuts each morning and eat four jelly-filled doughnuts for breakfast. Mid-morning, I stop by Starbucks and get a Vanilla Crème Frappuccino. By lunch time, I'm really hungry so I go to McDonald's and get two Big Macs, a super-sized order of fries, and a large Coke. This will usually hold me over until dinner, when I go to see the Colonel and get a bucket of extra crispy fried chicken. And then I'll top it off with a stop at Cold Stone Creamery, and get Founder's Favorite ice cream.

To my surprise, I recently learned the above food purveyors don't care if I gain weight by eating at their establishments. In fact, they're more interested in me spending money than hitting my weight goal.

...Of course, I really don't eat like this. I used the fast food industry as a metaphor for so much of what passes for investment advice published by the financial tabloids. While McDonald's does have healthy salads and Cold Stone has sinless ice cream and non-fat smoothies, both of these businesses are primarily concerned with making a profit, not producing low-fat, nutritious meals. And the financial media is no different.

What financial magazine editors and television producers try to do is produce a product that people want to buy. That's why you see so many magazine covers with fund managers who have great investment records. Reading about hot funds, stocks, or sectors has never worked for investors trying to make money though, but it is a great way to sell magazines to those who aren't savvy about financial matters.

Just like a dieter cannot count on a fast food restauranteur to help them meet their goals, an investor cannot count on the financial tabloids to make them wealthy. The restauranteur and publisher have different objectives in mind when it comes to dieters and investors, and they're typically contrary to what is healthy for you, physically and financially, whatever the case may be.

Empirically based, naked strategies are created to achieve a financial objective and are not influenced by circulation, advertising, or fashion.

Full disclosure: I do own two Cold Stone Creameries. You can get a delicious, low-fat shake that I call the "Bob Special" at Cold Stone if you ask the crew members to mix sinless ice cream with milk and strawberries in a blender. Have them throw in a little chocolate malt too if you like...

Labels: investment choices, investment diet

According to The Wall Street Journal, the CGM Focus Fund was the best performing mutual fund in the last decade. In a time when the Standard and Poor's 500 lost money, the CGM Focus Fund turned in a stellar return, averaging 18% per year. So why did most of the fund's shareholders lose money?

The problem is a matter of timing. The fund produced an amazing return of 80% in 2007. The financial media went wild. Fortune magazine called fund manager Ken Heebner America's hottest investor . His picture adorned the cover of Kiplinger's Personnel Finance magazine. Investor's Business Daily crowed about the fund's stellar performance as well. Yet, The Wall Street Journal said the fund sucked in almost three billion dollars in new assets in 2008, but then proceeded to produce a disastrous return, losing nearly half its value.

Page 72 of The Naked Portfolio Manager talks about the difference between time-weighted returns and dollar-weighted returns. When a fund is as volatile as the CFM Fund is, it can produce eye-popping, time-weighted returns in excess of 18% per year while still losing money for its average shareholder.

This is yet another example of the availability error discussed on pages 38 and 39 of The Naked Portfolio Manager. My new e-book, available for download now, discusses an allocation strategy that might prove helpful if you're thinking about investing in funds that have this type of volatility.

Labels: CGM Focus, Fortune Magazine, Kiplingers

With this blog, I have emphasized over and over again that by ignoring the stock market forecasters and prognosticators and simply following a set of empirically based rules in a disciplined manner, you can meaningfully improve your investment results. Here's an experiment you can do with your own computer to see the results of naked strategies for yourself.

One very simple thing you can do to enhance your return is rebalance your portfolio at regularly scheduled intervals. To test this, select up to ten stocks and then select a time period to test. Go to Google Finance Historical Stock Prices and download excel spreadsheets with the historical stock prices and the time period you have chosen. Then you can copy and past those historical prices into this spreadsheet that Professor Tom Scott of Sweet Briar College (I'm helping guide his "Principles of Investing" class apply rules-based investing strategies) was kind enough to share with us.

The spreadsheet compares the difference in return between a buy-and-hold portfolio with no rebalancing and a portfolio that is rebalanced at regularly scheduled intervals. You can download weekly data, monthly data, or yearly data and enter it into the spreadsheet. The calculation assumes that you rebalance your portfolio back to an equal weighting for each security at the end of each time period.

In most cases, you'll find that the rebalanced portfolio does better than the buy-and-hold. Depending on the volatility of the stocks you select, the difference can in some cases be 2% or more per year.

Now stop and think about this. We're comparing two strategies for investing for the exact same stocks. Yet one strategy results in meaningful differences in return. How is that?

Stocks are constantly oscillating on a range. When you rebalance, what happens is you sell stocks that are trading in the high part of the range and buy stocks that are in the low part of their range.

Now remember, no strategy works all the time for all stocks. It's possible to find time periods and stocks where systematic rebalancing does not produce better results than the buy-and-hold. And you of course need to consider the effects of taxes and trading costs. But if you do this experiment enough times, I think you'll agree that over time, you can add significant value by rebalancing at regularly scheduled intervals in a disciplined manner.

Labels: Sweet Briar

I think I set Wintergreen's record for the fastest time to becoming a homeowner this year.

I first visited the green and white slopes of Wintergreen on December 31st when my friend Patrick Morin invited me to a New Year's Eve Party there. I met some really great people and pretty much fell in love with the place.

The next weekend, I brought my whole family up to the mountain for a visit. While my oldest children snowboarded, I watched my six-year-old - on skis for the first time - ski circles around me. When I suggested we might buy a townhouse at Wintergreen, my thirteen-year-old son exclaimed that was "the best idea I ever had"!

The next weekend I met with real estate agent Brian Chase, and after being assured we were at the absolute bottom of the real estate market, I made an offer on a lovely home in Trillium. If all goes well, we close on Thursday of this week.

As the newest Wintergreen homeowner, long time resident and race team booster Janice Smeallie invited me to a party this weekend, which includes a silent auction to benefit the Wintergreen Alpine Race Team. The team has a supportive group of parents behind them who raise funds to help pay for the young athletes' training and coaching. The team competes against others in the Southern Alpine Racing Association. To show my appreciation for the invite and to support the community, I decided to donate two autographed copies of The Naked Portfolio Manager and to take the winning bidders to The Tobacco Company for an illuminating discussion of rules-based investing. A complete list of items that are going to be auctioned will be available here this Thursday, so check back then and make a bid. Go Wintergreen Racing!

Labels: Wintgreen

Professor Tom Scott of Sweet Briar College has compiled the results for the first month of our test.

If you will recall, the students in Professor Scott's "Principles of Investing" class created five "naked strategies" or rules-based methods and produced a portfolio based on empirical research. Each of these models is purely mechanical. There's no human judgment involved. You simply apply the rules to determine the stocks in each portfolio.

Obviously, we cannot draw conclusions after just one month, but according to Professor Scott, four of the models did indeed outperform the S&P 500, and only one trailed the Index in the first month. By the end of the year, we'll have a total of 60 data points (five models and twelve months) and may be able to draw some inferences based on the results.

You can go to Professor Scott's website and see the results for yourself for month #1. You'll also see the stocks the students' models identified for February.

Sign up for email alerts to my blog so you won't miss out on future updates on the Sweet Briar experiment!

Labels: Sweet Briar

Paul Meehl, who died in 2003, was a brilliant psychologist who wrote what is probably the most significant work on decision-making published in the last century. His short treatise, Clinical Versus Statistical Prediction, is still read and referenced today more than fifty years since it was written in 1954.

In what he would later call "my disturbing little book," Meehl advanced the theory that experts would make more reliable predictions if they used their expertise to construct models to make the decisions for them. Meehl felt that experts, because they were human, were inconsistent in the application of their expertise when it came to making decisions based on judgment. By contrast, a mechanical model would make the same decision for the same set of data each time and thus be more reliable.

During his lifetime, almost two hundred studies validated his theory that a defined set of rules - what we call naked strategies - would make more accurate predictions than the judgment of experts.

So why has Wall Street continued to ignore this important work? Money is one reason. After all, if a portfolio manager who is earning $5,000,000 per year can be replaced with a model, what justification is there for high management fees? Ego may be the second reason. What portfolio manager wants to believe he or she can be replaced by a relatively simple rules-based model?

If Meehl was right in his theory, then investors who use judgment-based portfolio managers may be paying a premium for mediocrity.

Don't expect Wall Street to change course any time soon though. As investing sage John Bogle says, if you pay a man a tremendous amount of money not to understand something, it is amazing how difficult it will be for him to learn it.

Labels: Bogle, Meehl

My mom makes great spaghetti sauce from scratch. She uses fresh Roma tomatoes, imported virgin olive oil, fresh garlic, parsley, and oregano - when she has the time. When she doesn't have time to make from scratch, she does what most mothers do: she buys sauce from the store.

Howard Moskowitz is a Harvard-educated scientist who made food-testing history twenty years ago for his then radical opinions about how to sell spaghetti sauce. In 1986 he was hired by the Campbell Soup company to develop new recipes for their Prego spaghetti sauce. Moskowitz developed empirical models that analyzed such inputs as spiciness, sweetness, tartness, thickness, and "mouth feel" to determine the best spaghetti sauce ingredients. He found that spaghetti sauce consumers fall into three categories: those that like plain sauce, those that like spicy sauce, and those that like chunky sauce. Prego brought chunky sauce to the marketplace, an innovation back in the mid-eighties, and promptly took huge market share from Ragu. And Moskowitz made food history for his research.

Moskowitz helped set the stage for the spaghetti sauce wars because he used empirical data and statistical prediction - better known to readers of this blog as "naked strategies" - to predict what type of consumer would like which sauce best.

Back to my mom. . . While she sometimes buys Prego, she feels compelled to alter it before serving. She'll add olive oil, grated cheese, sugar, or whatever "is needed" to improve the store-bought stuff. When she does this, she makes the sauce "hers," although she never feels it's as good as it would be if she had made it from scratch. But, by adding her own ingredients, she feels that at least she's making it better.

. . .I doubt if adding any of the extra ingredients actually makes the sauce score any higher on Mr. Moskowitz's statistical models though. After all, these sauces are optimized to hit the target palates. And here's my point: many people take well-developed statistical prediction models - developed for security selection and that have been carefully constructed - and make them theirs by second-guessing the results. In doing so they hardly ever improve the results.
Leading investment strategist Richard Cripps, who has spend years developing and testing a statistical model for security selection, tells me every time he shows the model to a security analyst, they say: "Wow, this is great. Now this is how by interjecting my judgment I can make it better."

Seems like Italian moms and security analysts need more convincing about why "naked strategies" are just fine for security selection or spaghetti sauce.